Equity Method class problem
Facts in the case.
Price per share of stock
HES shares purchased
Balance sheet for HES on investment date ($000):
2011 income statement from HES's books ($000):
Other operating expense
Income before taxes
Illini paid $14 million for 25% of the equity interest in HES, so HES's implied market value of the firm
is $14 mil / 25% =
What makes up this $56 million?
The Boards assume that the market prices all firm assets and liabilities at their fair values as of the
the investment date, including any that we don't record under financial reporting standards. Under
this assumption, the market value of HES equity breaks down as follows:
Market value of equity (based on stock purchase price)
Fair value of recorded assets
- Fair value of recorded liabilities
Fair value of recorded items
Excess MVE over FV (unrecorded net assets: goodwill)
Illini's 25% investment in HES gives them a proportional interest in the fair values of all HES assets
and liabilities (goodwill too), including the unrealized gains and losses on them.
All of the unrealized
gains and losses in HES's assets and liabilities before Illini invested are assumed to be reflected in the
price Illini paid for the stock: the unrealized gains made the stock price higher, while unrealized losses
made the stock price lower.
So, the stockholder owning the stock before Illini bore their share of
these gains and losses, and Illini does not.
These gains and losses should not be included in Illini's
investment income because they don't represent income Illini earns after it has invested in HES after
the investment date.
Let's do the 2011 investment income to see how this works.
How should Illini and HES account for the investment-related items?
First, the easy part:
HES reports its own book income of $1 million and records nothing related to
HES is a publicly-traded entity, and reports to its stakeholders using the
appropriate standards (GAAP/IFRS).
HES does not record or report the fair values of its assets or
liabilities (unless the appropriate standard for that asset or liability requires them to do so), and does
not need to otherwise adjust its standards-compliant book balances for any of the items above.
Now, the hard part.