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segment performance. Does one segment outperform its peers because it receives a rel-
atively low allocation of a common cost? If so, what are management™s motives for this
policy? Does the ¬rm simply have a poor cost allocation system? Or is management at-
tempting to understate the performance of one of its segments? What are the potential
internal implications of the ¬rm™s cost allocation approach?

Key Analysis Questions
The challenge in de¬ning business segments and measuring their performance
provides several opportunities for ¬nancial analysis. Given management™s control
over the way the ¬rm is structured and segments are reported, analysts can add val-
ue by evaluating the way the ¬rm™s business segments are de¬ned as well as the
reported performance for each segment. The following questions are likely to be
useful for analyzing segment data:
• What are a multibusiness firm™s major businesses? How are these aggregated
into segments for reporting purposes? Does management appear to have ag-
gregated segment data in such a way that it avoids presenting information for
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8-13 Part 2 Business Analysis and Valuation Tools

an important part of its operations? If so, is management legitimately con-
cerned that these data are proprietary, or is it concealing poor-performing
• What are the business relations between segments? This question is the heart
of the firm™s corporate strategy. How do these relations affect intersegment
transactions? Does a firm use one segment to subsidize the customers of an-
other? What are the financial effects of these intercompany transactions and
customer subsidies? How useful are segment data, given the relations be-
tween segments?
• What is the performance of segments relative to other firms in the same in-
dustries? Is management propping up poor-performing segments at the ex-
pense of other business units?

The entity principle de¬nes the boundaries of the ¬rm for ¬nancial reporting purposes.
When one ¬rm has control over the resources of another, it consolidates the performance
of the two ¬rms as if they were a single entity, using either the purchase method or the
pooling-of-interests method. If it does not have control but has signi¬cant in¬‚uence over
the other ¬rm, it reports its investment using the equity method of “one-line consolida-
Control has typically been assessed when one company owns more than 50 percent
of the voting stock of another. One company is viewed as having signi¬cant in¬‚uence
over another when it owns between 20 percent and 50 percent of its voting stock. How-
ever, as we have seen in this chapter, the implementation of these entity principles is not
always straightforward. The key implementation challenges arise when:
1. One company is able to control or have significant influence over another without
owning more than 50 percent or 20 percent, respectively, of its stock.
2. It is difficult to assess who has control over whom in a business combination.
3. There are complex business relations between firms that are difficult to classify
using the traditional definitions of control. These include R&D limited partner-
ships and franchise arrangements.
For ¬rms that consolidate the operations of multibusiness units, investors are also in-
terested in the separate performance of each business unit. Firms therefore report seg-
ment data in their ¬nancial statement footnotes. Segment reporting poses a number of
challenges. First, there are multiple ways of de¬ning segments, making it dif¬cult to
compare segments across ¬rms or even for the same ¬rm over time. Second, managers
often create multibusiness segments because they believe that there are opportunities for
synergies. For example, some companies use ¬nance subsidiaries to subsidize customers
290 Entity Accounting Analysis

Entity Accounting Analysis

of operating divisions. Other companies have signi¬cant intersegment transactions. In
either case, it is dif¬cult to know how to interpret segment data, since it is subject to
cross-subsidies, transfer prices, and cost allocations that would not arise for single busi-
ness ¬rms.
Both entity accounting rules and segment disclosures provide opportunities for ¬nan-
cial analysts to evaluate a ¬rm™s entity accounting. The rules for measuring control have
traditionally permitted management to avoid consolidating some types of ¬rms where it
has effective control. Rules on pooling-of-interests have permitted some ¬rms to use the
pooling method to avoid including the real cost of an acquisition in its ¬nancial state-
ments. The entity questions raised by these rules and practices enable analysts to add
value by assessing whether a ¬rm™s accounting presents an accurate picture of its entire
operations. If not, analysts can attempt to estimate the effect of consolidation. For seg-
ment disclosures, analysts can add value by assessing the quality of management™s seg-
ment de¬nitions, given the ¬rm™s businesses. They can also assess the relevance of
segment data for business analysis, given the extent of intersegment transactions and
subsidies across segments.

1. The Coca-Cola Company owns 42 percent of Coca-Cola Enterprises, the largest soft-
drink bottler in the world. On December 31, 1998, The Coca-Cola Company reported
the following information in its financial statement footnotes:
“The excess of our equity in the underlying net assets of Coca-Cola Enterprises over
our investment is primarily amortized on a straight-line basis over 40 years. The bal-
ance of this excess, net of amortization, was approximately $442 million at Decem-
ber 31, 1998. A summary of financial information for Coca-Cola Enterprises is as
follows (in millions):
December 31, 1998 1997
Current assets $ 2,285 $ 1,813
Noncurrent assets 18,847 15,674
Total assets $21,132 $17,487
Current liabilities $3,397 $3,032
Noncurrent liabilities 15,297 12,673
Total liabilities $18,694 $15,705
Share-owners™ equity $2,438 $1,782
Company equity investment $584 $184
Operating revenues $13,414 $11,278
Cost of goods sold 8,391 7,096
(continued )
Entity Accounting Analysis

8-15 Part 2 Business Analysis and Valuation Tools

December 31, 1998 1997
Gross pro¬t $5,023 $4,182
Operating income $869 $720
Net income $142 $171
Net income available to common
share owners $141 $169
Company equity income $51 $59

“Our net concentrate/syrup sales to Coca-Cola Enterprises were $3.1 billion in 1998.
Coca-Cola Enterprises purchases sweeteners through our Company. . . . These trans-
actions amounted to $252 million in 1998.”
Show the 1998 financial statement effects of reporting Coca-Cola Enterprises using
the equity method for The Coca-Cola Company. How much control does The Coca-
Cola Company have over Coca-Cola Enterprises? Is the equity method the most ap-
propriate method for recording this investment?
2. On April 22, 1999, MediaOne Group and AT&T agreed to merge. Under the merger,
MediaOne Group™s shareowners will receive .95 of a share of AT&T common stock
and $30.85 in cash for each share of MediaOne Group. The total package of cash and
stock was valued at $85 per share. MediaOne has 604.4 million shares outstanding.
Income Statement
December 31, 1998 (in $ millions) AT&T MediaOne
Business Services $23,611 ”
Consumer Services 22,885 ”
Wireless Services 5,406 $361
Broadband and Internet Services ” 2,491
Other and Corporate 1,321 30
Total Revenues 53,223 2,882
Operating Expenses 45,736 3,121
Total Operating Income (Loss) 7,487 (239)
Other income, net 1,247 3,368
Earnings (Loss) Before Interest and Taxes 8,734 3,129
Interest expense 427 491
Income from Continuing Operations Before Income 8,307 2,638
Provision for income taxes 3,072 1,208
292 Entity Accounting Analysis

Entity Accounting Analysis

Income Statement
December 31, 1998 (in $ millions) AT&T MediaOne
Income (Loss) from Continuing Operations 5,235 1,430
Income from discontinued operations 10 25,208
Gain on sale of discontinued operations 1,290
Extraordinary loss 137 333
Net Income $ 6,398 $26,305

Balance Sheet
December 31, 1998 (in $ millions) AT&T MediaOne
Total Current Assets $14,118 $1,200
Property, plant and equipment, net of accumulated 26,903 4,069
Licensing costs, net of accumulated amortization 7,948
Investments 4,434 9,705
Prepaid pension costs 2,074
Goodwill 2,205 11,647
Other assets 1,868 1,571
Total Assets $59,550 $28,192

Liabilities and Equity
Short-term debt 1,171 569
Other current liabilities 14,271 1,045
Total Current Liabilities 15,442 1,614
Long-term debt 5,556 4,853
Deferred credits and other 12,921 6,676
Minority interest in consolidated subsidiaries 109 1,099
Preferred stock 1,161
Common shareowners™ equity 25,522 12,789
Total Liabilities and Equity $59,550 $28,192

If MediaOne™s asset book values are approximately equal to their market values, how
much goodwill did AT&T pay for MediaOne? Prepare a pro forma income statement
and balance sheet for the merged firm for 1998.
3. As discussed in the chapter, on April 6, 1998, Citicorp and Travelers Group an-
nounced an agreement to merge to become Citigroup Inc., a global financial service
provider. Under the merger, each company™s shareholders owned 50 percent of the
Entity Accounting Analysis

8-17 Part 2 Business Analysis and Valuation Tools

combined firm. Citicorp shareholders exchanged each of their shares for 2.5 shares
of Citigroup, whereas Travelers shareholders retained their existing shares, which au-
tomatically became shares of the new company.
The financial statements for Citicorp and Travelers for 1997, the year prior to the
merger, are as follows:
Income Statement
December 31, 1997 (in $ millions) Citicorp Travelers
Interest and dividends $21,164 $16,214
Insurance premiums 8,995
Commissions and fees 5,817 5,119
Other 7,716 7,281
Total Revenues 34,697 37,609
Interest 13,081 11,443
Provision for credit losses 1,907 277
Insurance bene¬ts and claims 7,714
Other operating costs 13,987 13,163
Total Expenses 28,975 32,597
Income Before Taxes 5,722 5,012
Income taxes 2,131 1,696
Minority interest 212
Net Income $ 3,591 $ 3,104

Balance Sheet
December 31, 1997 (in $ millions) Citicorp Travelers
Cash $ 8,585 $ 4,033
Deposits with banks 13,049 ”
Securities and real estate investments 33,361 171,568
Trading account assets 40,356 139,732
Loans 181,712 ”
Receivables 3,288 21,360
Other 30,546 49,862
Total Assets $310,897 $386,555
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Entity Accounting Analysis


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