Question

mergers & Acquisitions

1. what do we mean by passive investment? What are the impacts of passive investments on the balance sheet and the income statement?

2. Accounting for inter-corporate investment under the equity method, and the Equity method impact on the ROE.

3. the basic rules for consolidation, accounting for non-controlling interests (minority interests).

4. difference between fair value hedge vs. cash flow hedge and impact of each hedge on the income statement.

5. Accounting equity carve-out: sell-off, spin-off, and split-off.

its a multi part question its all under the same part they are all together

Answer 1

1)Passive investment income refers to an investment income that does not require gross receipts from royalties, rental income, dividends, interests and gains from the sale or exchange of securities. Any interest or rental income from ventures is excluded from the definition of passive investments because they are received from actively and regularly engaged business operations.

The following are some examples of passive investment income:

1. Earnings from a business that does not require direct involvement from the owner or merchant;
2. Rent from property;
3. Royalties from publishing a book or from licensing a patent or other form of intellectual property; and
4. Earnings from internet advertisements on websites.

2)Under the equity method, the investor begins as a baseline with the cost of its original investment in the investee, and then in subsequent periods recognizes its share of the profits or losses of the investee, both as adjustments to its original investment as noted on its balance sheet, and also in the investor’s income statement. The share of the investee’s profits that the investor recognizes is calculated based on the investor’s ownership percentage of the investee’s common stock. When calculating its share of the investee’s profits, the investor must also eliminate intra-entity profits and losses. Further, if the investee issues dividends to the investor, the investor should deduct the amount of these dividends from the carrying amount of its investment in the investee.

3)With consolidation, the parent company reports the financial results of the subsidiary on its own financial statements as if the subsidiary doesn't exist as a separate entity at all. In some corporate situations, it's possible to have a controlling interest in a company even with less than majority ownership. In small-business relationships, though, your company will typically have to own more than 50 percent of the other firm for consolidation to be required. Even when consolidation is necessary, you can still produce separate financial statements for the two companies for your own internal use. But those prepared for the outside world -- lenders, potential investors, government agencies and so on should be consolidated.

When consolidating financial statements, all of the subsidiary company's assets become assets on the parent company's balance sheet. Similarly, all of the subsidiary's liabilities go on the parent's balance sheet as liabilities. In most cases, the price the parent pays for a subsidiary will be greater than the value of the subsidiary's net assets, its assets minus its liabilities. When this is the case, the "extra" goes on the balance sheet as an intangible asset called "goodwill." For example, say you paid Rs.100000 for a company with assets valued at Rs. 220000 and Rs.130000 worth of liabilities. The company's net assets equal Rs. 90,000 so you'll put Rs.10000 worth of goodwill on the consolidated balance sheet.

When consolidating the equity section of the balance sheet as well as the statement of owners' equity (or stockholders' equity, in the case of corporations), the subsidiary's equity disappears. During consolidation, the subsidiary ceases to exist, at least for the purposes of the financial statements, so it has no equity. However, if the subsidiary has minority owners -- that is, if the parent bought less than 100 percent of the subsidiary -- then their interest in the subsidiary must appear in equity. Say you pay Rs.100000 for 80 percent of a company with Rs.90000 in net assets. You'd add all the assets and liabilities to your balance sheet (including Rs.10000 in goodwill). In the equity section, and on the equity statement, you'd create an entry for "minority interest" or "non-controlling interest" with a value of Rs.18000 -- the 20 percent of the Rs.90000 in net assets that you don't actually own.

4)Fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.

5)SPIN-OFF

In a spin-off, the parent company distributes shares of the subsidiary that is being spun-off to its existing shareholders on a pro rata basis, in the form of a special dividend. The parent company typically receives no cash consideration for the spin-off. Existing shareholders benefit by now holding shares of two separate companies after the spin-off instead of one. The spin-off is a distinct entity from the parent company and has its own management. The parent company may spin off 100 percent of the shares in its subsidiary, or it may spin off 80 percent to its shareholders and hold a minority interest of less than 20 percent in the subsidiary.

SPLIT-OFF

In a split-off, shareholders in the parent company are offered shares in a subsidiary, but the catch is they have to choose between holding shares of the subsidiary or the parent company. A shareholder has two choices: (a) continue holding shares in the parent company or (b) exchange some or all of the shares held in the parent company for shares in the subsidiary. Because shareholders in the parent company can choose whether or not to participate in the split-off, distribution of the subsidiary shares is not pro rata as it is in the case of a spin-off.

CARVE-OUT

In a carve-out, the parent company sells some or all of the shares in its subsidiary to the public through an initial public offering (IPO). Since shares are sold to the public, a carve-out also establishes a net set of shareholders in the subsidiary. A carve-out often precedes the full spin-off of the subsidiary to the parent company's shareholders. In order for such a future spin-off to be tax free, it has to satisfy the 80 percent control requirement, which means that not more than 20 percent of the subsidiary's stock can be offered in an IPO.