Credit Analysis and Financial DistressAcct 503B Fall 2023

Week 6

1

Credit Analysis and Financial Distress –

Agenda

How does valuation of bonds differ from the valuation of stock?

– Payoffs as a function of firm value

– Stock is a call option given by bondholders to stockholders

Bond ratings

Bondholders will focus on measures of default probability. These

include measures of

– Liquidity (short-term cash availability)

– Solvency (long-term cash availability)

– Size and profitability

– The variance of the firm’s common stock

Bankruptcy prediction

Acct 503B Fall 2023

Week 6

2

Corporate Debt v Equity

Quick comparison

1. More debt is issued each year than equity

– 2022=YTD Debt = $1,142B; Equity = $77.2B

2. Equity is more liquid than debt

– 2022 Ave. Daily Volume Debt = $39B; Equity = $604B

3. Equity market is larger in value than corporate debt market

– 2022 2Q Outstanding Debt = $10.1T; 3Q Equity = $37.9T

4. 91.3% of Corporate debt issues 2022YTD are low default risk

(“investment grade)

Points 2, 3, and 4 suggest that far more resources are devoted to

analyzing corporate equity. Commercial loans by banks = $2.4T.

Evaluating these loans requires substantial credit analysis.

3

Acct 503B Fall 2023

(Source: SIFMA andWeek

FRED,

2022)

6

Valuation of Stock vs Valuation of Bonds

Payoffs as a function of Asset Value

To understand why valuation of bonds differs from valuation of

stocks we must first understand how the payoffs of these securities

differ as a function of firm value (V).

Assume:

V = value of the firm’s assets

P = promised payment on debt (including interest)

Stockholders’ payoff = maximum (0, V-P)

Bondholders’ payoff = minimum (V, P)

Bondholders lack the “upside” potential of stockholders.

– Cash flows promised by the firm to bondholders are

“capped.”

– After payment of principal and interest are assured,

bondholders receive no benefit from additional profits

generated by the firm.

Acct 503B Fall 2023

Week 6

4

Valuation of Stock vs Valuation of Bonds

Payoffs as a function of Asset Value

$

Payoff to Bondholders

P

Payoff to Stockholders

0

Value of Assets (V)

P (amounted owed on debt)

Acct 503B Fall 2023

Week 6

5

Valuation of Stock vs Valuation of Bonds

Payoffs as a function of Asset Value

$

Payoff to Stockholders

P

0

Once the value of firm’s assets is in

this region, stockholders’ value

(i.e., their expected payoffs)

changes very little.

Stockholders focus their

analysis on figuring out

where the firm will be

in this region.

Value of Assets (V)

P (amounted owed on debt)

Acct 503B Fall 2023

Week 6

6

Valuation of Stock vs Valuation of Bonds

Payoffs as a function of Asset Value

$

Bondholders focus their

analysis on figuring out

where the firm will be

in this region.

Payoff to Bondholders

P

Once the value of firm’s assets is in

this region, bondholders’ value

(i.e., their expected payoffs)

changes very little.

0

V

P

Acct 503B Fall 2023

Week 6

7

Valuation of Stock vs Valuation of Bonds

Differences between stock and bond valuation

Unlike stockholders, bondholders will focus their analysis on

situations where the value of the firm’s assets is less then P.

– Bondholders try to predict what would happen in default

• What is the liquidation value of the assets?

– Are the assets fungible or are they valuable only to this

company? How easy is it to covert them into cash?

– Banks will loan more readily on Accounts Receivable than on

PP&E.

– Evidence: Benmelech (2005) found railroads with more

common track gauge had longer debt maturities

• Do other creditors have senior claims in bankruptcy?

Acct 503B Fall 2023

Week 6

8

Valuation of Stock vs Valuation of Bonds

Differences between stock and bond valuation

Unlike stockholders, bondholders will place little weight on

growth or cash inflows that will only occur if the firm continues

to operate i.e., when V > P.

– Bondholders do not participate in these payouts so the

existence of this growth is irrelevant to bondholders.

– Examples include

(1) growth options, i.e., the option to expand if the firm’s current

investments are successful

(2) growth beyond a given threshold

– Bondholders care about growth only to the extent that it

provides an indication of the health of the firm’s current

operations

Acct 503B Fall 2023

Week 6

9

Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

The exercise price of the option is the promised payment on the

debt (P).

Stockholders will exercise the option (i.e., retain control of the

firm) if the value of the firm’s assets (V) exceeds the promised

payment on the debt (P).

Implications of thinking about stock as a call option

– Wealth is transferred from bondholders to stockholders

when the variance of the value of the firm’s assets

increases

– This option can create an “underinvestment problem.”

That is, shareholders will not want to invest in profitable

projects, because a portion of the payout from these

projects goes to the bondholders.

Acct 503B Fall 2023

Week 6

10

Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

Wealth is transferred from bondholders to stockholders when the

variance of the value of the firm’s assets increases.

Assume (1) bondholders are owed $25, (2) initially, firm assets are

expected to be worth either $15 or $25 when debt comes due, (3)

shareholders take actions that change these values to $35 or $5.

Initial possible values

of firm assets

(1)

Possible values after

shareholder actions

$25

$35

$15

$5

(1A)

Acct 503B Fall 2023

Week 6

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Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

Wealth is transferred from bondholders to stockholders when the

variance of the value of the firm’s assets increases

(1)

Expected value of bond = .5 × $25 + .5 × $15 = $20

Expected value of stock = .5 × $0 + .5 × $0 = $0

By increasing the variance of the payout, the owners have

transferred $5 from the bondholders to themselves.

(1A)

Expected value of bond = .5 × $25 + .5 × $5 = $15

Expected value of stock = .5 × $0 + .5 × ($35 – $25) = $5

Acct 503B Fall 2023

Week 6

12

Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

The possibility of default creates an underinvestment problem.

Assume (1) bondholders are owed $25, (2) initially, firms assets are

expected to be worth either $15 or $25 when debt comes due, (3)

shareholders can invest $2 and increase these values to $18 and $28.

A 50% return on investment! Will shareholders make the

investment?

Initial possible values

of firm assets

(1)

Possible values after

shareholder investment

$25

$28

$15

$18

(1B)

Acct 503B Fall 2023

Week 6

13

Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

The possibility of default creates an underinvestment problem.

As the firm approaches default, shareholders become less willing to

invest because they must share the returns with bondholders.

(1)

Expected value of bond = .5 × $25 + .5 × $15 = $20

Expected value of stock = .5 × $0 + .5 × $0 = $0

Shareholders will not make the $2 investment, because it

only increases their payoff by $1.50.

(1B)

Expected value of bond = .5 × $25 + .5 × $18 = $21.50

Expected value of stock = .5 × $0 + .5 × ($28 – $25) = $1.50

Acct 503B Fall 2023

Week 6

14

Valuation of Stock vs Valuation of Bonds

Bondholders have given stockholders a call option

Three conflicts between bondholders and stockholders

intensify as bankruptcy approaches

– Asset substitution

• Increases in variance of firm’s assets

– Underinvestment

• Shareholders become unwilling to invest in projects

even though these projects increase the value of the

firm.

– Liquidating the firm

• Paying out a large dividend to shareholders

Acct 503B Fall 2023

Week 6

15

Valuation of Stock vs Valuation of Bonds

Similarities between stock and bond valuation

The value of corporate bonds, like the value of common stock

depends on the future profitability of the firm.

– Lenders do not want to loan money to an unprofitable firm or a

firm with a poor competitive strategy.

The value of common stock, like the value of corporate bonds is

reduced in bankruptcy.

– Therefore, stockholders like bondholders are concerned about

the liquidity and solvency of the firm.

Lenders, like stockholders, should evaluate the company’s strategy,

profitability, and accounting quality.

Acct 503B Fall 2023

Week 6

16

Credit Analysis and Financial Distress

Bond Ratings

Standard and Poor’s and Moody’s and others rate bonds

These ratings provide investors with a measure of default risk

Ratings changes, particularly downgrades seem to convey

information to the market

– Stock price drops 3.96% on the date of down grade announcement

– Stock price increases 0.47% on the date of an up grade announcement, not

statistically significant

– The reaction has increased since the implementation of Regulation FD which

prevents private conversations between analysts and management, because

rating agencies are exempt from FD.

Acct 503B Fall 2023

Week 6

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Bond Ratings

Proceeds of debt issues by rating category

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Week 6

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Measures of Default Probability

Distribution of Bond Ratings on Capital IQ

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Bond Ratings

Yield of Bond Issue minus Yield of Treasury Bond

Acct 503B Fall 2023

Week 6

20

Measures of Default Probability

Liquidity

Availability of company resources to meet short-term cash

requirements. Relates to the timing of cash inflows and outflows

– Working capital and current ratios

• Current ratio

Current assets / current liabilities

• Quick ratio

Cash + short-term investments + accts. rec./ current liabilities

• Cash ratio

Cash + marketable securities / current liabilities

• Operating-cash-flow ratio

Cash flow from operations / current liabilities

– Receivables and inventory turnover

• Sales / AR and Cost of goods sold / inventory

• Provides information on the quality of specific current assets

Acct 503B Fall 2023

Week 6

21

Measures of Default Probability

Liquidity

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Week 6

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Measures of Default Probability

Liquidity

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Week 6

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Measures of Default Probability

Liquidity

Acct 503B Fall 2023

Week 6

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Measures of Default Probability

Liquidity

Acct 503B Fall 2023

Week 6

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Measures of Default Probability

Liquidity

What do these graphs tell us?

– Correlation between default risk and current ratios is

low. Why?

Acct 503B Fall 2023

Week 6

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Measures of Default Probability

Liquidity

What do these graphs tell us?

– Correlation between default risk and current ratios is low.

Why?

• Efficient firms minimize working capital

• Profitable firms can borrow to overcome short-term

cash shortfalls.

– Current performance is a better predictor of future default

risk. The operating cash flow ratio contains a measure of

current performance (i.e., operating cash flow) and it

seems to have some predictive power

– Firms default on debt when they are unable to run their

operations profitably. Predicting profitability is an

essential part of credit analysis.

Acct 503B Fall 2023

Week 6

27

Measures of Default Probability

Liquidity (example)

(in millions)

Current Assets < Current Liabilities
Acct 503B Fall 2023
Week 6
28
Measures of Default Probability
Liquidity (example)
Company’s (Clorox) liquidity situation looks precarious.
– Current ratio is only 0.88
However,
– Company is profitable so it can borrow to overcome
liquidity problems
• Clorox issued $500M of notes maturing in May 2030 at an
interest rate of 1.96%.
• Company has an A- long-term credit rating.
• Company has $1.2B credit line.
Profitability of operations is the key to liquidity
– Gross profit % is 36%
– Operations producing $178M of cash flow in the 9/30/2022 quarter
Acct 503B Fall 2023
Week 6
29
Measures of Default Probability
Solvency
A company’s long-run financial viability and its ability to
cover long-term obligations depends on success of
operating activities.
– Capital structure: Greater leverage implies greater variability in
shareholders’ equity; firm has less ability to absorb economic
problems
• Liabilities to equity ratio
Total liabilities/shareholders’ equity
• Debt-to-equity ratio
Short-term debt + long-term debt/shareholders’ equity
• Debt-to-market-value-of-equity ratio
Short-term debt + long-term debt/market value of shareholders’ equity
Acct 503B Fall 2023
Week 6
30
Measures of Default Probability
Solvency/Liquidity (continued)
Coverage ratios: provide a measure of the ease with which a firm can
meet is interest obligations from current operations.
– Interest Coverage (earnings basis)
Net income + interest expense + tax expense / interest expense
– Interest Coverage (cash flow basis)
Cash flow from operations + interest expense + tax paid / interest expense
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Week 6
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Measures of Default Probability
Solvency
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Measures of Default Probability
Solvency (with banks; higher leverage)
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Measures of Default Probability
Solvency
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Measures of Default Probability
Solvency
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Measures of Default Probability
Solvency/Liquidity
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Measures of Default Probability
Solvency/Liquidity
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Interest Coverage Ratio Example
Clorox’s lender controls its credit risk exposure by requiring
Clorox to maintain an interest coverage ratio greater than 4.0
Acct 503B Fall 2023
Week 6
38
Credit Analysis and Financial Distress
Solvency
What do these graphs tell us?
– We find a correlation between default risk and debt
to equity ratios. Why?
Acct 503B Fall 2023
Week 6
39
Credit Analysis and Financial Distress
Solvency
What do these graphs tell us?
– We find a correlation between default risk and debt
to equity ratios. Why?
• High debt relative to equity indicates
– higher variability in net income; greater sensitivity of equity
value to business cycles.
– lower equity cushion to protect bondholders
• Market value relative to debt is an excellent predictor
– Price of shareholders’ equity incorporates more information
about future profitability that does book value of
shareholders’ equity.
Acct 503B Fall 2023
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Measures of Default Probability
Profitability
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Credit Analysis and Financial Distress
Profitability
What do these graphs tell us?
– The correlation between default risk and profitability
is not as strong as the correlation between default
risk and coverage ratios
Why?
Acct 503B Fall 2023
Week 6
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Credit Analysis and Financial Distress
Profitability
What do these graphs tell us?
– The correlation between default risk and profitability
is not as strong as the correlation between default
risk and coverage ratios
Why?
• Profitability relative to interest burden is a more
precise measure of the default risk of debt than
profitability alone.
Acct 503B Fall 2023
Week 6
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Measures of Default Probability
Firm Size
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Credit Analysis and Financial Distress
Firm Size
What do these graphs tell us?
– We find a negative correlation between default risk
and size
Why?
Acct 503B Fall 2023
Week 6
45
Credit Analysis and Financial Distress
Firm Size
What do these graphs tell us?
– We find a negative correlation between default risk
and size
Why?
• Bigger firms are less likely to default
– Perhaps greater mark share means that the profits of larger
firms are less sensitive to economic downturns
– Larger firms have a longer history of profitability; they have
demonstrated their ability to succeed
Acct 503B Fall 2023
Week 6
46
Measures of Default Probability
Stock Return Volatility
Acct 503B Fall 2023
Week 6
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Credit Analysis and Financial Distress
Stock Return Volatility
What does this graph tell us?
– We find a positive correlation between default risk
and the company’s stock return variance
Why?
Acct 503B Fall 2023
Week 6
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Credit Analysis and Financial Distress
Stock Return Volatility
What does this graph tell us?
– We find a positive correlation between default risk
and the company’s stock return variance
Why?
• Greater volatility of shareholders’ equity implies a
greater volatility in the firms assets. Thus greater
volatility implies an increased chance that the value of
the firms assets will be less that the promised payment
on the debt.
• Shareholders’ equity is acts as a margin of safety
against default. Bondholders prefer a margin of safety
that is large and stable.
Acct 503B Fall 2023
Week 6
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Looking at all Variables Simultaneously:
Determinants of loan spread
Ordinary Least Squares regression of bond spread over treasury
Variables most strongly related to spread
Acct 503B Fall 2023
(Source: Compustat, fiscal 2016; SDC)
Week 6
50
Credit Analysis and Financial Distress
Bankruptcy Prediction Models
Research has produced models that seek to produce a
probability of bankruptcy based on historical financial
statement information.
One commonly used model is The Altman “Z-Score”
(1968)
The models use fiscal year end data to measure the
risk of bankruptcy over the 12-month period
beginning 4 months after the firm’s fiscal-year end.
KMV model calculates expected default probability
using asset value, asset volatility, and leverage.
Acct 503B Fall 2023
Week 6
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Bankruptcy Prediction Models
Altman Z-Score
The Altman model (updated by Hillegeist et al. 2004)
Z Score = -0.08 × WC/TA +
0.04 × Retained earnings/TA +
-0.10 × EBIT/TA +
-0.10 × Mkt. Value of equity/TL +
0.06 × Sales/TA +
-4.34
• Bankruptcy risk is increasing in Z-Score
• Bold/italicized coefficients are statistically significant (i.e.,
significantly different from zero)
• The model has an R-Squared of about 6%.
Acct 503B Fall 2023
Week 6
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Bankruptcy Prediction Models
Altman Z-Score
• To get a probability of bankruptcy, the Z score must be
transformed as follows: Prob = ez score / (1+ ez score)
– where e ≈ 2.718
• Bankrupt firms have an average Z-Prob of 1.21
• Solvent firms have an average Z-Prob of 0.77
Acct 503B Fall 2023
Week 6
53
Bankruptcy Prediction Models
Altman Z-Score
• GM’s 2008 Z-Prob pre-bailout
WC (Working capital) ≈
TA (Total Assets)
Retained earnings
EBIT (NI + taxes + int. expense)
Market value of equity
Sales
TL (Total Liabilities)
$-19,625
136,404
-58,470
-33,040
3,170
161,290
191,640
Plugging these numbers into the model gives a
Z-Score = -3.12 and a Z-Prob = 0.0422 or 4.22%
Thus GM’s Z-score indicated it was much more likely that the
average firm to go bankrupt in the next 12 months.
Acct 503B Fall 2023
Week 6
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Bankruptcy Prediction Models
Altman Z-Score
Acct 503B Fall 2023
Week 6
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Credit Analysis and Financial Distress
Conclusion
Bondholders focus on the health of current operations
rather than growth
Default risk is best measured by:
– Firm size
– Debt-to-equity
– Profitability relative to interest payments
– Variance of the firm’s common stock
The Altman model suggests that profitability and market
value of equity relative to liabilities are significantly
related to bankruptcy probability
Acct 503B Fall 2023
Week 6
56
Investments and Acquisitions
Announcements
Acct 503B Fall 2023
Week 6
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Alphabet’s balance sheet and income statement
consolidate many independently managed subsidiaries
Alphabet is comprised of
Google
(Search, Android, Chrome, hardware, Cloud,
Google Maps, YouTube)
and
Other Bets (Access, Calico, CapitalG, GV, Nest, Verily,
Waymo, and X)
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Week 6
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How much do these subsidiaries contribute?
Perhaps, we can understand why shareholders are
becoming a bit impatient with Google’s investment
decisions. “Cloud” and “Other Bets” lost $8.3B in 2021.
Acct 503B Fall 2023
Week 6
59
Investments and Acquisitions
The accounting method used for investments depends on the extent to
which the investor exerts influence over the investee.
The equity method
– Investee income (rather than dividends received) affects
income recorded in the investor’s financial statements
– Tends to increase the investor’s ROA and return on sales,
because investee assets are not included in the investor
financial statements
Consolidated accounting
– Consolidation does not affect investors shareholders’ equity
– Investee’s assets, liabilities, revenues and expenses are
incorporated into the investor’s financial statements.
– Understand what “noncontrolling interest” on the B/S and I/S
means
– Goodwill arises from acquisitions
Acct 503B Fall 2023
Week 6
60
Investments in the Stock of Other Companies
The accounting method for stock investments depends on the
degree of influence the investing company has on the decisions
of the investee.
Three methods of accounting for this investment:
Ownership:
50%
Influence:
“passive”
“significant
influence”
“controlling”
Reporting
Method:
Mark-tomarket
Equity
Equity with
Consolidation
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Week 6
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Significant Influence Equity Method
Assume the following events
1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE
Corporation for $10 per share
2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents
per share
3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income
Record these events on Balance sheet of investor company.
Cash
Long-term
Investment
=
R/E
1. Purchase
2. Dividends
3. Aff. earnings
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Significant Influence Equity Method
Assume the following events
1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE
Corporation for $10 per share
2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents
per share
3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income
Record these events on Balance sheet of investor company.
1. Purchase
2. Dividends
3. Aff. earnings
Cash
(480,000)
Long-term
Investment
480,000
=
R/E
Acct 503B Fall 2023
Week 6
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Significant Influence Equity Method
Assume the following events
1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE
Corporation for $10 per share
2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents
per share
3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income
Record these events on Balance sheet of investor company.
1. Purchase
2. Dividends
3. Aff. earnings
Cash
(480,000)
24,000
Long-term
Investment
480,000
(24,000)
=
R/E
40% × $60,000
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Significant Influence Equity Method
Assume the following events
1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE
Corporation for $10 per share
2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents
per share
3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income
Record these events on Balance sheet of investor company.
1. Purchase
2. Dividends
3. Aff. earnings
Cash
(480,000)
24,000
Long-term
Investment
480,000
(24,000)
40,000
40% × $60,000
40% × $100,000
=
R/E
40,000 (inv. inc.)
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Control Consolidation Method
When the investor controls the investee,
– The investor corporation becomes a parent.
– The investee corporation becomes a subsidiary.
– The parent prepares consolidated financial statements that
treat the parent and the subsidiary as a single economic
entity even though they are separate legal entities.
Consolidated financial reporting requires multiple sets
of financial records
– Each subsidiary maintains its own set of books that are
independent of who owns it
– Parent prepares consolidation financial statements.
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
Investment in S
Consolidated
S Co. Adjustment
P+S
$ 150
+
Liabilities
S. E.
200
300
40
110
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
390
Investment in S
110
Consolidated
S Co. Adjustment
P+S
$ 150
+
Liabilities
S. E.
200
300
40
110
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
390
Investment in S
110
Consolidated
S Co. Adjustment
P+S
$ 150
+
Liabilities
S. E.
200
300
200
300
40
110
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Week 6
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
390
Investment in S
110
Consolidated
S Co. Adjustment
P+S
$ 150
540
–110
0
540
+
Liabilities
S. E.
200
300
200
300
Eliminated
40
110
240
300
540
–110
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
390
Investment in S
110
Consolidated
S Co. Adjustment
P+S
$ 150
540
–110
0
540
+
Liabilities
S. E.
200
300
200
300
40
110
240
300
540
–110
Substitute assets and liabs. of S for “Investment in S”
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Consolidation Method: Initial 100% purchase
P Co. acquires 100% of S Co.’s stock for $110 cash.
Assume the book value of S’s assets, liabilities, and
shareholder’s equity equal their market value.
P Co.
P Co.
pre-acq. post-acq.
Cash, other assets $ 500
390
Investment in S
110
Consolidated
S Co. Adjustment
P+S
$ 150
540
–110
0
540
+
Liabilities
S. E.
200
300
200
300
40
110
240
300
540
–110
Acct 503B Fall 2023
“Shareholders’ equity does not increase when you buy something”
Week 6
72
Intuition Behind Consolidation Method
Assume P Co. buys a $150k truck for $110k cash and a $40k
loan.
Cash
Truck
Liabilities
S. E.
Original
Company
$ 500
Truck
Post-truck
Company
150
200
300
40
Where does the $110,000 cash go?
How does the purchase of the truck affect shareholders’
equity?
Acct 503B Fall 2023
Week 6
73
Intuition Behind Consolidation Method
Assume P Co. buys a $150k truck for $110k cash and a $40k
loan.
Cash
Truck
Liabilities
S. E.
Original
Company
$ 500
Truck
150
200
300
40
Post-truck
Company
390
500 - 110
150
240
300
Where does the $110,000 cash go?
How does the purchase of the truck affect shareholders’
equity?
Acct 503B Fall 2023
Week 6
74
Intuition Behind Consolidation Method
Assume P Co. buys a $150k truck for $110k cash and a $40k
loan.
Cash
Truck
Liabilities
S. E.
Original
Company
$ 500
Company
Truck
150
200
300
40
110
Post-truck
Company
390
500 - 110
150
240
300
Where does the $110,000 cash go?
How does the purchase of the truck affect shareholders’
equity?
Acct 503B Fall 2023
Week 6
75
Consolidation: Income Statement
P Co. owns 100% of S Co.’s stock.
Prepare a consolidated income statement using the following
separate income statements for P and S.
Sales
Expenses
Investment income
Net income
Equity Method
P Co.
S Co.
600
$ 180
– 450
– 160
150
20
-20
Consolidated
Adjustment
P+S
Acct 503B Fall 2023
Week 6
76
Consolidation: Income Statement
P Co. owns 100% of S Co.’s stock.
Prepare a consolidated income statement using the following
separate income statements for P and S.
Sales
Expenses
Investment income
Net income
Equity Method
P Co.
S Co.
600
$ 180
– 450
– 160
150
20
20
-170
20
Consolidated
Adjustment
P+S
Acct 503B Fall 2023
Week 6
77
Consolidation: Income Statement
P Co. owns 100% of S Co.’s stock.
Prepare a consolidated income statement using the following
separate income statements for P and S.
Sales
Expenses
Investment income
Net income
Equity Method
P Co.
S Co.
600
$ 180
– 450
– 160
150
20
20
-170
20
Consolidated
Adjustment
P+S
780
– 610
170
Acct 503B Fall 2023
Week 6
78
Consolidation: Income Statement
P Co. owns 100% of S Co.’s stock.
Prepare a consolidated income statement using the following
separate income statements for P and S.
Sales
Expenses
Investment income
Net income
Equity Method
P Co.
S Co.
600
$ 180
– 450
– 160
150
20
20
-170
20
Consolidated
Adjustment
P+S
780
– 610
170
– 20
0
170
Acct 503B Fall 2023
Week 6
79
Consolidation:

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