GAAP and Consolidation
The Generally Accepted Accounting Principles (GAAP) that are used in the United States issue very specific instructions on how companies should consolidate their financial reports when a merger or acquisition is accomplished. These instructions came as a result of the Enron scandal during the early 2000s, as the energy company shifted deadweight losses to subsidiary companies owned by executive staff to make its balance sheet look as profitable as possible. The losses were therefore hidden from public view, and contributed towards the impending financial collapse of the company. Because Enron led by example, the Financial Accounting Stability Board (FASB) amended GAAP to protect against these threats. So far, the FASB’s rules have helped protect the business sector from repeating the same mistakes it made during Enron; however, there are always other avenues of fraud, as some CEOs and executives bypass ethical behavior searching for profits.
GAAP requires joint financial statements, or consolidated financial statements, when one company’s voting/investing power is half of the total share (Marz & studio D, n.d.). Therefore, another company needs to own 50% of the stock of another company. For a modern example, Tesla is currently trying to acquire SolarCity this way, as controlling the voting power provides the buying company with significant power. The equity method rules in GAAP also require that if a business owns a significant percentage of outstanding stock, usually between 20-50%, the company must report their investments in their periodical financial reports.
Differences Between Equity and Consolidation
There are a few distinct differences between the consolidated accounting method and the equity accounting method. The equity method, like the former, is required when an investing company holds a significant portion of another company’s (the investee) stock (accounting tools, n.d.). Unlike a consolidated report, the company does not own all of the stock of another company. The equity approach requires that investing companies report the profits and losses of the investee when the investee also reports those numbers. This appears in the income statement of the investor. The investor also must indicate profits and losses incurred by its investment. If the investee is slow about reporting its financial information to the investor, the investor must report what information it already has, or provide the same time lag in reporting to remain consistent.
Consolidation is a lot more integrated. Under a consolidated accounting method, all of the assets of the investee become assets of the investor on the balance sheet, and the same is true of the liabilities. As far as equity goes, it as if the subsidiary company is no longer there, which is the case for most of the reporting done on consolidated financial sheets. However, if the investor does not own one hundred percent of the investee’s stock, a new equity entry must be created reporting on the “minority interest”; that is, the minority investors of the subsidiary. It is important to note that the consolidated method of accounting does not mean that the two companies are completely and fully integrated; they can still operate independently of each other. However, for accounting purposes, they are reported on the same financial sheets as one, single business entity.
This report studied the Ford Motor Company’s financial records to obtain the following information for the purposes of this report. Ford was chosen because it is a strong company on the automotive market, and because its financial reports and records are easily interpreted, for the most part. As one of the leading car industries, Ford has many assets on its balance sheets. Ford has several affiliated companies, and its most recent investment has been in the company Pivotal. In total, Ford owns assets in total of $20,087,000,000 of its subsidiaries (Ford, n.d.). These investments have helped streamline the company’s bottom line, and earned it $1.5 billion in 2015. The company uses the equity accounting method for evaluating its subsidiaries, but it does not list specific businesses it invests in on its financial reports in total. However, it does provide information on the changes made to its investments. For example, in the year 2015 it listed its subsidiaries as Sollers, Blue Diamond Trucks, Nemak, and its Venezuelan operations. Nemak is no longer a subsidiary of Ford after the fiscal year 2015, and the other companies were included because of minor changes in the accounting process that Ford uses for each company.
Thus, Ford’s other investments must be obtained via other financial documents, which makes finding the information difficult and nontransparent. Most of Ford’s consolidated companies are well known, but finding its smaller scale investments is a little more difficult. The company uses both cost based accounting and equity based accounting; it now uses cost based accounting with its Venezuelan market, for example. Thus, Ford’s methods of accounting differ depending on the relationship it has with its subsidiary, and they also depend on the actions Ford is seeking to perform, whether it be releasing the subsidiary back to the public via selling shares or tightening its grip in the form of consolidation.
Using the Equity Based Accounting Method
Companies must use equity based accounting when they own a substantial amount of another company in the form of stock. If the company owns less than fifty percent, this is perfect for equity based accounting. If it owns more than that, the company should use consolidated accounting. Equity based accounting can also be used in any case where the investing company has any amount of influence over the investee company, such as when it has some say on the Board of Governors of the investee, or things similar to that. The equity based method therefore does not provide a full consolidation of business financial statements, but provides just enough to show that the investor has a significant amount of influence over the control of another company, which can help display the direction the executive leadership of the investor is looking to take the company.
Goodwill and the FASB
Goodwill can often be a sign of a poorly executed acquisition by an investing company. If the goodwill is substantially larger than the market value, then it may reflect poorly on company leadership and damage the stock of the investor company as normal investors lose confidence in the company’s abilities to adequately manage expansions. It also can damage the return on the balance sheets of the investors, as the acquired company may not earn enough income immediately to account for the liabilities of the acquisition. Some companies rank very high on the list of having bad goodwill, such as Frontier Communications and Republic Services. However, some companies have very positive Goodwill, like Sealed Air. Sealed Air has a goodwill of about $2.92 million. It relates to the company’s acquisitions of several companies relating to foodstuffs, such as the companies Food Packaging, Food Solutions, and Diversey. The company has a high rate of return, making its goodwill positive in the long run.
The FASB has many different regulations governing the reporting of goodwill and other intangibles (FASB, n.d.). The equity method of accounting must be used to account for goodwill, and must examine if the goodwill is over or undervalued. This should be done by the investor anyway, as it should be critical to their decision making process. The FASB also specifically defines that goodwill is the difference between the costs to purchase another company minus the fair market value based on the company’s assets. Thus, goodwill is essentially extra money being used for the acquisition. The FASB requires that the amount of goodwill be given its own separate line and entry on a company’s financial statements. This is interesting because goodwill is not typically considered a serious financial issue. Does it sound important if a company wants to overpay while acquiring another company? If one considers the implications of cases of goodwill, it can. For instance, in the example of Tesla and SolarCity, if Tesla substantially overpays for the acquisition, it would likely be viewed by investors that Elon Musk is bailing out his cousin. Thus, companies are at a risk when incurring goodwill expenses, as it can affect their stock performance in numerous ways.
Old Goodwill vs. New
The old goodwill reporting system did not allow for accounting for intangible assets. The pooling of interests is no longer allowed, and goodwill is no longer amortized. This means that companies can no longer spread the costs of goodwill over an infinite amount of time. The cost is expensed when it occurs. This aspect of goodwill reporting is very important; if a company can disperse the goodwill cost over several accounting periods, it would be unethical in the business world because it is not relevant accounting. The new rules implemented by the FASB also require that goodwill cannot be lumped as a cost, but must remain transparent. In addition to this, companies must perform an impairment test at the end of each fiscal year to ensure that the amounts attributed to goodwill are correct.
Works Cited:
Marz, M., & studio D. Rules for consolidating financial statements vs. Equity method. Retrieved July 17, 2016, from AZ Central, http://yourbusiness.azcentral.com/rules-consolidating-financial-statements-vs-equity-method-28976.html
accounting tools. Equity method. Retrieved July 17, 2016, from Accounting Tools, http://www.accountingtools.com/equity-method
Ford. 2015 Financial Report. Retrieved July 17, 2016, from Ford, http://corporate.ford.com/content/dam/corporate/en/investors/reports-and-filings/Annual%20Reports/2015-Annual-Report.pdf
FASB. Update no. 2014-02—Intangibles—Goodwill and other (topic 350): Accounting for goodwill (a consensus of the private company council). Retrieved July 18, 2016, from FASB, http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176163744355&acceptedDisclaimer=true
