ACCOUNTING 2

STOCKHOLDERS EQUITY
STOCKHOLDERS EQUITY
Common Stock (outstanding)
11 - REPORTING AND INTERPRETING STOCKHOLDERS EQUITY Preferred Stock (outstanding)
BALANCE SHEET: Add Paid in par
Add Paid in no-par
TOT CONTRIBUTED
+ Retained earnings
TOT COTRIBUTED + EARNED
- Treasury stock
= TOT STOCKHOLDERS EQUITY
EARNED CAPITAL = Retained Earnings + OCI
(Other Comprehensive Income)

CONTRIBUTED CAPITAL = Common Stock + Add Paid In

—> money provided by investors in exchange for STOCKS

Treasury Stock —> CONTRA-EQUITY (+XSE)

2 MOMENTS FOR CONTRIBUTED CAPITAL:

1. CAPITAL CONTRIBUTED 2. CAPITAL IS RETURNED TO THE FIRM
(1) Initial Sale of Common Stock (Stock Issuance) (2) Repurchase of Common Stock
(3) Dividends on Common Stock
(4) Stock Dividends

ADVANTAGES OF CORPORATIONS = easy participation in ownership, compared to a sole proprietorship or partnership:

✓ Shares of stock may be purchased in small amounts
✓ Ownership interests can be transferred easily through the sale of shares on established markets
✓ Stock ownership provides investors with limited liability

OWNERSHIP OF A CORPORATION
Corporations enjoy a continuous existence separate and apart from its owners => A corporation can:
• Own assets
• Incur liabilities
• Sue others and be sued
• Expand and contract in size

BENEFITS OF COMMON STOCK OWNERSHIP

✓ A voice in management
✓ Dividends = proportional share of the distribution of profits
✓ Residual claim = proportional share of the distribution of remaining assets upon the liquidation of the company

TYPES OF SHARES
AUTHORIZED SHARES = maximum number of shares of stock a corporation can issue as specified in its charter
—> ISSUED SHARES = shares sold to investors
—> OUTSTANDING SHARES = owned by stockholders
—> TREASURY SHARES = issued but reacquired by the corporation
—> UNISSUED SHARES = shares that have never been sold

AUTHORIZED = ISSUED + UNISSUED = (OUTSTANDING + TREASURY) + UNISSUED

COMMON STOCK TRANSACTIONS

Common stock is held by investors who are the OWNERS of a corporation —> they have the right to:
‣ Vote
‣ Share in profits of the business
‣ Elect the board of directors who hire and monitor the executives who manage a company’s activities on a day-to-day basis

PAR VALUE ≠ MARKET VALUE

PAR VALUE = nominal value per share, established in the corporate charter (some states do not require to state it)
MARKET VALUE = price of the share on the market —> Cash invested / nr of shares issued

COMMON STOCK = the basic voting stock issued by a corporation

ADDITIONAL PAID IN CAPITAL = difference between PAR VALUE and PRICE of a stock
LEGAL CAPITAL = amount of capital that must remain invested in the business -> required by the State
1) INITIAL SALE OF STOCK
Assume IBM sold 100.000 shares of $0.20 par value common stock for $150 per share:

+ Cash = total received

+ Common stock = par value x nr of shares
+ Additional paid in capital = Cash - Common Stock

SALE OF STOCK IN SECONDARY MARKETS

‣ When a company sells stock to the public —> transaction is between corporation & investor
‣ After the initial sale, investors can sell shares to other investors without directly affecting the corporation => NO TRANSACTION

STOCK ISSUED FOR EMPLOYEE COMPENSATION => STOCK OPTIONS

Managers may be offered stock options = common form of compensation which permit them to buy stock at a fixed price
- Options specify that shares may be bought at the then-current market price
—> If the stock price increases, you can exercise your option at the low grant price and sell the stock at the higher price for a profit
—> If you hold a stock option and the stock price declines, you have lost nothing -> they are a risk-free investment
- Companies must estimate and report compensation expense associated with stock options
3 KEY STEPS:
GRANTING: employee gets the right to buy the stock at a given grant price - generally at discount
VESTING: time btw initial offer and when the option can be exercised
Stock vests
EXERCISING: options are exercised

2) REPURCHASE OF STOCK
A corporation repurchase its stock from existing stockholders for a number of reasons:
1. SUSTAIN THE PRICE of the stock in the market
-> in case of stock options, the company can give employees repurchased shares rather than issue new ones:
-> paying them with newly issued shares each period, would increase the number of shares in the market, which would decrease the
company’s stock price

2. AVOID DILUTION —> increasing the number of shares would dilute existing stockholders’ investments: each share of stock
owned would worth less

3. AVOID TAXES —> that incur when distributing cash

Stock that has been repurchased and is held by the issuing corporation is called TREASURY STOCK
=> Treasury shares have no voting, dividend or other stockholder right while they are held as treasury stock

• IBM reacquried 100.000 shares of its common stock when it was selling for $140 per share.

3) REISSUE OF TREASURY STOCK

• IBM reissued 10.000 shares of treasury stock at $150 per share.

—> nr shares x issue price

—> nr shares x repurchase price
—> difference

• IBM reissued 10.000 shares of treasury stock at $130 per share.

—> nr shares x issue price

—> difference
—> nr shares x repurchase price
 TREASURY STOCK = CONTRA-EQUITY ACCOUNT => NOT AN ASSET! —> do not generate Income

REPURCHASE OF STOCK
Treasury Stock (+XSE, -SE)
Cash (-A)

REISSUANCE OF STOCK AT HIGHER PRICE REISSUANCE OF STOCK AT LOWER PRICE

Cash (+A) Cash (+A)
Treasury stock (-XSE, +SE) Additional paid in capital (-SE)
Additional paid in capital (+SE) Treasury stock (-XSE, +SE)

WE DON’T RECORD A GAIN OR LOSS IN THE

INCOME STATEMENT BUT WE INCREASE OR
DECREASE THE ADDITIONAL PAID IN CAPITAL

When treasury stock is purchased with cash: on the BS: - Assets (- Cash: -A) & - Stockholders Equity (+Treasury Stock: +XSE, -SE)

Net Income
EARNINGS PER SHARE (EPS) = —> measures profitability => reported on Income Statement
Weighted Average Nr of
Common Shares Outstanding

RETURN FROM INVESTING = STOCK PRICE APPRECIATION + DIVIDENDS

—> Some investors prefer to buy stocks that pay little or no dividends:
‣ Companies that reinvest their earrings back in their operations tend to increase their future earnings potential and their stock price
‣ Wealth investors in high tax brackets prefer to receive their return in higher stock prices because capital gains may be taxed at a
lower rate than dividend income
—> Other investors, such as retired people who need a steady income, prefer to receive their return in dividends:
‣ Retirees seek stocks that will pay relatively high dividends, such as utility stocks

๏ CASH DIVIDENDS —> COMPANY DISTRIBUTES CASH

= value distribution to shareholders
—> Price drop when dividends are distributed - because it’s like you subtract value (capital) to the company
—> Higher tax rate - because they distribute earnings
—> Company has no legal obligations to distribute dividends before they are declared by the Board of Directors

=> DIVIDENDS are extracted from RETAINED EARNINGS:

ENDING RETAINED EARNINGS = BEGINNING RETAINED EARNINGS + NET INCOME - DIVIDENDS

DIVIDENDS = BEGINNING RETAINED EARNINGS + NET INCOME - ENDING RETAINED EARNINGS

DIVIDENDS ≤ CASH —> the company cannot distribute cash if it does not have it
=> it must have sufficient Retained Earnings + Cash to cover the amount of dividends

DIVIDEND DATES:

Declaration Date = Board of directors approves the dividends —> Liability

(Ex Dividend Date*) = two days before the Date of record, established by the stock exchange => NO JOURNAL ENTRY
Date of Record = Stockholders who own shares receive the dividend (identification of stockholder) => NO JOURNAL ENTRY
Date of Payment = Cash is disbursed to stockholders

=> DIVIDENDS ARE ONLY PAID ON OUTSTANDING STOCKS

DIVIDENDS DECLARATION DIVIDENDS PAYMENT DECLARATION + PAYMENT

Retained Earnings (-SE) Dividends payable (-L) Retained Earnings (-SE)
Dividends payable (+L) Cash (-A) Cash (-A)
 Dividends per Share
DIVIDEND YIELD = —> return from dividends => evaluate a company’s dividend policy
Market Price per Share

IMPACT OF DIVIDENDS ON STOCK PRICE

*The ex-dividend date = date two days before the date of record => established by the stock exchange to account for the fact that it
takes time (typical 3 days) to officially transfer stock from seller to buyer

—> If someone buys stock before the ex-dividend date, they will be listed as the owner and receive the dividend
—> If someone buys stock on or after the ex-dividend date, the previous owner will be listed as the owner of the dividend

=> Stock PRICES often FALL on the ex-dividend date since the STOCK no longer includes the right to receive the next dividend

๏ STOCK DIVIDENDS —> COMPANY DISTRIBUTES SHARES OF STOCK (when the company does not have cash)
• Stock is distributed pro rata: Stockholders retain the same % ownership after stock dividends are distributed
• A stock dividend has NO ECONOMIC VALUE!!

=> Stock dividends do not change the stock’s par value or total Stakeholders’ Equity

When stock dividend is issued: The stock market reacts immediately => The stock price falls
—> The lower market price may make the stock more attractive to new investors

BENEFITS:
1) Satisfy the appetite of investors for a “dividend”
2) Increase the liquidity of the stock —> LIQUIDITY = how frequently a firm is traded

CASH DIVIDENDS = - CASH & - RETAINED EARNINGS

STOCK DIVIDENDS = + COMMON STOCK, + ADD PAID IN, - RETAINED EARNINGS

2 CASES:
LARGE: Stock dividend > 20-25% => RETAINED EARNINGS at par value of stock
SMALL: Stock dividend < 20-25% => RETAINED EARNINGS at market value of stock —> DECLARATION DATE

(Difference to disincentive companies to give SMALL)

JOURNAL ENTRY FOR STOCK DIVIDEND = transfer from Retained Earrings —> to Common Stock (& Add. Paid-In Capital x small)

LARGE STOCK DIVIDEND

Assume IBM issued 50 million shares of its $0.20 par value stock. On the date of declaration:

SMALL STOCK DIVIDEND

Assume IBM issued 5 million shares of its $0.20 par value stock when it was trading for $150 per share. On the date of declaration:

LARGE STOCK DIVIDEND SMALL STOCK DIVIDEND

Retained Earnings (-SE) par value x nr shares Retained Earnings (-SE) market price x nr shares
Common Stock (+SE) par value x nr shares Common Stock (+SE) par value x nr shares
Add Paid In Capital (+SE) difference

NB!!
IN BOTH LARGE AND SMALL DIVIDENDS —> NO CHANGE IN TOTAL STOCKHOLDERS’ EQUITY (-SE = +SE)
RETAINED EARNINGS = AMOUNT OF DIVIDENDS DISTRIBUTED
COMMON STOCK -> ALWAYS CALCULATED WITH PAR VALUE
STOCK SPLITS
= gives stockholders a specified number of additional shares for each share they currently hold
=> NO JOURNAL ENTRIES: they change the par value per share, but the TOTAL PAR VALUE IS UNCHANGED

Assume a corporation had 3.000 shares of $2 par value common stock outstanding before a two-for-one stock split:

= Each share will be split in two

SHARES X 2

PAR VALUE / 2

= TOTAL PAR VALUE

STOCK DIVIDENDS => RETAINED EARNINGS (transaction) STOCK SPLITS => PAR VALUE (no transaction)

STOCK DIVIDEND STOCK SPLIT

TOTAL ASSETS No change No change

TOTAL LIABILITIES No change No change

COMMON STOCK + No change

TOTAL SE No change No change

MARKET VALUE — —

Company declared and distributed a 10% stock dividend on 20.000 shares of issued and outstanding $5 par value common stock.
The market price per share on the declaration date was $9 and was $10 on the distribution date.

Retained Earnings 18.000 —> 2.000 x $9

Common Stock 10.000 —> 2.000 x $5
Add paid in 8.000 —> difference

PREFERRED STOCK TRANSACTIONS

- Less risky because of preference over common stock —> receive first DIVIDENDS + ASSETS in case of liquidation
- Typically does not have voting rights
- Typically has a fixed dividend rate

=> part of SHAREHOLDERS EQUITY (not all companies issue preferred stock)

CURRENT DIVIDEND PREFERENCE = requires a company to pay current dividends to preferred stockholders before paying
dividends to common stockholders. After this is met then dividends can be paid to common stockholders.

CUMULATIVE DIVIDEND PREFERENCE = Requires any unpaid dividends on preferred stock to accumulate.
—> This amount is called dividends in arrears, must be paid before common dividends are paid.
=> NOTE: Dividends in arrears are disclosed in the notes to financial statements = not a liability until declared by board of directors

—> If preferred stock is non-cumulative, any dividends not declared in previous years are permanently lost and will never be paid.

Example: Company has the following stock outstanding:

Preferred stock: 6%, $20 par value, 2,000 shares outstanding. Assume current dividend preference
Common stock: $10 par value, 5,000 shares outstanding

(1) If Wally issues a $3,000 current dividend, the dividends would be allocated as follows:
Preferred: $20 par value × 6% × 2,000 shares = $2,400
Common: $3,000 − $2,400 = $600

(2) If Wally issues a $30,000 dividend and the dividends were in arrears for two years (assume cumulative dividend preference) the
allocation would be as follows:
Preferred: $2,400 current + ($2,400 in arrears × 2 years) = $7,200
Common: $30,000 − $7,200 = $22,800

METHOD:
No matter how many dividends the company issues — first calculate what is owed to PREFERRED stock: % * par value * nr shares
=> then the remaining amount: TOTAL DIVIDENDS ISSUED - PREFERRED STOCK = distributed to COMMON STOCK
APPENDIX A - INVESTMENTS IN OTHER CORPORATIONS

WHY INVESTING IN THE SECURITIES OF ANOTHER COMPANY:

➡ Earn a return on idle cash (money deposited)
➡ Influence the other company’s policies and activities —> to take an ACTIVE ROLE as an investor
‣ The ability of the investing company to have an important impact on the operating, investing and financial policies of another
company
‣ Presumed if the investing company owns from 20 to 50% of the outstanding voting shares
‣ Other factors may indicate significant influence such as membership on board of directors
➡ Control the other company’s future —> to achieve vertical INTEGRATION, horizontal GROWTH or operational SYNERGY
‣ The investing company has the ability to determine the operating and financial policies of another corporation
‣ Presumed when the investing company owns more than 50% of the outstanding stock of the company

BOND INVESTMENTS Other Firms’ Bonds = Financial Assets 1

- Passive investments
- Earn an interest income
- Driver of accounting reporting: investment horizon (investment purpose)

—> Purpose of PASSIVE investments = EARN A RETURN

3 TYPES OF SECURITY PURPOSE TYPE OF ASSET ACCOUNTING METHOD

Short term profit from change

ACTIVELY TRADED Current Fair value through Net Income
in market prices

Residual (medium term Fair value though OCI (Other

AVAILABLE FOR SALE Current or Long term
investment) Comprehensive Income)

Keep to maturity & earn Long term (only residual as

HELD TO MATURITY (Amortized) Cost
interest income current)

ACTIVELY TRADED = investments that are actively traded over short periods of time => TO EARN PROFITS
AVAILABLE FOR SALE = residual category
HELD TO MATURITY = investments intended to hold until their maturity date => TO EARN INTEREST INCOME

5 EVENTS TRADING AVAILABLE FOR SALE HELD TO MATURITY

1. INITIAL PURCHASE IN THE MARKET + INVESTMENTS, - CASH

2. EARNING INTEREST REVENUE + CASH, + INTEREST REVENUE (purchase AT PAR)

3. FISCAL YEAR END OF THE INVESTOR

Fair Value Fair Value
—
4. DISPOSAL OF BOND IN THE MARKET (through Net Income) (through OCI)

5. BOND MATURITY — — - INVESTMENTS, + CASH

FAIR VALUE = reports securities at their current market value

1. INITIAL PURCHASE IN THE MARKET

On October 1 2017, The Walt Disney Company paid the par value of $150,000 for 6% bonds that mature on September 30, 2022.
Interest at 6% per year is paid on March 31 and September 30

2. EARNING INTEREST REVENUE

Interest Revenue = $150,000 × 0.06 × 1⁄2 year = $4,500 —> earned and received in cash on March 31, 2018, and September 30, 2018
(No premium or discount needs to be amortized (because purchased at par)
FIRM VALUE = ASSETS IN PLACE + FUTURE ABILITY TO GENERATE PROFITS
Assets in place:
1) + Investors want timely assets VALUE -> FAIR VALUE is better than cost
2) - Need adjustment to record at fair value (accounting effort)

Ability to generate profits = ability of current Net Income to capture future Net Income
1) + Investors are interested in the “ordinary” Net Income
2) - Investors dislike Net Income which is too volatile

3. FISCAL YEAR END OF THE INVESTOR

๏ HELD TO MATURITY SECURITY => NO TRANSACTIONS: No Fair Value adjusting entry is necessary
=> Investments reported at COST, adjusted for the amortization of any discount or premium

๏ ACTIVELY TRADED SECURITY —> unrealized gain/loss in Income Statement

=> at the end of each fiscal year, the trading securities portfolio is adjusted up or down to fair value
=> adjusting entry reported on the income statement as unrealized gain or loss —> subsequently closed to Retained Earnings

๏ AVAILABLE FOR SALE —> unrealized gain/loss in Other Comprehensive Income

=> at the end of each fiscal year, the available for sale securities portfolio is adjusted up or down to fair value
=> adjusting entry NOT reported on the income statement —> unrealized gain or loss recorded in Other Comprehensive Income

4. DISPOSAL IN THE MARKET

๏ ACTIVELY TRADED SECURITY
When a SALE takes place 2 JOURNAL ENTRIES:
1) Adjustment to fair value on the sale date
2) Record of the sale

๏ AVAILABLE FOR SALE

When a SALE takes place 3 JOURNAL ENTRIES:
1) Adjustment to fair value on the sale date
2) Accumulated net unrealized gain or loss for investments sold is reclassified out of Other Comprehensive Income and reported on
the income statement as a realized gain or loss.
3) Record of the sale

ACTIVELY TRADED:
1) Walt Disney Company decide to actively trade its $150,000 in bonds at par
2) The investment in debt securities has a fair value at the end of the fiscal year on September 30, 2018, of $140,000
3) The investment is sold on September 30, 2019 (end of the next fiscal year), for $165,000.

3. END OF THE YEAR: The unrealized loss of $10,000 is reported on the INCOME STATEMENT to adjust to fair value:

4. DISPOSAL: When the securities are traded (SOLD) on September 30, 2019, there are TWO journal entries:
1) Adjustment to fair value of $165,000

(2) then the sale is recorded:

AVAILABLE FOR SALE:
+ UNEARNED GAINS
- UNEARNED LOSS
= OTHER COMPREHENSIVE INCOME —> in the BALANCE SHEET in EARNED SHAREHOLDERS EQUITY

1) Walt Disney Company purchased its $150,000 in bonds at par and intends to hold the securities for a couple of years
2) The investment in debt securities has a fair value at the end of the fiscal year on September 30, 2018, of $140,000
3) The investment is sold on September 30, 2019 (end of the next fiscal year), for $165,000.

3. END OF THE YEAR: unrealized loss of $10,000 is reported on OTHER COMPREHENSIVE INCOME to adjust to fair value:

=> THE UNREALIZED LOSS DOES NOT AFFECT NET INCOME

4. DISPOSAL: When the securities are traded (SOLD) on September 30, 2019, there are THREE journal entries:
1) Adjustment to fair value of $165,000

2) The total net unrealized gain or loss accumulated in OTHER COMPREHENSIVE INCOME for the securities that are sold is
reclassified as a REALIZED gain or loss to be reported on the income statement.
—> NET ADJUSTMENT = (-$10,000 + $25,000) = $15,000

REALIZED GAIN/LOSS:
Selling price - Purchase price

3) Finally, the sale is recorded with the investments account decreased by its book value (equal to fair value after the adjustment in
the first entry) and cash received of $165,000.

5. BOND MATURITY (HELD TO MATURITY BONDS):

SUMMARY:

HELD TO MATURITY BONDS PURCHASED OTHER THAN PAR VALUE — AMORTIZED COST METHOD
Bonds are issued at:
PAR price = face value —> coupon rate = market rate
DISCOUNT price < face value —> coupon rate < market rate
PREMIUM price > face value —> coupon rate > market rate

Bond par value = $1000 PV = $896 COUPON = 12% MARKET = 14% => DISCOUNT
Price = $896 —> present value
Cash x interest = $1000 x 12% = 125
Interest expense/revenue = $896 x 14%

ACCOUNTING: ISSUANCE ACCOUNTING: PURCHASE

Issue at discount: Purchase at discount:
Cash (+A) 896 Investments (+A) 896
Bond payable (-L) 896 Cash (-A) 896
Interest payment: Interest payment:
Interest Expense (+E) 125 Cash (+A) 120
Bond payable (-L) 5 Investment (+A) 5 => AMORTIZATION
Cash (-A) 120 Interest revenue (+R) 125

AMORTIZED COST METHOD

= reports investments in debt securities held to maturity at COST - PREMIUM AMORTIZATION or + DISCOUNT AMORTIZATION

PRICE OF BOND = PV of face value + PV of interest annuities PV FACE VALUE = face value / (1+market rate)n
PV ANNUITY = (face value x coupon rate) -> discounted w/market rate
CASH INFLOW = coupon rate * Face Value
INTEREST REVENUE = market rate * Bonds payable book value
INVESTMENTS = difference => AMORTIZATION

1 Oct company paid $92,278 cash for an 8%, 5-year $100.000 bond that paid interest semiannually. Bond yield was 10%.

1) PURCHASE OF THE BOND:

$92,278 = PRESENT VALUE of the bond on the purchase date

2) INTEREST REVENUE:
CASH: $100,000 × 0.08 × 1⁄2 year = $4,000
INTEREST REVENUE: $92,278 × 0.10 × 1⁄2 year = $4,614
EQUITY INVESTMENTS Other Firms’ Equity = Financial Assets 2
- Passive or active
- MAY earn a dividend income
- Driver of accounting reporting: Type of control

ACCOUNTING
3 TYPES OF EQUITY PURPOSE OWNERSHIP TYPE OF ASSET
METHOD

Fair value
PASSIVE Earn a return < 20% Current or Long term
(through Net Income)

SIGNIFICANCE
Active role as investor 20 - 50% Long term Equity method
INFLUENCE

Vertical / horizontal
CONTROL > 50% Consolidation
integration + synergies

5 EVENTS PASSIVE SIGNIFICANCE INFLUENCE

1. INITIAL PURCHASE IN THE MARKET + INVESTMENTS, - CASH - as bonds -

2. REPORTING NET INCOME —

Equity Method
3. EARN DIVIDEND REVENUE*
Fair Value
4. FISCAL YEAR END OF THE INVESTOR —
(through Net Income)
- as actively traded bonds -
5. DISPOSAL IN THE MARKET IF SOLD: Gain/loss on Income
Statement

* PASSIVE -> revenue earned recognized when company declares DIVIDENDS

* SIGNIFICANCE INFLUENCE -> revenue earned recognized when company reports INCOME/LOSS

PASSIVE EQUITY SECURITIES

1. PURCHASE OF STOCK
1 Oct: Disney Company purchased 10% of the voting common stock of Green Light Pictures for $15 per share. Green Light has
100,000 shares of stock outstanding. In addition, the studio pays a dividend of $0.50 per share each year at the end of September, its
fiscal year end.

10,000 shares × $15 per share = $150,000

2. NET INCOME => NO FOR PASSIVE

3. EARN DIVIDEND REVENUE

Green Light pays a dividend of $0.50 per share each year at the end of September.

10,000 shares × $0.50 per share = $5,000

=> SAME AS FOR BONDS, BUT WE HAVE DIVIDEND REVENUE INSTEAD OF INTEREST REVENUE

In case of DIVIDENDS DECLARED (not yet paid) —> Dividends Receivable in place of Cash
FAIR VALUE METHOD => applied for PASSIVE equity investments —> AS BONDS

1) The equity investments portfolio is increased or decreased each period to FAIR VALUE —> unrealized gain or loss reported on
the income statement.

=> The fair value of Green Light’s common stock was $12 per share at September 30, 2018 ($120,000), and $16.50 per share at
September 30, 2019 ($165,000)

2) Disney sold the stock portfolio on March 31, 2020, for $19 per share ($190,000) (before Green Light declared any dividends).

4. END OF THE YEAR (2018): The investments in equity securities is adjusted to fair value at the end of Fiscal Year 2018 is:

4. END OF THE YEAR (2019): The investments in equity securities is adjusted to fair value at the end of Fiscal Year 2019

4. DISPOSAL: There are two entries that need to be recorded for the sale of investments in equity securities:

1) Adjust to fair value: The investment account is again adjusted to its fair value on the sale date of March 31, 2020.
Current fair value = $190,000 — book value = $165,000 —> The adjustment = increase to the investment account of $25,000.

2) Record the sale of the equity securities: The sale is recorded with the investments account decreased by its book value (= fair value
after the adjustment) and cash received of $190,000.

REPORTING INVESTMENTS UNDER THE FAIR METHOD

‣ Reported on the balance sheet as long-term asset originally at COST
‣ Investment account => increased / reduced to Fair Value
ACTIVE SIGNIFICANCE INFLUENCE SECURITIES
An investor may want to exert influence without becoming the controlling shareholder.

Examples:
• A retailer may want to influence a manufacturer to be sure that it can obtain certain products designed to its specifications.
• A manufacturer may want to influence a computer consulting firm to ensure that it can incorporate the consulting firm’s cutting-edge
technology in its manufacturing processes.
• A manufacturer may recognize that a parts supplier lacks experienced management and could prosper with additional managerial
support.

EQUITY METHOD => applied when an investor can exert SIGNIFICANT INFLUENCE
= permits recording investor’s share of affiliate’s INCOME as part of the investor EARNINGS
—> Investor reports its portion of the affiliate’s net income/loss as its income and increases/decreases the investment account by the
same amount.
—> The receipt of DIVIDENDS by the investor is treated as a reduction of the INVESTMENT account, NOT REVENUE !!!!!
—> The Investments account is reported on the balance sheet as a long-term asset

1. PURCHASE OF STOCK
In early 2018, Disney purchased a 40% interest in Green Light Pictures for $400,000 in cash (40,000 shares of the 100,000
outstanding voting common stock).
=> The purchase of the asset would be recorded at COST

2. EARNINGS OF AFFILIATES
During the fiscal year ending in 2018, Green Light Pictures reported a net income of $500,000 for the year. The Walt Disney
Company’s percentage income = 40% × $500,000 = $200,000

The investor company bases its INVESTMENT INCOME on the affiliates’ earnings (NOT on DIVIDENDS affiliates declare)
=> If the affiliates report a Net Income => investor record Equity in Investee Earnings (+R) & increases investment
=> If the affiliates report a Net Loss => investor record Equity in Investee Losses (+E) & decreases investment

—> The Equity in Investee Earnings (or Losses) is reported in the OTHER ITEMS section of the INCOME STATEMENT

3. DIVIDENDS DECLARED
During the fiscal year ending in 2018, Green Light declared a cash dividend of $0.50 per share to stockholders.
DIVIDENDS = $0.50 × 40,000 shares = $20,000

Dividends receivable —> + Operating Assets , Investments —> - Financial Assets

REPORTING INVESTMENTS UNDER THE EQUITY METHOD

‣ Reported on the balance sheet as long-term asset originally at COST
‣ Later the investment account does not reflect either cost or fair value
➡Account is increased by: cost of shares purchased + proportional share of affiliates net income
➡Account is reduced by: proportional amount of dividends declared from affiliates + net losses + cost of shares sold

—> NO ADJUSTMENT TO FAIR VALUE AT YEAR END & AT DISPOSAL

—> IF SOLD: GAIN/LOSS IN “OTHER ITEMS” (IS)
BB - INCOME TAXES

INCOME TAXES = taxes paid by companies on the income earned

=> COST for the company: Cost debited & Liability to Tax Authority credited

1. End of fiscal year: account for all transactions and report adjusting entries
2. Compute Taxable Income (≠Profit Before Taxes)
• Compute Income Tax Expense = Taxable Income x Tax Rate
• Compute Net Income = Profit Before Taxes - Income Tax Expense

ADVANCED PAYMENTS -> required by law: in Italy paid on 30/6 (40%) & 30/11 (60%)

INCOME TAX RELATED JOURNAL ENTRIES:

(1) Income tax expense
(2) Cash payment (settlement of previous tax expense)
(3) Advance cash payment —> 30/6 + 30/11

31/12/n-1: Income Tax Expenses for the year amounts to 200$

1 . INCOME TAX EXPENSE —> establish a LIABILITY NET INCOME = PROFIT BEFORE TAXES
Income Tax Expense (+E, -SE) 200 - INCOME TAX EXPENSE
Income Tax Payable (+L) 200

30/06: The company pays the balance due + the first advance payment
2. CASH PAYMENT —> settlement of LIABILITY
Income Tax Payable (-L) 200
Bank Account (-A) 200 —> BANK ACCOUNT: Income Taxes are to be paid through the bank account

3. ADVANCE CASH PAYMENT 1 => on taxes the company expects to generate during the current fiscal year
Income Tax Receivable (+A) 80
Bank account (-A) 80 = 40% of previous year Income Tax Expense

30/11: The company pays the second advance payment of the remaining due
3. ADVANCE CASH PAYMENT 2
Income Tax Receivable (+A) 120 = 60% of previous year Income Tax Expense
Bank Account (-A) 120

31/12/n:
1 . INCOME TAX EXPENSE
Income Tax Expense (+E, -SE) 300 => CASH PAYMENT + ADVANCE 1 ALWAYS 30/06
Income Tax payable (+L) 300 => ADVANCE CASH PAYMENT 2 ALWAYS 30/11

30/06
2. CASH PAYMENT => difference btw PAYABLE - RECEIVABLE
If balance due (payable ≠ receivable) If NO balance due (payable = receivable)
Income Tax Payable (-L) 300 Income Tax Payable (-L)
Income Tax Receivable (-A) 200 Income Tax Receivable (-A)
Bank Account (-A) 100

3. ADVANCE CASH PAYMENT 1

Income Tax Receivable (+A)
Back Account (-A)

30/11
3. ADVANCE CASH PAYMENT 2
Income Tax Receivable (+A)
Bank Account (-A)

31/12/n+1:
1 . INCOME TAX EXPENSE
Income Tax Expense (+E, -SE)
Income Tax Payable (+L)

SUMMARY:
1. During the year Advance Payments are made
2. At the end of the year, Taxable Income is calculated: Profit Before Tax + Non-deductible costs - Non-taxable revenues
3. Calculate Income Tax Expense: Taxable Income x Tax Rate
4. Record Tax Expense and Tax Liability
5. The credit for down payments and the tax debt are offset, and any residual debt is paid
DETERMINING TAXABLE INCOME & INCOME TAX EXPENSE
The income to be taxed (Taxable Income) ≠ Income determined according to the “accounting rules” —> because accounting is based
also on the assumptions that could be used to manipulate income and pay less taxes.

=> to calculate TAXABLE INCOME we must first “recalculate income” according to Tax Authority rules —> determined SEPARATELY
form the accounting system:

TAXABLE INCOME = amount to which the tax rate is applied in order to arrive at the Income Tax Expense

TAXABLE INCOME ≠ PROFIT BEFORE TAXES —> because of VARIATIONS

Increasing Taxable Income: NON-DEDUCTIBLE COSTS
Decreasing Taxable Income: NON-TAXABLE REVENUES

TAXABLE INCOME = PROFIT BEFORE TAXES + NON-DEDUCTIBLE COSTS - NON-TAXABLE REVENUES

(same result would be reached by “cancelling” all costs and revenues not recognize by tax law)

Example: the owners of the company spend $9,000 for personal presents:
—> costs for personal use (not inherent to the business) are not considered

1) PROFIT BEFORE TAXES = 5 (100-30-50-15)

IS (ACCOUNTING PURPOSES)
Other Expenses —> related to personal use, paid with the credit card of the firm
DEBIT CREDIT
2) IN ACCOUNTING PERSPECTIVE: transaction properly reported
30 Salaries 100 Revenues
3) IN TAX PERSPECTIVE: no considered expenses related to shareholders benefits
50 Depreciation
=> 15 = NON-DEDUCTIBLE COST
15 Other Expenses
4) TAXABLE INCOME = = 5 + 15 = 20

INCOME TAX EXPENSE = TAXABLE INCOME x TAX RATE

Higher Income => Higher Income Tax Expense
➡ Higher Taxable Revenues => Higher Income Tax Expense
➡ Higher Deductible Expenses => Lower Income Tax Expense

Example: Taxable Income 16,000 Income Tax Rate 30% => Income Tax Expense = 16,000 x 30% = 4,800
31/12: Income Tax Expense (+E, -SE) 4800
Income Tax payable (+L) 4800

PERMANENT & TEMPORARY VARIATIONS —> 2 types of variations to apply to Profit Before Taxes to calculate Taxable Income:
1. PERMANENT CHANGES = when a cost or revenue is recorded in the general accounting but the tax legislation does not
recognize it nor in the current period nor in the future—> for tax authorities these costs do not exist: will never be taxed
2. TEMPORARY CHANGES = when a cost or revenue is recorded in the general accounting and the tax legislation does not
recognize it in the current period, but will recognize it in the future

=> the TEMPORARY changes generate: Deferred Tax Assets & Deferred Tax Liabilities: (DON’T CONFUSE WITH TAX PAYAB./RECEIV.)
• Temporary variation COSTS (increasing T. I.) = “Deferred Tax Asset” -> when taxed: in Non taxable Revenues (NOT COSTS)
• Temporary variation REVENUES (decreasing T.I.) = “Deferred Tax Liability” -> when taxed: in Non Deductible Costs (NO
REVENUES)
ie. Litigation allowance: non-deductible until x+1
NON-DEDUCTIBLE COSTS
—> year x: in “Non ded. Allowance” in Non deductible costs
PERMANENT
—> year x+1: “Release of allowance” in Non taxable revenues
- Telephone Expenses (deductible for 80%)
- Donations (deductible for 1% of revenues)
- Vehicles cost for personal purposes
- Private benefits costs

TEMPORARY (Deferred Tax Assets)

- Start-up costs (deductible spreading over 5 years)
- Bad Debt Allowance (deductible when credit loss occurs)
- Litigation allowance

NON-TAXABLE REVENUES
PERMANENT
- Dividend revenues

TEMPORARY (Deferred Tax Liability)

- Capital gain on equipment disposal
12 - CASHFLOW STATEMENT

ACCRUAL ACCOUNTING: CASH BASED ACCOUNTING:

1. Revenues are recognized when EARNED (realized) 1. Cash inflows
2. Expenses are reported when INCURRED to generate revenues 2. Cash outflows

Consider the following financial information for year X:

- Beginning cash balance: 1.000
- Service revenues earned: 80.000, of which in accounts receivable at year end: 30.000
- Salaries expense: 40.000, of which in salaries payable: 10.000
- Payment for insurance premium: 12.000, insurance covers the company for 2 years
- Payment for office supplies: 2.000, 1.000 worth supplies have been used to generate the services sold in the year
IS - ACCRUAL ACCOUNTING IS - CASH ACCOUNTING
REVENUES 80.000 REVENUES 50.000
EXPENSES EXPENSES
Wages 40.000 Wages 30.000
Insurance 6.000 Insurance 12.000
Supplies 1.000 Supplies 2.000
NET INCOME = 33.000 CASH FLOW = 6.000

Earnings should be a more representative value driver because earnings aggregates value in both cash flows and accruals. Still,
many practitioners prefer to use CASH FLOWS, arguing that accruals involve discretion and are often used to manipulate earnings.

POSITIVE CASH FLOWS permit a company to:

✓ Pay dividends to owners
✓ Expand its operations
✓ Take advantage of investment opportunities
✓ Replace worn assets

=> it is important to understand the sources & uses of cash associated with business activity

WHAT IS CASH
CASH = cash + cash equivalents
CASH EQUIVALENTS = short-term + highly liquid investments + that are readily convertible into cash + so near to maturity that
there is little risk that their value will change if interest change —> investments with original maturities ≤ 3 months (ie. Treasury
security with maturity in 2 months, short-term debt issued by a large investment grade company with maturity 1 month, funds investing
in the securities above - money market fund) => NO: BOND ISSUED AND TRADED TWICE A WEEK WITH MATURITY 5 YEARS

CASH FLOW STATEMENT = representation of inflows and outflows of CASH

—> reconcile cash account at beginning of the year with the cash account at the end of the year

SOURCES OF INFLOWS (SOURCES) & OUTFLOWS (USES):

➡ From OPERATING activities = related to earnings from normal operations
➡ From INVESTING activities = related to acquisition or sale of productive facilities & investments in securities of other companies
➡ From FINANCING activities = related to external sources of financing (owners + creditors) for the enterprise

On the Balance Sheet:

OPERATING => Current Operating Assets / Liabilities
INVESTING => Investments
FINANCING => Financial liabilities + Shareholders equity

CASH FLOW FROM OPERATING ACTIVITIES — Outflows: Cash paid for:

+ Inflows: Cash received from: • Purchase of goods and services for resale (to suppliers)
• Customers • Salaries and wages (to employees)
• Dividends and interest on investments • Income taxes
• Interest paid to creditors
CASH FLOW FROM INVESTING ACTIVITIES:
+ Inflows: Cash received from: — Outflows: Cash paid for:
• Sale or disposal of property, plant and equipment • Purchase of property, plant and equipment
• Sale or maturity of investments in financial assets • Purchase of investments in financial assets

CASH FLOW FROM FINANCING ACTIVITIES:

— Outflows: Cash paid for:
+ Inflows: Cash received from:
• Repayment of principal (to creditors) -> NO interest = operating
• Borrowings on notes, mortgages, bonds (from creditors)
• Repurchasing stock from owners
• Issuing stock to owners
• Dividends to owners
The COMBINATION OF NET CASH FLOWS from the 3 must = Net increase/decrease in CASH

➡ If POSITIVE cash flow = cash provided

➡ If NEGATIVE cash flow = cash used

BS - IS RELATIONSHIP:
Information needed to prepare a statement of cash-flows:
- Comparative balance sheets
- Complete income statement
- Additional details concerning selected accounts

Δ CASH = CASH Ending - CASH Beginning

Δ CASH = ΔCFO + ΔCFI + ΔCFF

ΔCFO: NI + Depreciation - (Gains on Inv. Sales + Losses on Inv. Sales) - ΔCurrent Oper. Assets + ΔCurrent Oper. Liab.
Δ CFI: - Purchases + BVSold + (Gains on Inv. Sales - Losses on Inv. Sales)
Δ CFF: +ΔLong Term Debt + ΔCommon Stock + ΔAdditional Paid in Capital - Dividends

CASH FLOW FROM OPERATIONS

ΔCFO = NI + Depreciation - (Gains on Inv. Sales + Losses on Inv. Sales) - ΔCurrent Operating Assets + ΔCurrent Operating Liabilities

INDIRECT METHOD => adjust Net Income to compute cash flows from operations by eliminating non cash items:
NET INCOME
+ Non cash expenses (depreciation & amortization)
+ Losses
- Gains
- Δ Current Assets
+ Δ Current Liabilities
= CASHFLOW FROM OPERATING ACTIVITIES

Step 1: ADJUST NET INCOME FOR DEPRECIATION AND AMORTIZATION

Step 2: ADJUST NET INCOME FOR GAINS AND LOSSES

• Cash received from the sale or disposal of long-term assets is classified as investing cash inflow.
• Gains/losses on income statement are subtracted from/added to net income in order to compute operating cash flow.

GAINS —> subtracted from Net Income to avoid double counting the gain
LOSSES —> added to Net Income to avoid double counting the loss

Step 3: ADJUST NET INCOME FOR CURRENT ASSETS AND LIABILITIES

ASSETS —> subtracted from Net Income since they decrease Cash
= Accounts Receivable, Prepaid Expenses, Inventory
LIABILITIES —> added to Net Income since they increase cash
= Accounts Payable, Accrued Expenses
ADJUST NET INCOME FOR GAINS AND LOSSES
• Equipment with a net book value of $90,000 is sold for $100,000
• Cash (+A) 100,000
Income Statement effect: + 10,000
Equipment (-A) 90,000
Cash flow from investing activities: + 100,000
Gain on disposal (+R, +SE) 10,000
Indirect cash flow from operations adjustment: 100,000 - 90,000 = 10.000
—> to be subtracted: - 10,000 —> Gains on Inv. Sale

ADJUST NET INCOME FOR CHANGES IN CURRENT ASSETS

ACCOUNTS RECEIVABLE
‣ Sales on account: increase accounts receivable
‣ Collections from customers: decrease accounts receivable

• Accounts receivable of $10,000 was collected

• On 31/12, $1,000 of new sales was made on credit
Cash (+A) 10,000
Accounts receivable (-A) 10,000 Income Statement effect: + 1,000
Cash flow from operating activities: + 10,000
Accounts receivable (+A) 1,000 Indirect cash flow from operations adjustment: 1,000 - 10,000 = - 9,000
Sales revenue (+R, +SE) 1,000 —> to be subtracted: + 9,000 —> Current Oper. Assets

PREPAID EXPENSES
• A rent expense incurred for $2,000. The expense relates to a 2-year rent contract which was fully paid at beginning of previous year
($4,000 of overall cash outflow)
• A prepayment of $9,000 for a legal risk insurance was made at the start of the fiscal year, the overall insurance coverage is 3 years

Prepaid Expenses (+A) 9,000

Cash (-A) 9,000
Income Statement effect: + 5,000
Insurance expense (+E, -SE) 3,000 Cash flow from operating activities: - 9,000
Rent Expense (+E, -SE) 2,000 Indirect cash flow from operations adjustment: 6,000 - 2,000 = 4,000
Prepaid Expenses (-A) 5,000 —> to be subtracted: - 4,000 —> Current Oper. Assets

INVENTORY
• A car is sold for $50,000 for cash. The carrying amount of the car in the car dealer’s inventory equaled $40,000
• During the fiscal year, the car dealer purchased a car for cash from its supplier for $15,000

Cash (+A) 50,000

Sales revenue (+R, +SE) 50,000
Income Statement effect: + 10,000
Cost of sales (+E, -SE) 40,000 Cash flow from operating activities: + 35,000
Inventory (-A) 40,000 Indirect cash flow from operations adjustment: 15,000 - 40,000 = - 25,000
—> to be subtracted: + 25,000 —> Current Oper. Assets
Inventory (+A) 15,000
Cash (-A) 15,000
ADJUST NET INCOME FOR CHANGES IN CURRENT LIABILITIES
ACCOUNTS PAYABLE
• Outstanding accounts payable of $10,000 was paid
• On 31/12, $1,000 of new raw materials were purchased on credit

Accounts Payable (-L) 10,000

Cash (-A) 10,000 Income Statement effect: 0
Cash flow from operating activities: - 10,000
Inventory (+A) 1,000 Indirect cash flow from operations adjustment: 1,000 - 10,000 = - 9,000
Accounts payable (+L) 1,000 —> to be added: - 9,000 —> Current Oper. Liabilities

ACCRUED EXPENSES
• The electricity invoice is billed at end of every other month. On 31/12, $50 of electricity expenses have been accrued (but not billed)

Utilities Expense (+E, -SE) 50 Income Statement effect: - 50

Accrued Expense (+L) 50 Cash flow from operating activities: 0 (no cash payment)
Indirect cash flow from operations adjustment: 50 - 0 = + 50
—> to be added: + 50 —> Current Oper. Liabilities

SUMMARY:

ITEMS OF IS WHICH DON’T AFFECT OPERATING CASH FLOW:

• Depreciation (tangible assets)
• Amortization (intangible assets)
• Depletion (natural resources)
• Impairment loss
• Unrealized gain or loss in case the asset is classified as “fair value through net income”
• “Equity in investee earnings/losses” under the equity method
• Gain/loss on disposal of assets

INTERPRETING CASH FLOWS FROM OPERATING ACTIVITIES

=> analysts avoid firms with rising Net Income but falling Cash Flow from operations:
- Investors: will not invest in a company if cash generated from operations cannot pay them dividends or expand the company
- Creditors: will not lend money if cash generated from operations cannot pay them back the loan
EXERCISE:
If the balance in Prepaid Expenses increased during the year, on the statement of Cashflows => The change in the account balance
should be subtracted because the net increase in Prepaid Expenses did not impact Net Income, but reduced Cash balance

Prepaid Expense (+A) => NO AFFECT NET INCOME, BUT REDUCE CASH
Cash (-A)

DIRECT METHOD VS INDIRECT METHOD

=> the two formats for reporting Cash Flow from Operating activities
DIRECT METHOD: reports the cash effects of each operating activity
INDIRECT METHOD: starts with Accrual Net Income and converts to cash flow from operating activities

—> cash flows are always the same in both methods

CURRENT ASSETS

CURRENT LIABILITIES
CASH FLOW FROM INVESTING

ΔCFI = - Purchases + BVSold + (Gains on Inv. Sales - Losses on Inv. Sales)

PURCHASES = Cash Outflows for the purchase of investments (either PPE or securities)
BV SOLD = Cash Inflow for the sale of investment (COST - ACC. DEPRECIATION)

CASH FLOW FROM SALE = BV + GAINS / - LOSS (no consider purchases of other investments)
BV + GAINS = Cash Inflow if asset is sold at MORE than book value
BV - LOSS = Cash Inflow if asset is sold at LESS than book value

—> only purchases paid with CASH or CASH EQUIVALENTS are included
—> the amount of cash received is always included, regardless of asset is sold at gain or loss

CASH FLOW FROM FINANCING

ΔCFF = + ΔFinancial Debt + ΔCommon Stock + ΔAdditional Paid in Capital - Dividends

—> only debt/stock issued for CASH are included

DIVIDENDS and INTEREST from Investment = OPERATING Cash Flow —> because routinely earned by firms (under GAAP)
INTEREST paid to creditors = OPERATING Cash Flow —> because routinely paid to creditors (under GAAP)
=> ONLY DIVIDENDS PAID ARE FINANCING

Current non-operating investments are INVESTMENTS => not operating!! (Ie. Actively traded bonds)
Short-term financial liabilities are FINANCIAL LIABILITIES => not operating!! (ie. Short-term borrowing from banks)

STOCK OPTIONS => + Cash & + Common Stock —> + CFF

ACQUIREMENT OF BUILDING IN EXCHANGE FOR SHARES => Transaction recorded on Cashflow Statement in “Schedule of Non-
cash Investing and Financing Transactions” for the value of the issued shares

The long-term GROWTH of a company is normally financed by 3 SOURCES:

1. Cash from operating activities
2. Issuance of stock
3. Money borrowed long-term
=> the statement of Cash Flows show how management has chosen to fund its growth (used by analysts to evaluate company)

LISTED IN THE NOTES OF CASH FLOW STATEMENT:

- non cash investing and financing activities (ie. Purchase of a building with a mortgage given by the former owner)
- cash paid for interest and income taxes (for companies that use the indirect method)
13 - FINANCIAL STATEMENTS ANALYSIS

• Financial statements help people make better economic decisions

• Published financial statements are designed primarily to meet the needs of EXTERNAL DECISION MAKERS:
➡ Present and potential owners
➡ Investment analysts INVESTMENT DECISION:
➡ Creditors STRONG BUY
➡ Managers of corporations BUY
➡ Governments HOLD
➡ Employees and Unions UNDERPERFORM
SELL
INVESTMENT DECISION FACTORS: invest - yes or no?
1. Economy-wide factors: overall health of the economy (unemployment, inflation, interest rates)
2. Industry factors: events that can impact the company within the industry
3. Individual company factors: financial statements + visit the company + understand its STRATEGY

UNDERSTANDING A COMPANY’S STRATEGY

While financial statements reflect transactions, each of those transactions is the result of a company’s operating decisions as it
implements its business strategy.

Strategies to earn a high rate of return: product differentiation (UNIQUE) & cost differentiation (LOWER PRICES)

FINANCIAL STATEMENTS ANALYSIS

WHY: To uncover value, performance and characteristics of companies

MAIN GOALS = assessment of the PERFORMANCE and the SOUNDNESS of the firm, according to the following CATEGORIES:
1. PROFITABILITY & EFFICIENCY = ability to generate a return for investors and to maximize the output
2. LIQUIDITY = ability to meet current obligations
3. SOLVENCY = ability to meet long-term obligations
4. GROWTH = ability to get the resources to expand and grow

COMPARABILITY IN FS (RECLASSIFICATION)
We don’t simply rely on financial statement analysis alone but Financial Statement Analysis is based on COMPARISONS

Financial Analysis follows best practices and some approaches are well established, however there is NO RULES on:
- Specific ratios to apply and/or how to build them
- Financial statements to be used for

๏ Accounting standards across firms should be the SAME

๏ Financial statement formats should be HOMOGENEOUS

TYPES OF COMPARISON
✴ Time-series analysis = information for a single company is compared over time
✴ Cross-sectional analysis = information for multiple companies is compared at a point in time

✴ VERTICAL / COMPONENT PERCENTAGES:

➡ Express each item in a financial statement as a percentage of a total (Net Sales on IS - Tot Assets on BS)
➡ Provides evidence of structural changes in the accounts: ie. Increased profitability through more efficient production, or greater
dependence on borrowing to finance new investment
➡ Typically: key competitors + industry average

✴ HORIZONTAL / LINE-BY-LINE: Comparison of accounts of current and previous year

➡ Provides, over a number of years, a trend of changes, decline or growth of a specific item

NB: Balance sheet amounts are as of a specific point in time while income statement amounts relate to a period of time
=> To adjust for this difference, most analysts use the average (ending-beginning) balance sheet amount when comparing a balance
sheet number to an income statement number.
FINANCIAL STATEMENTS FORMATS = way to order the items inside the Balance Sheet and Income Statement.
—> also called “Reformulation of financial statements”

NOTE: there is NO RULE regulating how to prepare financial statement formats, what is important is CONSISTENCY in the definitions
used and a clear understanding of what is behind each of them

BALANCE SHEET FORMAT

LIQUIDITY/CASH BASIS
• Assets are classified according to their liquidity (first short term - then long term)
• Liabilities are classified according to their maturity (first short term - then long term)

INCOME STATEMENT FORMAT

NET SALES
- Cost of goods sold (except depreciation and amortization)
GROSS PROFIT
+ Other operating revenues
- SG&A expenses (except depreciation and amortization)
EBITDA = Earnings before interests, taxes, depreciation and amortization
+ Depreciation and amortization expense
EBIT = Earnings before interests and taxes
+ Interest & financial revenues
- Interest expense and financial charges
INCOME BEFORE TAXES (EBT)
- Taxes
NET INCOME

ITEMS DETAILS:
Net sales: total sales net of returns and allowances -> always first item in a multiple step IS
Cost of goods sold: reported in detail:
• x merchandising company, COGS is: Purchases +/- ΔInventory
• x manufacturing company, COGS is: Production costs +/- ΔInventory
Gross profit (or Gross Margin): how profitable the core of the business activity is -> the profitability at this level must be able to
cover all the other expenses the company has to bear (problems at this level are very alarming!)
Other operating revenues: other revenues arising from the operating activity (ie. rentals, license fees)
General and Administrative expenses: staff and directors executives salaries, bonuses and costs, costs related to fixed assets used
for the G&A activity (depreciation and maintenance of buildings), research costs, professional fees
Selling expenses: sales salaries, commissions and bonuses; advertising and promotion, warehousing, transportation, costs related to
fixed assets used in the selling activity (depreciation and maintenance)
EBITDA = operating income without considering depreciation and amortization expense
Depreciation and Amortization = of long-lived assets
EBIT (Operating Income) = earnings before interest and taxes —> shows if and how profitable the core activity of the company
• OI tends to be stable in time, if the company makes no change in the strategy
• If OI is negative or too low, a restructuring process is probably needed to save the company
 RATIO ANALYSIS

RATIO ANALYSIS = tool that measures the proportional relationship between two financial statements amounts.

GROUPS:
PROFITABILITY AND PERFORMANCE
= management’s ability to control expenses to earn a return on resources committed to the business
—> primary measure of the overall success of a company
—> ratios compare income with one or more primary activities
—> focus: on overall efficiency of a company in generating profits and cash from a given investment base

EFFICIENCY AND EFFECTIVENESS

= performance of the management of a company in terms of specific resources (such as inventories, debtors, employees)
=> ASSET TURNOVER RATIOS = capture how efficiently a company uses its assets

LIQUIDITY AND STABILITY

= measure the ability of a firm to meet its current obligations
—> a second meaning includes the concept of converting an asset into cash with little or no loss in value

CAPITAL STRUCTURE
‣ debt = “double-edged” sword: allows for generation of profits using other’s people money but creates claims on earnings with
higher priority
‣ Financial Leverage = magnification of risk & return resulting from the use of fixed-cost financing (such as debt & preferred stock)

LIMITS IN RATIOS ANALYSIS

 PROFITABILITY RATIOS

PROFITABILITY = management’s ability to control expenses to earn a return on resources committed to the business

Net Income NI x TA —> measure of value generation

ROE (Return on Equity) = —> synthesis of a firm’s value drivers
Average Tot Stockholders Equity TA SE
=> ≈10-15% - but also compare w/ companies
• Measures the income earned on the shareholder’s investment in the business
• Efficiency of the company in earnings profits on behalf of is ordinary shareholders
• More appropriate to take a before tax “Net Income”
• A higher ROE isn’t always better -> it means you have a low Equity comparing to Net Income = RISKY -> high debt

Net Income
ROA (Return on Assets) = —> operating profitability
Average Total Assets

• Measures how much the firm earned for each dollar of investment in assets
• Broadest measure of profitability and management effectiveness, independent of financing strategy
• Firms with higher level of ROA are doing better, all other things better

Average Tot Assets

FINANCIAL LEVERAGE =
Average Tot Stockholders Equity

Gross Profit —> ability to charge premium prices & produce at low cost
GROSS PROFIT PERCENTAGE =
Net Sales Revenue => high: luxury — low: normal
=> higher gross profits = higher Net Income
GROSS PROFIT = Net Sales - Cost of Sales
• Measures a company’s ability to charge premium prices and produce goods and services at low cost

Net Income
NET PROFIT MARGIN = —> ability to generate profits from sales
Net Sales Revenue

• Measures how much of every sales dollar generated during the period is profit
• The higher it is, the more efficient is the management of sales and expenses

EARNINGS PER SHARE (EPS) = Net Income —> earnings x share of outstanding stock
Weighted Average Nr of —> return on investment based on outstanding shares
Common Shares Outstanding

• Emphasizes the amount of earnings attributable to a single share of outstanding common stock
• There is a base EPS (nr of shares currently outstanding) & a diluted EPS (nr of shares if bond holders convert securities into stock)
• NOT to be compared with EPS of other companies: might be misleading because of different number of shares in issue

Operating Cash Flow —> ability to generate cash

QUALITY OF INCOME =
Net Income => if >1 = high quality / <1 = low quality

• Focuses on the ability to generate cash

• Show proportion of Net Income that was generated in cash
 ASSET TURNOVER RATIOS (EFFICIENCY)

EFFICIENCY = how efficiently a company uses its assets ability to maximize output for a given amount of input

Net Sales Revenue

TOTAL ASSET TURNOVER = —> how well assets are used to generate revenues
Average Total Assets

• Measures how well the company uses its assets to generate revenues
• The higher it is, the more efficient is total assets usage

Net Sales Revenue

FIXED ASSET TURNOVER = —> how well fixed assets are used to generate revenues
Average Net Fixed Assets

FIXED ASSETS = Property + Plant + equipment

• Measures how well the company uses its “fixed assets” to generate revenues
• The higher it is, the more efficient is net fixed assets usage

—> how many times inventory is produced & sold

Cost of Goods Sold
INVENTORY TURNOVER RATIO =
Average Inventory

• Reflects how many times average inventory was produced and sold during the period
• A higher ratio indicates that inventory moves more quickly through the production process to the ultimate customer, reducing
storage and obsolescence costs

365
AVERAGE DAYS TO SELL INVENTORY = —> time to produce & deliver inventory
Inventory Turnover

• Indicates the average time it takes the company to produce and deliver inventory to customers
• The higher it is, the LESS efficient is the production process = WORSE

Net Credit Sales

RECEIVABLE TURNOVER =
—> how many times receivables are collected
Average Net Receivables

• Shows how many times in a year the company collects its accounts receivable
• The higher it is, the FASTER is the collection of receivables
• A higher ratio benefits the company because it can invest the money collected to earn interest income or reduce borrowings to
reduce interest expenses
• Sometimes, when Net Credit Sales are not specified, Net Sales is used as approximation

365
AVERAGE DAYS TO COLLECT RECEIVABLES = —> time to collect receivables in cash
Receivables Turnover

• Indicates the average time it takes receivables to convert in cash

• The higher it is, the GREATER time needed to collect cash = WORSE

Cost of Goods Sold

ACCOUNTS PAYABLE TURNOVER = —> how many times suppliers are paid
Average Accounts Payable

• Shows how many times in a year the company pays its suppliers
• A higher ratio normally suggests that the company is paying its suppliers in a timely manner

365
AVERAGE DAYS PAYABLE ARE OUTSTANDING = —> time for payables to be paid in cash
Accounts Payable Turnover

• Indicates the average time it takes payables to be paid in cash

• The higher it is, the GREATER time the company takes to pay back its accounts payable = WORSE
 USING RATIOS TO ANALYZE THE OPERATING CYCLE

Each of the ratios measures the number of days it takes, on average, to complete an operating activity
—> helps us understand the cash needs of the company

=> it’s CRITICAL for a firm to MANAGE INVENTORIES, RECEIVABLES & PAYABLES:
INVENTORY => no return while inventory sits within the company -> VALUE generation when converted into revenues
ACCOUNTS RECEIVABLE => effectively a loan granted to a customer
ACCOUNTS PAYABLE => effectively a loan obtained from a supplier
 FINANCIAL ANALYSIS
Breaking down ROA & ROE into their components allows you to more fully understand what underlies a company’s performance

DU-PONT MODEL => used by analysts to better assess how a company is implementing its business strategy: VALUE DRIVERS
The model is broken down into 3 components:

FINANCIAL LEVERAGE = ROE - ROA —> extent to which a company uses its liabilities to leverage up its return to stockholder
 LIQUIDITY RATIOS

LIQUIDITY = ability to meet short-term obligations —> they will be paid with current assets - focus on current

Current Assets —> ability to pay short term liabilities with current assets
CURRENT RATIO =
Current Liabilities => 1-2 (if <1 = INSUFFICIENT)

• Indicates if liquid resources are sufficient to pay short term liabilities —> if <1 = INSUFFICIENT
• Should be btw 1 & 2: time for converting stocks and receivables in cash should be considered as payments of taxes, dividends…
• Industry comparison -> “window dressing”

Current Assets - Inventory* —> ability to pay short term liabilities with highly liquid assets
QUICK RATIO =
=> not < 1 = INSOLVENT
Current Liabilities

* Cash & equivalents + Net Acc. Receive. + Marketable Securities

• Current ratio criticized because stock is not readily convertible into cash => it provides a more strict TEST OF LIQUIDITY
• It should not fall below 1, otherwise it might become insolvent
• Important to know the extent to which unused loans and overdrafts are available

Cash & Equivalents

CASH RATIO = —> ability to pay short term liabilities with cash & equivalents
Current Liabilities
=> must not be too high = NO PRODUCTIVE INVESTMENTS

• Is is a more RESTRICTIVE TEST of liquidity

• Measures how well a company can pay off its current liabilities with only cash & cash equivalents
• Should not be too high because holding excessive amounts of cash implies that the company is not investing the cash in more
productive assets to grow the business.

SOLVENCY RATIOS

SOLVENCY = ability to meet long-term obligations

Operating Cash Flow —> cash coverage of interest payments required

CASH COVERAGE RATIO =
Interest Paid

• Indicates the number of times the cash flows from operations cover the interest payment to lenders

NI + Int. Exp. + Income Tax Exp. —> income available to pay interest
TIME INTEREST EARNED RATIO =
Interest Expense => high = secure position for creditors

• Shows the relation between interest obligation and profit available to pay it
• It is a margin of protection for creditors
• Interest Expense & Income Tax Expense are included in the numerator because these amounts are available to pay interest

Total Liabilities
DEBT TO EQUITY RATIO = —> debt proportion of stockholders equity
Total Stockholders Equity

• Express a company's debt proportion of its stockholders equity

• A high ratio indicates that a company relies heavily on debt financing relative to equity financing => increases RISK of not being able
to meet contractual financial obligations

= CAPITAL STRUCTURE RATIO

=> Debt is RISKY but borrowing money has many ADVANTAGES: companies use a mix of debt & equity financing
—> debt to equity evaluate this mix
 MARKET RATIOS

MARKET RATIOS = relate the current price per share of a company’s stock to the return that accrues to stockholders

PRICE-EARNINGS RATIO (PE) = Market Price x Share —> relationship btw Market Price & EPS
EPS => high: EARNINGS EXPECTED TO GROW RAPIDLY
= + WORTH
• Measures the relationship between current market price and EPS
• Market price reflects the expectations of the market for future earnings
• A company that expects to increase its earnings in the future is worth more than one that cannot grow its earnings
• Is based on future subjective expectations, not on actual past figures

Dividend x Share
DIVIDEND YIELD RATIO = —> return of solely dividends paid
Market Price x Share

• Measures how much a company pays out in dividends relative to its share price
• Reflects the return on investment absent any capital appreciation => The return attributed solely to the dividends a company pays

Market Price x Share

PRICE-TO-BOOK RATIO (PB) =
Equity (T. Assets - T. Liabilities) —> relationship btw stock Market Value & Book Value

• Compares stock market value to its book value

• Calculated by dividing the current closing price of the stock by the latest quarter’s book value per share
• A lower PB ratio could mean that the stock is undervalued, but also that something is fundamentally wrong with the company
• As with most ratios, be aware that this varies by industry

Would you invest into company X?

ANALYSIS STEP:
1. Frame the industry
2. Use and elaborate on firms financials: Profitability ratios + Liquidity ratios + Solvency ratios
3. Incorporate Industry and macro economics factors…. To:
4. Forecast firms “future value”… to:
5. Make more informed investments decisions

FORECAST FIRMS FUTURE VALUE

We look at Financial Analysts Report: experts in firms valuation, highly visible & qualified, provide recommendations & target prices

What they do:

• “Filter” the information released by the firms and insert it in their own evaluation process
• The elaboration of the information end with the output of the specific activity of an analyst: the production of the analyst reports

ANALYST REPORT = step by step procedure: from the collection & elaboration of information, to the conversion of the forecasts into
the estimation of the firm value and the formulation of target prices & stock recommendations that can influence the market behavior

3 TYPES:
‣ INITIAL COVERAGE: first time an analyst issues a report
‣ ANALYST REPORT: regular reports on a constant basis
‣ UPDATES: needed when firms’ related event might influence firms’ value
CONSOLIDATION - Accounting for Business Combinations

PREFACE ON BUSINESS COMBINATIONS

Firms grow/expand (or they attempt/wish) over time. They might expand:
‣ Horizontally = getting in businesses in the same sector
‣ Vertically = integrating parts of their production processes
‣ Internally = grow within itself (new facilities, assets, hires new managers)
‣ Externally = buy other firms —> in this case we have “Business Combinations” => Consolidated Accounting

Example:
TOD’s —> horizontal growth: enter luxury apparel skiwear market — vertical growth: produce and sell eyewear

INTERNAL:
• horizontal: new industrial facilities and equipment, leasehold improvements for fitting out Directly Operated Stores in ski resorts,
sponsorships in Olympics
• vertical: new industrial facilities and equipment in different market, hiring top managers with specific expertise in eyewear industry,
setting up new relationships with eyewear retailers

EXTERNAL:
• Business Combinations

INTERNAL
Strategy:
+ Progressive and flexible growth
- Slow process, lack of specific expertise and reputation

Accounting: conventional accounting practices

EXTERNAL
Strategy:
+ Quick and responsive growth, acquisition of expertise and reputation, potential synergies
- Financial pressure and integration uncertainty

Accounting: Consolidated Accounting

BUSINESS COMBINATION = a company achieves control of another company through shareholders RIGHTS = buy its shares
—> MERGER & ACQUISITIONS

MERGER = one company (acquirer) buys another company (target), normally by acquiring its shares and the target operations are
incorporated into the acquirer
➡ the target company stops existing as independent entity after the merge
➡ the acquirer company remains an INDIVIDUAL ENTITY

ACQUISITION = one company (acquirer) buys another company (target), normally by acquiring its shares but the target continues to
exist and keep its own assets and liabilities
➡ the target company will continue existing as an independent entity after the acquisition
➡ the companies become a GROUP
=> they will produce each their financial statements + the acquirer also CONSOLIDATED FINANCIAL STATEMENTS

In terms of accounting process:

Anytime one firm “acquires” another one, accounting for Merger and Acquisition is the SAME.
The only DIFFERENCE will be that:
‣ if there is a Merger, the accounting process will take place once
‣ If there is an Acquisition, the accounting process will happen at the end of each accounting period as the target continue to exist

NOWADAYS
- Almost all Publicly listed firms are organized as Business Groups
- Group structure is mostly a function of size…
Therefore, most of the firms you will be looking at, report Consolidated Statements. Hence, it is of crucial importance to get familiar
with Consolidation Accounting
CONSOLIDATION & THE CONCEPT OF CONTROL

= WE CONSOLIDATE WHEN
THERE IS CONTROL

Consolidation “issues” arises when one company CONTROLS another company (normally by acquiring its shares), but the latter
continues to exist as a separate entity and to keep its own assets and liabilities = ACQUISITION

From an accounting point of view this is the case in which:

➡ we have a GROUP OF COMPANIES
➡ we have to prepare CONSOLIDATED FINANCIAL STATEMENTS

CONTROL = the power to govern the operating and financial policies of an entity so as to obtain benefits from its activities
=> 3 CONDITIONS x situation of control: (IFRS 10)
The investor: => 3 CONDITIONS MUST HOLD SIMULTANEOUSLY
1. Possesses power over the investee => NEED OF CONSOLIDATION
2. Has exposure to variable returns from its involvement with the investee
3. Has the ability to use its power over the investee to affect its returns (link power & returns)

CONSOLIDATED STATEMENTS -> combine the financial statements of the holding with those of the subsidiaries into an overall set
of statements as if the parent and its subsidiaries were a single entity.

=> assets, liabilities, revenues & expenses of each subsidiary are ADDED to the parent’s accounts as if the parent had acquired
directly the assets and liabilities of the subsidiary instead of investing in its shares.

Therefore, the consolidation process doesn’t consist only in adding up the individual companies’ financial statements, but also in
making them consistent with each other and eliminating all those items that wouldn’t be there if the activities were actually performed
by the parent company only -> thus avoiding double counting

TERMINOLOGY
PARENT = entity that has one or more subsidiaries
SUBSIDIARY = entity, including an unincorporated entity such as a partnership, that is controlled by another entity (the parent)
GROUP = parent and all its subsidiaries
NON-CONTROLLING / MINORITY INTEREST = equity in a subsidiary not attributable, directly or indirectly, to a parent
SEPARATE FINANCIAL STATEMENTS (STAND ALONE) = statements presented by companies as single legal entities
CONSOLIDATED FINANCIAL STATEMENTS = financial statements representing the group as a unique economic entity

CONSOLIDATION METHODS
WHEN: Businesses Combination obtaining control of subsidiary
WHAT: Fair Value (=Market Value) of acquired assets & liabilities, even those not recorded yet
HOW: In its financial statements, the acquiring company accounts all the target’s assets/liabilities identified at 100% of their fair
value, regardless of the share held by parent and considering the deferred tax effect

ACCOUNTING:
1. Recognition of consolidation difference -> if positive: goodwill = purchase price - fair market value of target NET ASSETS
2. Separate recognition of non-controlling interests accounted at fair value

Recall: Goodwill & non-controlling interests will change depending on method used (Acquisition Method or Full Goodwill approach)

- Accounting for Consolidation is addressed by IFRS 3 “Accounting for Business Combinations”

- Consolidation can be carried out using different approaches - accounting standard. Methods differ with reference to the value
given (and reported) to non-controlling shareholders in the Consolidated Statements
THE METHODS UNDER IFRS: => they differ in the non-controlling shareholders that is generated by the identified Goodwill
1) Acquisition Method
2) Full Goodwill Approach

FAIR VALUE = amount for which an asset could be exchanged or a liability settled, between knowledgeable willing parties in a
transaction —> MARKET VALUE
➡ If PAID PRICE > TOT FAIR VALUE => GOODWILL — ASSET to be impaired each year
➡ If PAID PRICE < TOT FAIR VALUE => BADWILL — GAIN to be allocated to IS (not capitalized as an asset)

GOODWILL = all non identifiable resources which are expected to generate future economic benefits —> will be recorded:
‣ Acquisition Method: only the PART ACQUIRED by the parent
‣ Full Goodwill Approach: in FULL

IMPORTANT: NO TAX EFFECT IS RECORDED ON GOODWILL

THE CONSOLIDATION PROCESS

1. Collect companies’ individual financial statements
2. Make them uniform as concerns: 1. Accounting period’s dates, 2. Accounting policies, 3. Reporting currency, 4. Layout
3. Combine like items — “Aggregate situation”
4. Offset investment in subsidiaries against the parent’s portion of equity
Recognize any increase in subsidiaries’ assets & liabilities
Account for any related goodwill
Recognize non-controlling interests
5. Depreciate/amortize any plus value/minus value
6. Eliminate any intra-group transactions
7. Allocate the group’s and minorities’ results
8. Close the consolidation process & prepare the statements

STEPS:
1) PRE-CONSOLIDATION ADJUSTMENTS AND AGGREGATION (1+2+3)
2) INVESTMENT WRITE-OFF + GOODWILL CALCULATION + NON-CONTROLLING INTEREST
3) AMORTIZATION/DEPRECIATION SURPLUSES
4) CONSOLIDATION ADJUSTMENTS
5) COMPUTATION OF NC NET INCOME

!!!!!!!!!!WHEN DOING THE ADJUSTMENTS ALWAYS MAKE SURE TOT ASSETS = TOT LIABILITIES!!!!!!!!!!!

PRE-CONSOLIDATION ADJUSTMENTS (1+2+3)

Purpose = guarantee UNIFORMITY of all the statements to be aggregated with regard to:
✓ Accounting principles & policies adopted
✓ Reporting currency
✓ Closing dates of statements
✓ Layout — Schemes & contents of financial statements

≠ FORMATS: all formats must be aligned before starting the consolidation process
≠ CLOSING DATES: they may use different closing dates as long as the difference btw the two does not exceed 3 months
—> must prepare ad-hoc financial statements if difference is larger than 3 months
≠ CURRENCIES: all financial statements are accounted using the same currency.
- For income statement: average exchange rate of the financial year
- For balance sheet: items exchange rate at the “closing” date
- NOTE: differences in the exchange rates will generate a “currency exchange difference” —> to be reported in the Equity
4. WRITE-OFF OF THE INVESTMENT
CARRYING VALUE OF INVESTMENT = Net Fair Value of all assets & liabilities of subsidiary acquired by parent at acquisition date

—> after aggregating line by line the balances of target & acquirer, the investment in the subsidiary has to be ELIMINATED
—> in fact, the VALUE OF THE INVESTMENT reported by the acquirer = summary of the values of assets & liabilities of the target

STEPS:
1. Remove the value of the investment => PRICE PAID
2. Write-off of subsidiary book value equity at acquisition date => COMMON STOCK + RETAINED EARNINGS
3. Recognition of surplus/minus values at acquisition date => BV - FV
4. Recognition of deferred tax (tax effect of FV adjustment) => % on BV - FV —> WITH +!
5. Recognition of goodwill/badwill => WHAT IS LEFT after all allocations (if + = goodwill / if - = badwill)

—> the Badwill should be recorded in the IS but also as increase in Net Income in BS!

Example:
- Let’s assume we are Firm A and we acquire 100% of shares of Firm B
- B has PPE that we need and to make it simple, we assume that the value in the BS of such assets is equal to the book value

BEFORE ACQUISITION AFTER ACQUISITION

CONSOLIDATED STATEMENTS
=> write-off the investment in the subsidiary & its equity
=> report its PPE in the Assets of the parent

—> the consolidation method assumes that there is no separate subsidiary - but a single economic entity = there cannot be any
owner’s equity belonging to it

4. PURCHASE PRICE ALLOCATION (PPA)

= process through which we determine:
1. The Fair Value of assets & liabilities of the acquiree
2. The Goodwill + its functions as starting point to determine the non-controlling interests

PPA PROCESS:

NOTE: Subsidiary’s EQUITY VALUE to use is the one at ACQUISITION DATE

If INVESTMENT = BV EQUITY OF THE INVESTEE => NO DIFFERENCES TO BE ALLOCATED

➡ No Fair Value adjustments to assets and liabilities
➡ No Tax Effect due to fair value adjustments to assets and liabilities
➡ No goodwill/badwill
4. TAX EFFECTS OF FV
Taxation happens at Subsidiary Level —> we expect taxes = 0 at consolidated level
If FV ≠ BV => Account for related DEFERRED TAX ASSETS & LIABILITIES

If Δ Tax Expenses > 0 —> Deferred Tax Liabilities

If Δ Tax Expenses < 0 —> Deferred Tax Assets

Example:
- Company A acquires company B
- Company B reports PPE with BV 1,200. The FV of PPE in the consolidation process is 1,500
- The PLUS VALUE of 300, resulting from the FV adjustment of consolidation, is not fiscally recognized
—> the yearly depreciation recognized by the tax authority refers to the original BV of the asset (1,200)
- Tax rate equals 50%

Future Taxes Outflow (150) > Future Taxes Recognized (based on Consolidated IS: 0)

PURCHASE PRICE ALLOCATION (PPA) WITH TAXES

PURCHASE PRICE ALLOCATION (PPA) WITH BADWILL

EXERCISE 1
- On 1/1/X, Alfa company purchases a total investment in Beta company, for €10.000.
- Beta’s equity at book value at this date is €7.500. The fair value of Beta’ assets and liabilities at the same date equals their book
value, except for the plant which has a book values of €600 and fair value of €2.600 (the plus values are gross of the relevant tax
effect).
- Using the worksheet given below, make the operations regarding the elimination of investments and depreciation of the plus values.
-Note that the tax rate applied by the group is 50%.

STEPS
1) Remove the value of the investment
2) Offset against the equity of the subsidiary
3) Express assets and liabilities of the acquiree at FV
4) Account for the tax effect of FV adjustment
5) Goodwill
IN CASE OF BADWILL (case 5)

—> the Badwill should be recorded in the IS but also as increase in Net Income in BS!

NO TAX EFFECT ON
GOODWILL/BADWILL
4. COMPUTATION OF NON CONTROLLING INTERESTS (MI - Minority Interest)
With the Acquisition Method and Full Goodwill approach, subsidiaries are consolidated at 100% and Assets and Liabilities are
accounted for at Fair Value.

However, if the Parent firm does not own 100% of subsidiary shares -> consolidated financial statements need to account for third
parties ownerships values.

=> Such values are to be identified separately. The so called “non-controlling interests”. The amount will be:
➡ With the Acquisition Method: Fair Value of the non-controlling interests %
= no Goodwill will be given to the non-controlling shareholders —> all goodwill to the parent

➡ With the Full Goodwill approach: % of the Enterprise Value that belongs to non controlling interests
= including the Goodwill - Notice, in this case the amount will be already provided

PURCHASE PRICE ALLOCATION (PPA) + ACQUISITION METHOD

• Remove the Non controlling Interests equity in the subsidiary

• Report Non controlling Interests as part of the equity of the consolidated groups
• Non controlling Interests => proportionate share (%) of the subsidiary identifiable Net Assets => no goodwill to minorities

PURCHASE PRICE ALLOCATION (PPA) + FULL GOODWILL

• Remove the Non controlling Interests equity in the subsidiary

• Report Non controlling Interests as part of the equity of the consolidated groups
• Non controlling Interests => fair value = proportionate share (%) of the subsidiary identifiable Net Assets + goodwill

NOTE: Subsidiary’s EQUITY VALUE to use is the one at ACQUISITION DATE

IN THE END, THE ADJUSTMENT IS DONE IN A SINGLE COLUMN, SO BOTH METHODS ARE THEN AT 100%
EXERCISE 2 - Acquisition Method
- On 1/1/X, Alfa company purchases an investment of 70% in Beta company for € 8000.
- Beta’s net assets at that date are € 7.500. The fair value of Beta’s assets and liabilities at the same date coincides with the book
values, with the exception of equipment which has a book value of € 500 and a fair value of € 900 (the plus values are gross of the
relative tax effect).
- Using the worksheet given below, make the operations regarding elimination of the investment and depreciation of the plus values.
- Note that the group companies are subject to a tax rate of 50%.

STEPS
1) Remove the value of the investment
2) Offset against the equity of the subsidiary
3) Express assets and liabilities of the acquiree at FV
4) Account for the tax effect of FV adjustment
5) Goodwill
6) Recognize MI

=> PRICE PAID

=> % OWNED

=> ALL THE GOODWILL TO THE PARENT

=> % OWNED (70-30%)

=> ALL GOODWILL TO PARENT
=> PRICE

=> % OWNED (70-30%)

30% x (7.500 + 400 - 200)

=> % OWNED (70-30%)

Non Controlling Interest = % x (Equity + Change Assets - Def Tax Liabilities) => NO GOODWILL
EXERCISE 4 - Full Goodwill
- On January 1, X company A buys 80% of shares in company B. The cost of the investment is €11.000. The equity of B, on the same
date, is €10.000.
- The fair value of assets and liabilities of B equals their book value, except for the following:
Book Value Fair Value Gross surplus
Property 6.000 8.000 2.000
Patents 1.000 3.000 2.000
- Consider that the tax rate applied by the two companies is 50%.
- We proceed to accounting entry of the elimination of participation in Beta in accordance with IFRS, attributing the positive difference
as goodwill.
- The company applies the “full goodwill method”. Assume that the fair value of the non-controlling interests is 2.750€.

STEPS
1) Remove the value of the investment
2) Offset against the equity of the subsidiary
3) Express assets and liabilitIes of the acquiree at FV
4) Account for the tax effect of FV adjustment
5) Goodwill
6) Recognize MI

=> PRICE + NON CONTROLLING INTEREST (11.000 + 2.750)

=> 100%

=> GOODWILL TO BE ALLOCATED TO NC INTERESTS

=> 100%

=> PRICE

=> 100%

20% x (11.000+4.000-2000+1.750)

Non Controlling Interest = % x (Equity + Change Assets - Def Tax Liabilities + GOODWILL)

=> in Full Goodwill the NCI is always given

 DIFFERENCES IN METHODS
ACQUISITION METHOD FULL GOODWILL
Investment price = price paid Investment price* = price paid + non-controlling interest
PPE + taxes + goodwill at % owned (but then together at 100%) PPE + taxes + goodwill at 100%
Non-controlling interest = % of Equity + Net Assets —> no goodwill Non-controlling interest = % of Equity + Net Assets + Goodwill
* but write-off = PRICE

5. SURPLUS AMORTIZATION/DEPRECIATION
Positive & negative surpluses on assets and liabilities follow the same treatment of the assets or liabilities they refer to.
So, if they are related to:
‣ Depreciable assets —> the SURPLUSES are amortized over the residual useful life of the assets to which they relate;
‣ Non-depreciable assets —> the SURPLUSES may, together with the assets to which they relate to, be tested for impairment
(Goodwill shall be tested for impairment every year)

DEPRECIATION = SURPLUSES * RESIDUAL USEFUL LIFE

PRE CONSOLIDATION ADJUSTMENTS - Accounting Policies

• To prepare consolidated financial statements -> necessary to add together balance sheets income statements of the parent
company and of all the subsidiaries
• They must be prepared using UNIFORM accounting policies (harmonization of pre-consolidation phase)
• The uniformity of accounting policies may be obtained in different ways…

3 possible scenarios:
1) Subsidiaries adopt ex-ante in their financial statement the same accounting policies used by the parent company -> if such
standards are compliant with the local regulation
2) Subsidiaries prepares stand-alone financial statements as required by local rules & additional “ad hoc” financial statements with
the necessary adjustments are prepared and sent for the consolidation process only.
3) Harmonization is managed at the parent level => all adjustments are prepared at corporate level, during the consolidation process

The logic to make adjustments to harmonize accounting principles and valuation criteria is as follows:
1. Effective accounting: Identify the accounting actually made by the company subsidiary -> entry reflected in the aggregated sheet
2. Proper accounting: identify the accounting that the company would have made to adopt principles and policies consistent with
those followed by the group
3. According to the difference between proper & effective accounting -> intensify Adjustments to Consolidated Financial Statements

INVENTORY DIFFERENCES
- Company A acquired 100% of shares in company B
- At the end of the year, Company A has to consolidate company B accounts
- With reference to Inventories: Company A inventories are accounted using FIFO, Company B inventories are accounted using LIFO
- The difference in inventory methods, should company B have valued inventory using FIFO would results in a lower COGS of 500€

x Harmonization —> The subsidiary (B) will need to “adjust” inventory value to stick with the parent (A) accounting policy.

Company B accounting at FIFO means: The decrease in COGS by 500 + An increase in Inventory by 500:
When B - using LIFO - accounted inventory and COGS, recorded an entry as follows:
COGS Inventory 500
Inventory 500

If FIFO has to be used, the COGS would be lower by 500. This means that we need to adjust the entry above, as follows:
Inventory 500
COGS inventory 500

=> This is intuitive, as if COGS decreases, this means that the amount “not sold” (so the adjustment) is actually still on hand —> the
amount on hand is stored in the inventory account: this is why we debit inventory.

With the adjustment, we also indirectly change the Pre Tax Income —> we need to take into account the TAX EFFECT (that will
always be present if through consolidation adjustments we modify pre-tax income)
EXERCISE 5 - INVENTORY
- Alfa owns 100% of shares in company Beta.
- While drawing up the consolidated financial statement of year X Alfa ascertains that Beta has valued inventory using LIFO method,
when the consolidation manual requires using FIFO method.
- Should Beta have valued inventory using FIFO method, cost of goods sold would have been smaller by 500.
- Using the following worksheet make the pre-consolidation adjustments with reference to accounting policies harmonization.
- Consider that the tax rate applied by the two companies is 50%.

STEP:
1. Adjust Operating Expenses = difference in COGS
2. Adjust Income Taxes
3. Adjust Balance Sheet: 1) NI, 2) Inventory, 3) Def. Tax Liability

=> - COGS

=> TAX EFFECT

=> + INVENTORY

=> REPORT NET INCOME

=> x + TAXES
EXERCISE 6 - R&D
- Alfa owns 70% of shares in company Beta => % OWNED DOESN’T COUNT
- While drawing up the consolidated financial statement of year X Alfa ascertains that Beta has capitalized R&D costs for 300 (Beta
does not adopt the IFRS). These have been depreciated using a constant rate in 5 years.
- Under the group’s accounting policies stated in the consolidation manual, these costs should have been totally expensed in the
Income Statement.
- Using the following worksheet make the pre-consolidation adjustments with reference to accounting policies harmonization.
- Consider that the tax rate applied by the two companies is 50%.

=> + R&D EXPENSED

= capitalization - depreciation

=> TAX EFFECT

=> - R&D CAPITALIZED

= capitalization - depreciation

=> x - TAXES

=> REPORT NET INCOME

6. CONSOLIDATION ADJUSTMENTS
= elimination of intra-company transactions —> all transactions within the group are to be canceled in consolidated statements

1. Elimination of inter-company RECEIVABLES & PAYABLES and REVENUES & EXPENSE

2. Elimination of inter-company PROFITS & LOSSES ( included in the value of inventories & of long-lived asset)
3. Elimination of inter-company DIVIDENDS

• Consolidated financial statements provide the representation of economic and financial situation of the group as a SINGLE ENTITY
• Transactions that occur btw group companies are EQUIVALENT to transactions btw divisions/functions within a company (in CS)
• Such transactions, since are not with “third parties”, should not even be recognized in the general accounting system
• The consolidated statement should represent only operations that group companies have made with third parties outside the group.

1. ELIMINATION OF INTER-COMPANY RECEIVABLES & PAYABLES + REVENUES & EXPENSE

• Trading or financing operations within companies group determine payables and receivables, costs and revenues.
• For the group, seen as a company, these items are irrelevant —> should be eliminated in the consolidated financial statement.

In particular, should be removed:

- intra-group revenues and expenses recognized during the financial year
- Intra-group receivables and payables not yet settled at the end of the year

=> adjustments of elimination of intra-group receivables & payables + costs & revenues are FULLY OPERATED AT 100% (=%
OWNED DOES NOT MATTER)

TRANSACTIONS
• Acquiring and selling company -> give rise to purchase expenses and selling revenue
• Intra-group grants of financial loans -> give rise to financial revenues to financed company and expenses to financing company
-> give rise to financial receivables to financing and financial liabilities to financed company
• Transactions still to be settled at closing date -> give rise to trade receivables to the selling and liabilities to acquiring company

➡ These operations do not give rise to deferred tax assets or liabilities.

RECONCILIATION OF INTRA-GROUP TRANSACTIONS

• The removal of intra-group transactions is based on the assumption that there is equivalence btw accounts of each company.
• This equivalence exists if all group companies have correctly pointed out such operations.
• If, by mistake or imperfect information, there is no equivalence between accounts, we need to "reconcile" the values of intra-group
transactions ensuring that they are properly recognized by all companies.
• After the reconciliation, you can proceed with their elimination.

STEPS:
1. Identify which values of credit/debt, costs/revenues, arising from intra-group transactions, are recorded in the financial
statements of companies included in consolidated financial statement.
2. Make sure there is mutual equivalence between accounts —> if this equivalence is not present, reconcile intra-group values.
3. Delete the mutual accounts (receivables and payables, costs and revenues).
EXERCISE 7 - Loan
- Alfa owns 80% of the shares of Beta. In order to prepare the consolidated financial statement for the year X using the integral
consolidation method, the following information is given.
- At the beginning of the year, Beta grant Alfa a €4.000 loan, to be paid back through constant installments of 500;
- On 31/12/X, with reference to this loan, Alfa and Beta registered financial expenses and revenues of 120 and both registered the
payment of the first installment of 500.
- Using the following worksheet, make the necessary consolidation entries

NO IMPLICATIONS ON CASH: THE TWO AMOUNTS

OFFSET EACH OTHER = NO ADJUSTMENTS

=> INTEREST EXP. & REVENUE

NET FIN. REC. = 3500 -> divide current & non

500 current - 3000 non current

NET LOAN = 3500 -> divide current & non

500 current - 3000 non current
EXERCISE 8 - Transaction to be settled
- Alfa owns 90% of the shares of Beta
- On 23rd of December Beta carried out a service for Alfa for €400; both the companies have registered the relative invoice.
- On 29th of December Alfa settled its liability, but on 31st Beta has not yet received the receipt of payment from its bank.
- Using the following worksheet, make the necessary consolidation entries.

IN THIS CASE WE HAVE IMPLICATIONS ON CASH

SINCE BETA HAS NOT RECEIVED CASH YET

=> SERVICE EXP. & REVENUE

=> CASH & RECEIVABLES

2. ELIMINATION OF INTER-COMPANY PROFITS AND LOSSES
In the consolidated financial statement, group result should be that generated by the group with any third party and not the one that
individual companies have achieved working together.

• So, any intra-group profits and losses which relate to assets still included in the heritage group at year-end, must be removed.

• This consolidation adjustment is intended to eliminate the impact of intra-group operation, as reporting in the absence of the
transaction itself.
—> It should not eliminate inter-company losses expressing an actual decrease in value of property that is necessary to represent.

• From the elimination of intra-group emerge temporary differences -> must therefore detect the deferred tax assets or liabilities
arising from these differences.

=> adjustments of elimination of intra-group profits and losses are FULLY OPERATED AT 100% (=% OWNED DOES NOT MATTER)

The elimination of inter-company profits and losses is achieved by:

➡ Adjusting the carrying value of assets —> must be "brought back" to the value of if they wouldn’t have been transferred
➡ Adjusting the related income items that are "generated" by the intra-group transaction —> this change must be eliminated

PROFIT AND LOSSES INCLUDED IN THE VALUE OF INVENTORIES

In the case of profits (or losses) included in the value of inventories, intra-group profits (or losses) must be eliminated to the extent that
it is linked to the assets are still in the warehouse of the acquirer at year-end.

STEPS:
1. Calculate the total inter-company profit (or loss) result
2. Calculate the inter-company profit (or loss) not made with third parties = total inter-company profit (1) x % goods still in warehouse
3. Reduce (increase) the closing balance of inventory by the amount of inter-company profit (or loss) not made with third parties (2)

If inventories are transferred between two companies belonging to the same group, the relative unrealized profit must be eliminated.
In particular, we must distinguish the case in which:

CASE A: All inventories are still on hand in the acquiring company at the end of the year.
CASE B: Part of the inventories have been sold from the acquiring company at the end of the year.
—> we must split the transactions in 2 PARTS: 1. % inventories on hand & 2. % inventories sold
CASE A
- During year X Alfa (parent company) sells Beta (subsidiary fully owned) inventories, for a price of €120.
- In the same exercise, such inventories had been acquired by Alfa from external parties at a cost of €100.
- At the end of the year, ALL inventories are still on hand.
- Make the needed consolidation entries in order to eliminate the effects of this internal transaction

=> sale must be eliminated -> SALES & COGS = 0

=> inventory as bought by A but never sold -> = 100

=> - SALE (selling price)

=> - COGS (purchasing price)
=> difference

=> TAX EFFECT

=> INVENTORIES TO BEFORE SALE VALUE

=> x - TAXES

=> REPORT NET INCOME

CASE B
- During year X Alfa (parent company) sells Beta (subsidiary) inventories, for a price of €600.
- In the same exercise, such inventories had been acquired by Alfa from external parties at a cost of €350.
- At the end of the year, 60% inventories are still on hand.
- Make the needed consolidation entries in order to eliminate the effects of this internal transaction.

STEPS:
1. => SALE
3. => difference
2. => profit from sale * 60%
(600-350 * inventory on hand)

=> INVENTORIES TO BEFORE SALE VALUE

WRITING DOWN OF INVENTORIES

• The Lower-of-cost-or-market rule requires an asset to be reported at the lower btw historical cost or market value.
• If the market value falls below its historical cost, the business unit writes down the value of its goods to market value:

COGS (+E) xx
Inventory (-A) xx xx = cost - market value

EXERCISE 9
- Company Beta purchases inventories from Company Alfa at a price of €4000.
- These inventories cost Company Alfa €3000.
- At the end of the year, all inventories were still on hand and were registered by Company Beta for €3500: Beta, by consequence,
wrote down inventories at their market value (which is €3500).
- The tax rate is assumed to be 50%.
- Make the necessary adjustment in order to eliminate the intra-group profit

COGS must be 0, since without the selling

inventory is valued at 3000, so there is no LCM
adjustment to do
=> - SALE
=> - COGS*
*COGS = 3000 x alfa + 500 x beta (write down)

=> TAX EFFECT

=> WRITE DOWN

=> x - TAXES

=> REPORT NET INCOME

CASE C
- Company Alfa owns 100% of shares of Company Beta.
- During exercise X, company Alfa sells company Beta goods for a total amount of €6000. Alfa purchased these goods for €10000.
- At the end of the year, all inventories were still on hand of Company Beta. The market value of these inventories at year-end equals
€8.500.
- The tax rate is assumed to be 50%.
- Make the necessary adjustments in order to eliminate the intra - group loss.

SALE = must be eliminated -> 0

COGS = write down (10000 - 8500)
INVENTORY = market value

COGS must be 1500, since without the selling

inventory is valued at 10000, so there is LCM
adjustment of 8500 to do

STEPS:
1. => Sales
2. => - COGS
3. => difference

=> + INVENTORIES

In case MARKET VALUE > INVENTORY COST —> NO ADJUSTMENT TO DO

ELIMINATION OF INTER-COMPANY LOSSES

• If two companies belonging to the same group set up a commercial transaction which gives rise to an intra-group loss => must be
fully eliminated, if not realized with external parties.
• In any case, International Accounting Standards state that the causes underlying the loss should be examined.
• If this loss is due to a long term reduction in the asset’s value, the intra-group loss must not be eliminated, as it reflects the loss on
value of the asset.
PROFIT AND LOSSES INCLUDED IN THE VALUE OF LONG-LIVED ASSETS
In case of profits (or losses) included in the value of long-lived assets, you must:
1. Report the transferred assets (still held by the acquirer at year-end) at the carrying amount that would have been in absence of
inter-company transaction;
2. Reverse any gains/losses realized as a result of alienation;
3. Adjust depreciation to report them as there would be in absence of alienation.

From a consolidated viewpoint, depreciation must be based on the cost of the asset to the consolidated entity, which is the
asset’s historical cost to the related company that originally purchased it from an outsider.

Eliminating entries are needed in the consolidation work paper to restate the asset, associated accumulated depreciation, and
depreciation expense to the amounts that would appear in the financial statements if there had been no inter-company transfer.

STEPS:
1. identify the accounting effect that the inter-company transaction has led, with particular reference to gains/losses, sold assets
and their depreciation. This entry is reflected in aggregated balance sheet;

2. identify the values that the items affected by the transaction (gains/losses, sold assets and depreciation) would have had in the
absence of operation. This entry is that which must be reflected in the consolidated financial statement;

3. as a result of differences found between values (1) and (2), identify corrections to be made to the aggregated balance sheet for
obtaining the consolidated financial statement.

=> With reference to losses on sales, the book value of the asset must be compared with its value in use.

EXERCISE 11
- Alfa owns 100% of the shares of Beta.
- During the year X, Alfa sells Beta a plant for a total amount of €4.000. The historical cost of the non-current asset was 6.000, with an
accumulated depreciation of 3600.
- At 31/12/X, the plant is still on hand. Alfa used to depreciate the plant evenly at a rate of 10% (depreciation = 10% * 6.000 = 600),
while Beta depreciates the same pant evenly at a rate of 20% (depreciation = 20% * 4.000).
- Using the following worksheets, make the necessary consolidation entries (tax rate applied by the two companies is 50%).

=> Gain on sale

=> Depreciation difference

=> - Gain & + Depreciation

=> in case of depreciation

we use the OPPOSITE:
If: — DEF. TAX ASSETS
+ DEF. TAX LIABILITIES

If: — DEF. TAX LIABILITIES

+ DEF. TAX ASSETS

* PPE = 6.000 - 3.600 = 2.400 —> PPE we should have

* GAIN = 4.000 - 2.400 = 1.600
3. ELIMINATION OF INTER-COMPANY DIVIDENDS
When a subsidiary (Target) pays dividends to a parent (Acquirer) during a certain accounting period, journal entries prepared by the
two entities are the following:
SUBSIDIARY PARENT
Retained earnings (-SE) Cash (+A)
Cash (-A) Dividend revenue (+R)

The journal entry of the subsidiary has no impact on its income statement.
The journal entry of the parent has impact on its income statement.

—> Nevertheless, as you all know, dividends are taxed only for a very small amount (5%) for consolidation purposes, we assume
taxation on dividends is zero [this is valid not only in this course, but also in professional practice].

CONSOLIDATION ADJUSTMENTS - 2 CASES:

1. wholly owned subsidiary (which is only one adjustment) => DIVIDENDS = 100%
2. non-wholly owned subsidiary (which requires the precedent adjustment, plus another one).

STEPS - Wholly owned STEPS - Non-wholly owned

1) Remove the financial revenue (% owned * dividends) 1) Remove the financial revenue (% owned * dividends)
+ adjust related effect on IBT & Net Income (+ in BS) + adjust related effect on IBT & Net Income (+ in BS)
2) Refill retained earnings for the divided issued (100% dividends) 2) Refill retained earnings for the divided issued (100% dividends)
3) Remove the NC share in equity (% minorities * dividend)

IN CASE OF WHOLLY OWNED —> CASH OFFSET + JUST REVERSE RETAINED EARNINGS & DIVIDEND REVENUE
SUBSIDIARY PARENT
Retained earnings (-SE) Cash (+A) —> Cash offsets
Cash (-A) Dividend revenue (+R)

IN CASE OF NON-WHOLLY OWNED —> we have to adjust the amount of retained earnings pertaining to minorities & restate the
amount pertaining to the group

EXERCISE 14 - Wholly owned

- On 1 January X Alfa purchases 100% of the shares in company Beta.
- During year X, Beta distributes dividends for €2.000. Alfa records dividends received among financial revenues.
- Make the necessary consolidation entries relative to dividends-writing off (do not consider tax effects).
DIVIDENDS MINORITIES - Non wholly owned
- On January 1, company Alpha acquired 90% stake in company Beta paying a price of €9900. The group prepare the Consolidated
FS relying on the Acquisition Method.
- The balance sheet of Beta at the date of acquisition showed common stock for 9,600 and total equity for 11,000 (=> RE=1400).
- During the year, Beta paid dividends for 1,000.
- Using the following worksheets, make the necessary consolidation entries relative to dividends-writing off

STEPS:
1) Remove the financial revenue (% owned * dividends) -> + adjust related effect on IBT & Net Income (also in BS)
2) Refill retained earnings for the divided issued (100% dividends)
3) Remove the MI share in equity (% minorities * dividend)

NB: In the exam, it might be not specified whether dividends are paid throughout the year or not: be careful
Only intra-group dividends shall be taken into consideration
7. COMPUTATION OF NC NET INCOME
In case of non-wholly owned investment:
• Assets are, in any case, accounted by the Parent at 100% in consolidated F/S
• Liabilities are, in any case, accounted by the Parent at 100% in consolidated F/S
• In stockholders’ equity, in a separate item, we show the value of minorities’ equity %

If parents owns 70% of the subsidiary, to prepare consolidated F/S:

1. Add up in the aggregate F/S 100% of assets liabilities and stockholders equity
2. Them splitting the stockholders equity into two, eliminating 70% and keeping the 30% owned by the minorities (x IFRS 10)

CONT’D
Recalled that stockholders equity is made of:
- Common stock
- Retained earnings (of precent accounting periods)
- Profit/loss fo the year

And recalled that minorities are assigned 1 & 2 above in the phase of the elimination of the investment, the final consolidation
adjustments consists in assigning to the minorities a PORTION OF 3: PROFIT/LOSS OF THE YEAR

TO COMPUTE NCI => WE USE A STANDARDIZED FORMULA APPROACH:

NCI NI = (Pr Sub +/- ADJ) * %NCI

NCI NI = Net Income attributable to Non Controlling Interest

Pr Sub = Net Income realized by the subsidiary in its separate financial statements
Adj = Adjustments to net profit due to consolidation entries, whereas the adjustment pertain the subsidiary
%NCI = % owned by the minorities in the common stock of the subsidiary

The adjustments that shall be taken into consideration:

- Generated by depreciation/amortization of surpluses
- Generated by upstream transactions = all transactions where the seller is the Subsidiary and the buyer is the Parent

=> Once the NCI share of net income is computed, then the consolidation adjustment is:
1) Decrease “Net Income” in the income statement
2) Increase “NCI share of income” in the income statement
3) Decrease “Net Income” in the stockholders’ equity
4) Increase “NCI share of income” in the stockholders’ equity

SEE EXERCISE 17