Question

Choose at least two concepts from the following: partnership, corporation, liquidation, bankruptcy chapter 7, bankruptcy chapter 11, reorganization, trust, estates, consolidation, parent company, subsidiary, acquisition, partnerships termination, variable interest entity, equity method, fair value method.

Required:

Explain how you may use them in your present or future accounting position. Make sure you provide details to include how each concept will help you support the financial goals of the company you currently work for or will work for in the future.

Answer 1

Equity method:

The equity method is an accounting technique used to assess the profits earned through investments in other companies. My company reports the income earned on the investment on its income statement, and the reported value is based on the my company’s share of the company assets. The reported profit is proportional to the size of the equity investment.

My company holds 20% of another company's stock, it has significant control, which signifies the power my company can exert over the other company. This power includes representation on the board of directors, partaking in policy development and the interchanging of managerial personnel. If the other company earns a net income of $1 million, my company reports earnings of 20% of it, i.e. $200000.

The initial investment is recorded at cost. That value is periodically adjusted to reflect the changes in value due to my company’s share in the other company’s income or losses.

Equity Method Earnings Adjustment

My company has a significant influence on the operating and financial results of another company, the investee, hence, it can directly affect the value of the investor's investment. If my company is holding above 20%, then I can record my share of the investee's earnings as revenue from investment, which increases the carrying value of my investment.

Equity Method Loss Adjustment

When the investee company reports a net loss, the investor company records its share of the loss as loss on investment, which decreases the carrying value of the investment.

Using the equity method, my company reports the carrying value of investment independent of any fair value change in the market. With a significant influence over another company's operating and financial policies, my investment value is based on changes in the value of that other company's net assets from operating and financial activities and the resulting performances, including earnings and losses.

Equity Method Dividend Adjustment

When the investee company pays a cash dividend, it decreases the value of its net assets. Using the equity method, my company records an increase its cash balance but, meanwhile, reports a decrease to the carrying value of investment.

Other financial activities that affect the value of the investee's net assets should have the same impact on the value of my share of investment. The equity method ensures proper reporting on the business situations for the investor and the investee, given the substantive economic relationship they have.

Consolidation

Preparing consolidated financial statements
A subsidiary is an entity that is controlled by another entity. An entity has control if it has the ability to direct the operating and financial policies of another with a view to gaining economic benefit. If an entity owns 100% of another entity, it will usually have control.

When preparing consolidated financial statements:

1. We are replacing the cost of the investment in the holding entity’s accounts with the fair value of the assets and liabilities of the subsidiary.
2. Goodwill is likely to arise on acquisition. Shares purchased at the market price may not reflect the fair value of the assets and liabilities of the subsidiary. Any difference between the amount paid and the value of the assets is goodwill.
3. There must be no double counting. All items that relate to transfers within the group must be eliminated on consolidation.

Pre-acquisition and post-acquisition reserves
When preparing consolidated financial statements it is important to distinguish between pre-acquisition reserves and post-acquisition reserves:

• Pre-acquisition reserves are retained profits and other reserves that exist in a subsidiary’s statement of financial position at the date of acquisition.
• Pre-acquisition reserves are capitalized at the date of acquisition by including in the goodwill calculation. They must not be included in the consolidated income statement or consolidated statement of financial position.

Profits/losses (including unrealized gains and losses) made after acquisition that are shown in the subsidiary reserves can be included in the consolidated statement of comprehensive income and in reserves in the consolidated statement of financial position.

Intra-group activities
The impact of any intra-group activities must be cancelled out in the consolidated financial statements.

1. Inter-entity trading. Sales and purchases figures need to be adjusted on the income statement to remove double counting of the sales. Any goods in closing inventory at the end of the year will include unrealized profit in the inventory value, this must be removed.
2. Current accounts should be reconciled, making adjustments for any items in transit and then cancelled out on consolidation.
3. Intra/inter-group dividends received are cancelled on consolidation against dividends paid.

Format: The same format can be used for consolidated financial statements.

Consolidated financial statement preparation - checklist

1. Percentage of investment in the other company’s stock and establish the status of the entity
2. Establish fair value of assets acquired and calculate net assets of the subsidiary
3. Calculate goodwill arising on acquisition
4. Adjust for any intra-group activities
5. Calculate balance carried forward on consolidated retained earnings
6. Calculate balance carried forward on consolidated reserves
7. Prepare consolidated financial statements, statement of financial position and/or consolidated statement of comprehensive income.