2. Control is difļ¬cult to measure.
3. Deļ¬ning and measuring performance for core business segments is difļ¬cult.
control over the resources of another, the two can be considered to be a single entity. Of
course, many ļ¬rms have only partial rather than complete control over the resources of
another. One entity question for ļ¬nancial reporting is therefore determining whether one
ļ¬rmā™s level of control over another is sufļ¬cient to justify viewing the two as a single en-
tity. A second challenge is that, for some business relations, it is difļ¬cult to measure the
extent of one ļ¬rmā™s control over another.
The decision to account for two or more ļ¬rms as a single entity for ļ¬nancial reporting
purposes does not eliminate investorsā™ demand for information on each of the subunits,
particularly if they are in dissimilar businesses. Consequently, ļ¬rms with different busi-
nesses report summary ļ¬nancial information for each segment. Of course, segment
reporting has its own complications. How are segments deļ¬ned? How is segment per-
formance measured when there are transactions between segments?
Challenge One: Partial Control
For many company investments, the purchaser clearly acquires control of another entity.
For example, on June 25, 1999, Lucent Technologies Inc., the leading maker of tele-
phone equipment, agreed to acquire 100 percent of the stock of Nexabit Networks, a pri-
vate company that developed high-speed switches for moving data trafļ¬c on
telecommunications networks. Lucentā™s offer was for nearly $900 million in stock. By
offering to acquire 100 percent of Nexabitā™s stock, Lucent ensured that it would have
complete control over Nexabitā™s assets.
Entity Accounting Analysis
8-3 Part 2 Business Analysis and Valuation Tools
Typically, when one ļ¬rm owns more than 50 percent of the voting stock of another,
it has control. In this case, it is required to combine or consolidate the performance of
the acquiree with its own ļ¬nancial results. As discussed below and in Chapter 4, two
methods of consolidation have been used in the U.S., the pooling-of-interests method
and the purchase method.
An acquirer can also exercise considerable control over an acquiree when it owns less
than 50 percent of its voting stock. At what point, then, should one ļ¬rm be viewed as hav-
ing control over another? Should an investing ļ¬rm with less than 50 percent ownership in
another consolidate its performance with that of the acquiree? In addition, for some busi-
ness combinations, it can be difļ¬cult to ascertain who has control over whom. How
should these types of combinations be reported? Both situations are discussed below.
EXAMPLE: INVESTMENTS OF LESS THAN 50 PERCENT INTEREST. On May 19,
1999, Amazon.com, a leading Internet retailer specializing in books, music, and videos,
announced that it had acquired a 35 percent stake in Homegrocer.com, an online grocery
delivery service in Portland and Seattle, for $42.5 million. Amazon.com announced that
its investment would allow Homegrocer.com to accelerate its expansion into new cities.
How should Amazon.com record this investment? How much control, if any, does the
company have over Homegrocer.com? Should Amazon.com consolidate its results with
those of Homegrocer.com?
Assessing whether a company has control over the resources of another is clearly sub-
jective. It depends on the percentage ownership acquired, the purpose of the acquisition,
as well as the voting strength of the other owners. Accounting rules in the U.S. (APB 18
and FASB Interpretation 35) recognize this ambiguity and require ļ¬rms to use the equity
method to report investments where an investor has āsigniļ¬cant inļ¬‚uenceā over the
operations of another ļ¬rm but lacks control.1 The equity method is effectively a āone-
line consolidation.ā It provides a way of recognizing that there is a middle ground be-
tween full consolidation and treating an investment as a marketable security.
Under the equity method, the investor reports its share of the other companyā™s earn-
ings (less any goodwill amortization or depreciation on written-up assets) in a separate
line item in its income statement. In other words, the investorā™s bottom-line earnings un-
der the equity method are identical to those under purchase accounting, even though the
details presented in the income statement differ. In the balance sheet, the investor reports
the investment asset as a one-line item at cost plus its share of undistributed proļ¬ts since
The FASB notes that prima facie evidence of āsigniļ¬cant inļ¬‚uenceā is the ownership
of more than 20 percent and less than 50 percent of another companyā™s common voting
stock. However, the 20 percent minimum threshold is not intended to be a hard-and-fast
rule. An investor with a stake of less than 20 percent in another company may be viewed
as having signiļ¬cant inļ¬‚uence, and an acquirer with a stake of more than 20 percent may
not. In February 1999, the FASB proposed modifying the 50 percent threshold that had
been used to distinguish whether a ļ¬rm has signiļ¬cant inļ¬‚uence or outright control over
another. Under the proposal, some ļ¬rms with less than 50 percent ownership stakes but
280 Entity Accounting Analysis
Entity Accounting Analysis
effective control over another entity may be required to consolidate the entities, rather
than using the equity method to record their investments.
The accounting rules that deļ¬ne the boundaries of an entity permit managers to ex-
ercise judgment in deciding how to deļ¬ne the ļ¬rmā™s boundaries. Managers certainly
have the best information on the nature of the relation between their ļ¬rm and other com-
panies. However, the rules also provide opportunities for managers to use their discre-
tion to window-dress their ļ¬rmsā™ reported performance. For example, if managers
classify the securities as āavailable for saleā rather than as investments reported under
the equity method, income statement effects from the investment are limited to dividend
EXAMPLE: WHO CONTROLS WHOM? For some combinations it is difļ¬cult to infer
who controls whom. For example, on April 6, 1998, Citicorp and Travelers Group an-
nounced an agreement to merge to become a global ļ¬nancial service provider. The
merged ļ¬rm, Citigroup Inc., served over 100 million customers in 100 countries around
the world and had interests in traditional banking, consumer ļ¬nance, credit cards, invest-
ment banking, securities brokerage and asset management, and property casualty and
life insurance. Under the merger, each companyā™s shareholders owned 50 percent of the
combined ļ¬rm. Citicorp shareholders exchanged each of their shares for 2.5 shares of
Citigroup, whereas Travelers shareholders retained their existing shares, which automat-
ically became shares of the new company. The new ļ¬rm also announced that John S.
Reed, Citicorpā™s Chairman and CEO, and Sanford I. Weill, the chairman and CEO of
Travelers, would serve as cochairmen and coCEOs of the merged ļ¬rm.
In the Citicorp-Travelers combination, it is not clear which company is the acquirer
and which the acquired. How, then, should accounting reļ¬‚ect this combination? The
boundaries of the new entity are clear. But what is the value of its assets, liabilities, rev-
enues, and expenses? Given the difļ¬culty in identifying which party is the acquirer, ac-
countants have historically simply summed up the two ļ¬rmsā™ ļ¬nancial statements.
Under this approach, called āpooling-of-interests,ā the consolidated ļ¬nancials are the
aggregated book values of the two ļ¬rmsā™ individual statements.
In contrast to the Citicorp-Travelers merger, most combinations do have an identiļ¬-
able acquirer and target. For these types of investments, investors want to know how
much the acquirer paid for the target ļ¬rm and whether the investment creates value for
shareholders. The pooling-of-interests approach does a poor job of providing this type
of information, since it consolidates the two ļ¬rmsā™ ļ¬nancial statements at their book val-
ues. Acquirers typically pay a considerable premium over book value, and even over pre-
acquisition market value, to take control over other companies.
The second method of consolidation, called purchase accounting, provides more rel-
evant information by combining the target ļ¬rmā™s assets and liabilities into the balance
sheet of the acquirer at their market values. Any difference between the price the ac-
quirer paid for the target ļ¬rmā™s equity and the market value of the separable net assets is
then reported as goodwill. Goodwill is subsequently amortized over as many as 40 years,
or in some countries is written off if there is evidence of impairment.
Entity Accounting Analysis
8-5 Part 2 Business Analysis and Valuation Tools
One challenge in accounting for business combinations has been in assessing when
pooling-of-interests or when purchase values provide more relevant information for in-
vestors. Under APB 16, ļ¬rms were required to use the pooling method when both partners
had been autonomous companies for more than two years, the deal was largely a stock
swap, voting and dividend rights for shareholders were unchanged, and there were no ma-
jor asset sales for at least two years following the combination. Otherwise, acquisitions
have to be accounted for using the purchase method. However, in April 1999, the FASB
proposed new rules that would require all mergers and acquisitions to be reported using
the purchase method and would limit the maximum life of goodwill to twenty years.
Key Analysis Questions
Several opportunities for ļ¬nancial analysis arise from the difļ¬culty in assessing
whether one company has control over another. First, accounting rules provide
management with some latitude in entity reporting. Management can use this dis-
cretion to ensure that ļ¬nancial statements reļ¬‚ect the underlying entityā™s perfor-
mance. However, it can also seek to omit important resources or commitments
from the ļ¬rmā™s ļ¬nancial statements. Second, accounting rules require a ļ¬rm to
consolidate, to use the equity method, or to mark an investment to market. In con-
trast, the degree of control that one company has over another lies on a continuum
between no control and complete control. Consequently, the information generat-
ed by entity accounting rules is unlikely to reļ¬‚ect all of the subtleties associated
with control. Given these challenges, the following questions are likely to be use-
ful for analysts:
ā¢ What are a firmā™s major investments in other companies? What percentage of
these companysā™ stock does it own? Who are the other key owners of the
same firms, and how much stock do they own? Is there other evidence of a
firmā™s control over others, such as representation on the boards of directors?
ā¢ What are the assets and leverage of related companies that are not consolidat-
ed? Does the investorā™s management appear to be using its reporting discre-
tion to keep key resources and commitments off the balance sheet? What is
the performance of related companies that are not accounted for using the eq-
uity method? What are the investor managementā™s incentives for this report-
ā¢ How have significant acquisitions been recorded? Does management of the
acquirer appear to have used the pooling-of-interests method to avoid show-
ing the full cost of the acquisition? If so, what was the effective cost of the
acquisition? Has it generated an adequate return for shareholders? If the pur-
chase method has been used, has the acquirer been forced to write down the
value of the assets it acquired?
282 Entity Accounting Analysis
Entity Accounting Analysis
Challenge Two: Control Is Difficult to Measure
Certain complex business relations, such as research and development (R&D) limited
partnerships and franchise agreements, raise questions about whether one party in the
relation effectively has control over the other, or whether the two parties are separate en-
tities. Also, in some situations, a ļ¬rmā™s managers but not its stockholders have control
over another company.
EXAMPLE: R&D LIMITED PARTNERSHIPS. In 1997 Dura Pharmaceuticals Inc., a
company that developed respiratory drugs, formed a limited partnership with Spiros
Development II Inc. to raise capital for development of a new form of pulmonary drug
delivery process. Under the partnership agreement, Spiros II made a $94 million public
offering of a package of securities that included its own callable common stock (valued
at $81.3 million) and warrants for Duraā™s common stock (valued at $12.7 million). Dura
also invested $75 million in Spiros II. In exchange for the warrants and $75 million in-
vestment, Dura received an option to purchase Spiros IIā™s callable common stock at
prices that increase over time, as well as the exclusive rights to any products developed.
Spiros then uses these funds to acquire research from Dura to develop the new products.
The contractual relationship between Dura and Spiros II is called an R&D limited
partnership. Under this type of relationship, one general partner (in this case Dura) per-
forms the research, and the limited partners (public investors in this case) supply ļ¬nanc-
ing. The arrangement differs from more traditional equity ļ¬nancing in that the limited
investors receive a claim on only the speciļ¬c research project covered in the agreement.
In contrast, if Dura were to raise the funding itself through a public offer of its own stock,
the new shareholders would have a claim on all of Duraā™s research output. The arrange-
ment also provides a way for Dura to ofļ¬‚oad some of the risks associated with speciļ¬c
research projects. Dura effectively reduces its exposure to development failures and in
return shares the upside if a drug is developed and becomes a market success.
How should Duraā™s relation with Spiros II be recorded? Does Dura exercise control
over Spiros? If it does, then Spiros is effectively a Dura subsidiary. If it does not, Spiros
can be considered a separate entity. A key question for investors is to understand how
much of the projectā™s risk and upside has been sold by Dura. If most of the risk resides
with Spiros IIā™s public owners, it is inappropriate to consolidate the two ļ¬rms. Alterna-
tively, if most of the risk resides with Dura, consolidation of Spiros IIā™s results with
those of Duraā™s is more likely to give investors an accurate understanding of Duraā™s per-
Historically, the decision to consolidate Spiros II has been determined by Duraā™s own-
ership of Spiros IIā™s stock. If Dura owns more than 50 percent of Spiros IIā™s voting stock,
it is required to consolidate; otherwise it is not. However, in 1999 the FASB suggested
broadening the deļ¬nition of control. Under the proposed approach, control is likely to be
deļ¬ned as āthe ability to derive beneļ¬ts from the use of individual assetsā (of another
ļ¬rm) āin essentially the same way a controlling entity can direct the use of its own assets.ā
Evidence of control is likely to include domination of another entityā™s board of directors,
Entity Accounting Analysis
8-7 Part 2 Business Analysis and Valuation Tools
ability to obtain a majority voting interest in another entity through ownership of convert-
ible securities, a sole general-partner interest in a limited partnership, and the ability to
dissolve an entity and assume control of its assets. This broader view of control would
almost surely require Dura to consolidate Spiros II, both because it is the general partner
in a limited partnership and because it has an option to acquire Spiros II.
It is interesting to consider Duraā™s reporting of its relation with Spiros in its 1997 an-
nual report. The key transactions are recorded as follows:
ā¢ The initial $75 million contribution to Spiros II is reported as a Purchase Option
Expense, included in Duraā™s income statement.
ā¢ The warrants issued as part of Spiros IIā™s public offering are included in Duraā™s
Additional Paid-In Capital and Warrants Proceeds Receivable recorded on its bal-
ā¢ Annual payments from Spiros II for contracted research are recorded as contract
revenues by Dura and effectively offset the research costs of the development pro-
ā¢ Finally, when Dura has exercised its option to acquire limited partners in similar
earlier agreements, it has written off much of the outlay as purchased R&D.
The fact that R&D limited partnerships permit R&D risks to be shared between part-