WHOLLY OWNED SUBSIDIARIES: POSTCREATION PERIODS

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CHAPTER 2

• WHOLLY OWNED SUBSIDIARIES POSTCREATION PERIODS

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FOCUS OF CHAPTER 2

• Ways to Value the Parents Investment
• Account in POSTCREATION Periods
• Cost Method vs. Equity Method Driven
  Consolidation Procedures
• Income Statements
• Statements of Retained Earnings
• Parent-Company-Only (PCO) Statements
• Articulation with Consolidated Statements

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The Cost MethodHow It Works

• It is cash basis driven
• Record income at the parent level ONLY when sub
  declares a dividend.
• Ignore subs earnings.
• Do NOT ignore subs losses.
• Write-down investment ONLY IF valuehas been
  impaired.
• Write-downs result in a NEW cost basis.

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The Cost Method How It Works (cont.)

• It is a one-way street!The investment can be
  written down--but NEVER written up.

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The Cost Method Pros Cons

• Pros
• Minimal G/L bookkeeping by parent.
• Simple consolidation procedures.
• Cons
• Overly conservative valuation.
• Parent can manipulate its reported income.
• PCO statements--if used internally or issued--may
  be of limited value.

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The Cost Method MAJOR Point of Interest

• Although the parent CANmanipulate its
  OWNreported net income,it can NEVER manipulate
  CONSOLIDATED net income.

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The Equity MethodHow It Works

• It is accrual basis driven
• Record income at the parent level based on subs
  earnings and losses--an AUTOMATIC VALUATION
  TECHNIQUE.
• Subs dividends reduce the parents investment
  (the parent has less invested).

autopilot
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The Equity Method How It Works (cont.)

• It is a two-way street!The investment can
  be(1) written up AND(2) written down.

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The Equity MethodPros and Cons

• Pros
• Based on economic activity--not the
  parent-controlled dividend policy.
• Has 2 built-in checking figures.
• Cons
• Entails continual bookkeeping.
• Unnecessary work if PCO statementsare not used
  internally or issued to outsiders.

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The Equity Method MAJOR Point of Interest

• Compared with the cost method, the consolidation
  entry under the equity method has a new kid on
  the block.
• A posting must be made to eliminate the
  subsidiarys beginning retained earnings.

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The Cost Method Things to Remember in
Consolidation

• Consolidated NET INCOME does NOT equal the
  parents NET INCOME.
• Consolidated RETAINED EARNINGSdoes NOT equal
  the parents RETAINED EARNINGS.

P S Subs Divies
CON. 54,000 24,000 - 4,000
74,000
P S
CON. 103,000 20,000 123,000
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The Cost Method Things to Remember in
Consolidation

• NONE of the subs beginning or ending RETAINED
  EARNINGS is eliminated in consolidation.
• ONLY the parents DIVIDENDS arereported in the
  consolidated column.

P S CON.
54,000 20,000 74,000
P S Subs Divies
CON. (51,000) (4,000) - 4,000
(51,000)
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The Equity Method Things to Remember in
Consolidation

• Consolidated net income EQUALSthe parents net
  income.
• Consolidated retained earnings EQUALSthe
  parents retained earnings.

P CON. 74,000 74,000
P CON. 123,000
123,000
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The Equity Method Things to Remember in
Consolidation

• ALL of subs beginning ending RETAINED
  EARNINGS are eliminated in consolidation.
• ONLY the parents DIVIDENDS arereported in the
  consolidated column(also occurs under the cost
  method).

P S Subs
R.E. CON. 123,000 20,000 -
20,000 123,000
P S Subs Divies
CON. (51,000) (4,000) - 4,000
(51,000)
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PCO Statements Presented in Notes to the
Consolidated Statements

• PCO statements are mandatory for publicly owned
  banks and SLs (SEC rules).
• Can ONLY use the equity method.
• Equity method results in 100articulation
  between PCO statementsand consolidated
  statements
• SAME net income amounts.
• SAME retained earnings amounts.

Bank of USA
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PCO Statements Presented in Notes to the
Consolidated Statements

• Retained Earnings Available for Dividends
• Based on the parents G/L amount--NOT on the
  consolidated retained earnings amount.
• Use of the equity method in PCO statements
  produces IDENTICALretained earnings amounts.
• Use of the cost method in PCO statements creates
  CONFUSION.

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Consolidation The Most Important Point of All
on Investment Basis

• The consolidated statement amounts are identical
  whether the parent usesthe cost method or the
  equity method--this holds true for ALL 3
  statements.

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Total Investment Loss Situations Equity Method
Procedures

• Parent Has GUARANTEED Subs Debt
• NO interruption occurs in the application of the
  equity method.
• Parent can lose more than it has invested
  --parent ison the hook.

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Total Investment Loss Situations Equity Method
Procedures (cont.)

• Parent Has NOT GUARANTEED Subs Debt
• Discontinue equity method when subs equity
  reaches zero--resume ONLY WHEN subs equity
  becomes positive.
• Parent can NEVER lose more than it has invested.

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AROI Versus IRR They Serve Entirely Different
Purposes

• Annual Return on Investment (AROI)
• Tells what was actually earned onan investment
  EACH year.
• Based on actual GAAP net income.
• Can be used to calculate an average AROI covering
  several years.

1 2 3
AVG. 18 12 15 45
45/3 15
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AROI Versus IRR They Serve Entirely Different
Purposes

• Internal Rate of Return (IRR)
• An assumed rate covering SEVERAL years.
• Based on cash flows for those years.
• CANNOT show what was actually earnedin any GIVEN
  year.
• Artificially assumes that each years unrecovered
  investment (at B-O-Y) earns the SAME rate.

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AROI vs. IRR They Serve Entirely Different
Purposes
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Review Question 1

• Under the COST METHOD, a subs DIVIDENDS
  wouldA. NOT be eliminated in consolidation.
  B. Be the parents investment income. C.
  Reduce the parents investment. D. Increase
  the parents investment. E. None of the above.

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Review Question 1--With Answer

• Under the COST METHOD, a subs DIVIDENDS
  wouldA. NOT be eliminated in consolidation.
  B. Be the parents investment income. C.
  Reduce the parents investment. D. Increase
  the parents investment. E. None of the above.

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Review Question 2

• Under the COST METHOD, a subs LOSSES wouldA.
  Never reduce the parents income. B. Always
  reduce the parents income. C. Always reduce
  the parents investment. D. Always be
  eliminated in consolidation. E. None of the
  above.

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Review Question 2--With Answer

• Under the COST METHOD, a subs LOSSES wouldA.
  Never reduce the parents income. B. Always
  reduce the parents income. C. Always reduce
  the parents investment. D. Always be
  eliminated in consolidation. E. None of the
  above.

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Review Question 3

• Under the EQUITY METHOD, a subs DIVIDENDS
  wouldA. NOT be eliminated in consolidation.
  B. Be the parents investment income. C.
  Reduce the parents investment. D. Increase
  the parents investment. E. None of the above.

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Review Question 3--With Answer

• Under the EQUITY METHOD, a subs DIVIDENDS
  wouldA. NOT be eliminated in consolidation.
  B. Be the parents investment income. C.
  Reduce the parents investment. D. Increase
  the parents investment. E. None of the above.

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Review Question 4

• Under the EQUITY METHOD, a subs LOSSES
  wouldA. Never reduce the parents income.
  B. Normally reduce the parents income. C.
  Always reduce the parents investment. D.
  Always be eliminated in consolidation. E. None
  of the above.

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Review Question 4--With Answer

• Under the EQUITY METHOD, a subs LOSSES
  wouldA. Never reduce the parents income.
  B. Normally reduce the parents income. C.
  Always reduce the parents investment. D.
  Always be eliminated in consolidation. E. None
  of the above.

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Review Question 5

• On 1/1/04, Paxco invested 500,000 in Saxco
  (100-owned). For 2004, Saxco (1) earned
  70,000, (2) declared dividends of 40,000, and
  (3) paid dividends of 30,000. What amounts does
  Paxco report?
  Cost EquityInvestment
  income for 2004.....
  Investment in Saxco at Y/E......Retained
  earnings increase.......

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Review Question 5--With Answer

• On 1/1/04, Paxco invested 500,000 in Saxco
  (100-owned). For 2004, Saxco (1) earned
  70,000, (2) declared dividends of 40,000, and
  (3) paid dividends of 30,000. What amounts does
  Paxco report?
  Cost EquityInvestment
  income for 2004..... Investment in Saxco at
  Y/E......Retained earnings increase.......

40,000 70,000
500,000 530,000
40,000 70,000
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Review Question 6

• A parent can lose MORE THAN than it has
  investedA. Only under the cost method. B.
  Only under the equity method. C. Under either
  the cost or equity methods. D. Only if the
  subsidiary is not consolidated. E. None of the
  above.

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Review Question 6--With Answer

• A parent can lose MORE THAN than it has
  investedA. Only under the cost method. B.
  Only under the equity method. C. Under either
  the cost or equity methods. D. Only if the
  subsidiary is not consolidated. E. None of the
  above.

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Review Question 7

• Parent-company-only (PCO) statements are usually
  presented in notes only whenA. The parent
  uses the cost method. B. The parent uses the
  equity method. C. The subsidiary is not
  consolidated. D. The SECs rules require them.
  E. None of the above.

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Review Question 7--With Answer

• Parent-company-only (PCO) statements are usually
  presented in notes only whenA. The parent
  uses the cost method. B. The parent uses the
  equity method. C. The subsidiary is not
  consolidated. D. The SECs rules require them.
  E. None of the above.

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Review Question 8

• When a parent-sub relationship exists, STATE LAWS
  require dividends to be based on theA.
  Parents retained earnings. B. Subs retained
  earnings. C. Consolidated retained earnings.
  D. The lower of the parents OR the
  consolidated retained earnings. E. None of
  the above.

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Review Question 8--With Answer

• When a parent-sub relationship exists, STATE LAWS
  require dividends to be based on theA.
  Parents retained earnings. B. Subs retained
  earnings. C. Consolidated retained earnings.
  D. The lower of the parents OR the
  consolidated retained earnings. E. None of
  the above.

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End of Chapter 2

• Time to Clear Things Up--Any Questions?