This chapter explains how to report stock investments and distinguishes the cost method from the equity method of accounting for them. It covers journal entries for short-term stock investments and for long-term investments of 20 to 50 percent, parent and subsidiary corporations, and preparing consolidated financial statements.
Cost method versus equity method
A short-term or a long-term investment of less than 20 percent in another company’s stock, where the investor cannot exert significant influence, is generally accounted for under the cost method, recording dividends received as income. Once an investment reaches 20 to 50 percent, significant influence is presumed and the equity method applies instead, under which the investor recognizes its proportionate share of the investee’s income as it is earned, not merely when a dividend is declared, and adjusts the investment account accordingly.
Parent and subsidiary corporations
When one corporation, the parent, acquires a controlling interest, typically more than 50 percent, in another corporation, the subsidiary, the two remain separate legal entities but are combined for financial reporting purposes as a single economic unit. This combination is necessary because the parent’s own financial statements alone would not reflect the full scope of resources and operations it actually controls through its subsidiaries.
Consolidated statements and analyzing returns
Consolidated financial statements are prepared using a consolidated statement work sheet that combines the parent’s and subsidiary’s individual statements and eliminates transactions between them, such as intercompany receivables and payables, so the group is reported as though it were one company; they carry the limitation of obscuring the results of any single subsidiary. Dividend yield, dividends per share divided by market price, and the payout ratio, dividends divided by earnings, help analysts assess a stock’s return to shareholders relative to its price and profits.
This chapter compares the contribution margin income statement to the traditional income statement format and introduces differential analysis as a framework for short-term decisions. It covers using differential analysis for pricing decisions, accepting or rejecting special orders, eliminating or adding product lines, choosing whether to process joint products further, and make-or-buy decisions.
Contribution margin format and differential analysis
The contribution margin income statement separates variable costs from fixed costs, in contrast to the traditional format, which separates manufacturing costs from selling and administrative costs, and this makes it far more useful for the short-term decisions covered in this chapter. Differential analysis compares the revenues and costs that differ between two or more alternatives, focusing only on those relevant differences rather than on costs that will be incurred regardless of which choice is made.
Special orders, product lines, and joint products
A special order below normal selling price can still be worth accepting if it uses otherwise idle capacity and the incremental revenue exceeds the incremental cost, since existing fixed costs are typically unaffected either way. Deciding whether to eliminate or keep a product line or segment requires examining whether that segment’s own contribution margin covers its directly traceable fixed costs, and a joint product reaching its split-off point should be processed further only if the additional revenue exceeds the additional processing cost.
Make-or-buy and quality decisions
A make-or-buy decision compares the cost of producing a component internally, including only the costs that would actually be avoided by buying it, against the price of purchasing it from an outside supplier, while also weighing what else the freed-up capacity could be used for. Differential analysis can likewise support decisions to invest in improving product quality, by comparing the added cost of quality improvements against the value of the defects, returns, and lost sales they are expected to prevent.
This chapter explains responsibility accounting and its use in a business, and how to prepare responsibility accounting reports for the managers held accountable for each responsibility center. It covers preparing a segmental income statement using the contribution margin format, calculating return on investment, margin, and turnover for a segment, and calculating a segment’s residual income.
Responsibility centers and reports
As a business grows, authority for its activities is delegated to lower-level managers who are then held responsible for the revenues, costs, or investments under their control, and the business is organized into responsibility centers accordingly. Responsibility reports measure each manager’s performance against a budget for only the items that manager can actually control, with unfavorable and favorable variances highlighted so results flow up through the organization from first-level supervisors to top management.
The segmental income statement
A segmental income statement uses the contribution margin format, separating variable from fixed costs and further dividing fixed costs into those directly traceable to a segment and those that are common to the company as a whole, so a segment’s contribution to overall profit can be judged without being distorted by arbitrary allocations of unrelated costs.
Return on investment and residual income
Return on investment relates a segment’s income to the assets invested in it, and can be broken into margin, income divided by sales, and turnover, sales divided by invested assets, so a change in return on investment can be traced to a change in profitability or in asset efficiency. Residual income instead measures the income a segment earns above a minimum required return on its invested assets, which can avoid return on investment’s tendency to discourage a manager from accepting a profitable project that would lower an already-high average return.
This chapter describes the kinds of operations that call for a process cost system and distinguishes it from job costing. It explains the concept of equivalent units, computing equivalent units and unit costs under the average cost procedure, preparing a production cost report, and distinguishing normal spoilage from abnormal spoilage.
When process costing applies
Process costing suits companies that produce large quantities of similar or identical units through a continuous, standardized process, such as a food or chemical manufacturer, in contrast to job costing, which accumulates costs by individual job or batch for companies producing distinct, custom units. Under process costing, costs are accumulated by department or process for a period and then spread evenly over all the units that passed through it.
Equivalent units and unit costs
Because a department typically has partially completed units in process at both the beginning and end of a period, process costing converts those partial units into equivalent whole units to make cost averaging possible; a unit that is 40 percent complete counts as 0.4 of an equivalent unit for that cost element. Dividing total costs by total equivalent units, under the average cost procedure, produces the unit cost used to value both units transferred out and the ending work in process.
The production cost report and spoilage
A production cost report ties directly to the Work in Process Inventory account, showing the physical units and costs a department is accountable for and how those costs are assigned to units completed and to ending inventory. Some spoilage is normal, an expected byproduct of the production process absorbed into the cost of good units, while abnormal spoilage, arising from unusual circumstances, is instead treated as a loss of the period in which it occurs.
This chapter shows how to calculate and record the sale, retirement, and destruction of plant assets, and how to account for exchanges of nonmonetary assets. It covers determining the periodic depletion cost of a natural resource, depreciating plant assets on extractive industry property, recording the acquisition and amortization of intangible assets, and total assets turnover.
Disposing of plant assets
When a plant asset is sold, retired, or destroyed, its cost and accumulated depreciation must first be removed from the accounts, and any difference between the amount received, if any, and the asset’s remaining book value is recorded as a gain or a loss. Exchanges of one nonmonetary asset for another follow a related but distinct set of rules for measuring the new asset’s cost and recognizing any gain or loss on the transaction.
Depletion of natural resources
A natural resource such as timber, oil, or a mineral deposit is gradually consumed as it is extracted, and its cost is allocated to the units removed through depletion, calculated per unit and then applied to the quantity extracted during the period. Plant assets located on extractive industry property, such as roads or equipment built to support extraction, are depreciated in a manner that reflects the resource’s own extraction pattern rather than a simple straight-line schedule.
Intangible assets
Intangible assets, such as patents, copyrights, trademarks, and goodwill, lack physical substance but still provide future economic benefit, and their acquisition cost is recorded and then amortized over their useful or legal life, whichever is shorter. The chapter closes by using total assets turnover, which relates net sales to average total assets, to analyze how effectively a company is using its full base of assets, tangible and intangible, to generate revenue.
