Pert 12 Intercorporate Investments Chapter15

CHAPTER 15
INTERCORPORATE INVESTMENTS
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INTERCORPORATE INVESTMENTS
Intercorporate investments include investments in the debt and
equity securities of other companies.
Reasons for investing in other companies:
- To achieve additional profitability.
- To enter new markets through companies established in those areas.
- To diversify.
- To obtain competitive advantages.
The classification of intercorporate investments is based on the degree
of influence or control that the investor is able to exercise over the
investee.
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CLASSIFYING INTERCORPORATE INVESTMENTS

Investments are classified into four categories based on the degree of
influence or control:
Investments in financial assets (ownership percentage < 20%):
Investments in which the investor has no significant control over the
investee.
Investments in associates (ownership percentage between 20% and
50%): Investments in which the investor has significant influence but
not control over the investee.
Business combinations (ownership percentage > 20%):
Investments in which the investor has control over the investee.
Joint Venture: An entity operated by companies that share control.
ACCOUNTING FOR
INVESTMENTS IN FINANCIAL ASSETS
Type
Intent
Accounting Treatment
Held to maturity
(for debt securities)
Has intent and ability to

hold the debt until it
matures.
Reported at amortized cost.

Changes in value ignored unless
deemed as impaired.
Available for sale
Does not intend to sell in

the near term, elect fair
value accounting, or hold
until maturity.
Recorded at fair value.

Changes in value are recognized
in other comprehensive income.
Held for trading

and
those designated as fair
value through profit or
loss
Intends to sell in the near

Recorded at fair value.
term (i.e., held for trading ) Changes in value are recognized
or has otherwise elected
in profit or loss on income
fair value accounting.
statement.
ACCOUNTING FOR
INVESTMENTS IN FINANCIAL ASSETS
Both IFRS and U.S. GAAP permit reclassification of intercorporate investments,
although certain criteria must be met.
- IFRS generally prohibit the reclassification into or out of the designated at fair
value category, and reclassification out of the held for trading category is
severely restricted.
- U.S. GAAP allow reclassifications between all categories using fair value at
the date of reclassification.
Impairment occurs when the carrying value of a financial asset is expected to
permanently exceed the recoverable amount.
- Regardless of classification, a loss will be recorded on the income statement
in the period impairment occurs.
- For available-for-sale securities that have become impaired, the cumulative
loss that had been recognized in other comprehensive income (OCI) will be
reclassified from equity to profit or loss.
INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE

On 1 January 2008, Baxter Inc. invested 300,000 in Cartel Co. debt securities (with
a 6% stated rate on par value, payable each 31 December). The par value of the
securities was 275,000. On 31 December 2008, the fair value of Baxters
investment in Cartel is 350,000.
Assume the market interest rate when the bonds were purchased was 4.5%. If the
investment is designated as held to maturity, the investment is reported at
amortized cost using the effective interest method. A portion of the amortization
table is as follows:
End of
Interest
Interest
Carrying
Year
Payment
Income
Amortization
Value
300,000
1*
16,500
13,500
3,000
297,000
16,500
13,365
3,135
293.865
16,500
13,224
3,276
290,589
*6% Par value (275,000) = 16,500; 4.5% Carrying value (300,000) = 13,500

1. How would this investment be reported on the financial statements at 31
December 2008 under either IFRS or U.S. GAAP (accounting is essentially the
same in this case) if Baxter designated the investment as (1) held-to-maturity,
(2) held for trading, (3) available-for-sale, or (4) designated at fair value?
Income Statement
Balance Sheet
Statement of
Owners Equity
Held-tomaturity
Interest income: 13,500
Reported at amortized
cost: 297,000
No effect
Held for
trading

and 53,000 unrealized gain
recognized through profit
Reported at fair value:

350,000
Availablefor-sale
Designated
at fair value

Interest income 13,500
and 53,000 unrealized gain
recognized through profit

350,000
350,000
No effect
53,000
unrealized gain
(net of tax)
reported as OCI
No effect
7

2. How would the gain be recognized if the debt securities were sold on
1 January 2009 for 352,000?
Held-to-maturity
352,000 297,000 = 55,000
Fair value through profit or loss

(held for trading)
352,000 350,000 = 2,000
Available-for-sale
(352,000 350,000) + 53,000

(removed from OCI) = 55,000
3. How would this investment appear on the balance sheet at

31 December 2009?
If the investment was held-to-maturity, the reported amount at amortized cost
on the balance sheet would be 293,865.
If it was classified as either held for trading, available-for-sale, or designated at
fair value, it would be reported at its fair value at 31 December 2009.
ACCOUNTING FOR
INVESTMENTS IN ASSOCIATES
The equity method is used to account for investments in associates.
To qualify, a company must have significant influence over the
investee. Significant influence is presumed with 2050% ownership,
but exceptions can be made based on other indicators of influence,
including
- Representation on the board of directors
- Participation in policymaking
- Material transactions between companies
- Interchange of management
- Technological dependency
Because of this influence, it is presumed that the investees income is
at least partially attributed to the influence of the investor. As such, the
investor recognizes a proportionate amount of investees income.
EQUITY METHOD
The investors share of the investees income and dividends is
recognized on the income statement.
The investment is classified as noncurrent on the balance sheet. It is
recorded at cost plus the investors share of post-acquisition income
less any dividends paid.
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EQUITY METHOD: EXAMPLE

Branch Inc. purchases a 20% interest in Williams Inc. for 200,000 on 1
January 2008. Williams reports income and dividends as follows:
Income
Dividends
2008
200,000
50,000
2009
300,000
100,000
2010
400,000
200,000
900,000
350,000
Calculate the investment in Williams that appears on Branchs balance

sheet as of the end of 2010:
200,000 + 20% (900,000 350,000) = 310,000
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INVESTMENTS IN ASSOCIATES:
WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE
When investment costs exceed the investors proportionate share of the
investees net identifiable assets, the difference is allocated to the
following:
- Any specific assets whose fair values exceed book values. These
amounts are then amortized over the useful life of these specific
assets.
- Any remaining difference between the investment cost and the fair
value of net identifiable assets that cannot be allocated to specific
assets is treated as goodwill.
- Goodwill is not amortized; it is checked for impairment annually.
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WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE:
EXAMPLE
Assume that Blake Co. acquires 30% of the outstanding shares of Brown Co.
At the acquisition date, information on Browns recorded assets and liabilities is
as follows:
Book Value
Fair Value
Current assets
10,000
10,000
Plant and equipment
190,000
220,000
Land
120,000
140,000
320,000
370,000
100,000
100,000
220,000
270,000
Liabilities
Net assets
Blake Co. believes the value of Brown Co. is higher than the fair value of its
identifiable net assets. They offer 100,000 for a 30% interest in Brown Co.
Calculate goodwill.
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WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE:
EXAMPLE
Purchase price
100,000
30% of book value of Brown (30% 220,000)
66,000
Excess purchase price
34,000
Attributable to net assets:

Plant and equipment (30% 30,000)
9,000
Land (30% 20,000)
6,000
Goodwill
19,000
34,000
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FAIR VALUE OPTION AND IMPAIRMENT

Fair value option: The option at the time of initial recognition to record
an equity method investment at fair value.
- Under IFRS, only venture capital firms may opt for fair value.
- Under U.S. GAAP, the fair value option is available to all entities.
Equity method investments need periodic reviews for impairment.
- Under IFRS, an impairment is recorded only if there is objective
evidence that one (or more) loss event(s) has occurred since the
initial recognition and that loss event has an impact on the
investments future cash flows, which must be reliably estimated.
- U.S. GAAP take a different approach. An impairment must be
recognized if the fair value of the investment falls below its carrying
value and if the decline is considered permanent.
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TRANSACTIONS WITH ASSOCIATES

An investor company can influence the terms and timing of transactions
with its associates. Thus, the investor companys share of any profits
resulting from transactions with associates must be deferred until the
transactions are confirmed with a third party.
- In an upstream sale, the investee sells goods to the investor.
- In a downstream sale, the investor sells goods to the investee.
- Regardless of directions, IFRS and U.S. GAAP require the
elimination of profits to the extent of the investors ownership of the
investee.
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JOINT VENTURE
A joint venture can be a convenient way to enter foreign markets,
conduct specialized activities, and engage in risky projects.
Joint ventures are defined differently under IFRS and U.S. GAAP.
Under IFRS:
- Three types of joint ventures: jointly controlled operations, jointly
controlled assets, and jointly controlled entities.
- Proportionate consolidation is the preferred accounting treatment.
It requires the venturers share of assets, liabilities, income, and
expenses of the joint venture to be combined on a line-by-line basis.
Under U.S. GAAP:
- Joint venture refers only to jointly controlled separate entities.
- Requires the use of the equity method to account for joint ventures.
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ACCOUNTING FOR JOINT VENTURE

Because the single line item on the income statement under the equity
method reflects the net effect of the sales and expenses of the joint
venture, the total income recognized is identical under the equity
method and proportionate consolidation.
Similarly, because the single line item on the balance sheet item
(investment in joint venture) under the equity method reflects the
investors share of the net assets of the joint venture, the total net
assets of the investor is identical under both methods.
But there can be significant differences in ratio analysis between the
two methods because of the differential effects on values for total
assets, liabilities, sales, expenses, and so on.
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EQUITY METHOD VS.

PROPORTIONATE CONSOLIDATION: EXAMPLE
19
EQUITY METHOD VS.

PROPORTIONATE CONSOLIDATION: EXAMPLE
Equity
Method
Proportionate
Consolidation
Net profit margin
32.0%
26.7%
Return on assets
11.2%
10.7%
1.65
1.80
Debt/Equity
Analysts will observe differences in performance ratios based on the

accounting method used for joint ventures.
IFRS prefer proportional consolidation because it more effectively
conveys the economic scope of an entitys operation when those
operations include interests in one or more jointly controlled entities.
20
BUSINESS COMBINATIONS
Business combinations involve the combination of two or more entities
into a larger economic entity. They are motivated by expectations of
added value through synergies.
Types of business combinations
- Under IFRS, there is no distinction among business combinations
based on the resulting structure of the larger economic entity.
- Under U.S. GAAP, business combinations are categorized as
merger, acquisition, or consolidation based on the structure after the
combination.
21
ACCOUNTING FOR BUSINESS COMBINATIONS

IFRS and U.S. GAAP now require that all business combinations be accounted
for using the acquisition method.
- Identifiable assets and liabilities of the acquired company are measured at
fair value on the date of the acquisition.
- Assets and liabilities that were not previously recognized by the acquiree
must be recognized by the acquirer.
- At the acquisition date, the acquirer can reclassify the financial assets and
liabilities of the acquiree (e.g., from trading security to available for sale
security).
- Goodwill is recognized as
- Partial goodwill under IFRS: the difference between purchase price and
the acquirers share of acquirees assets and liabilities.
- Full goodwill under U.S. GAAP: the difference between total fair value of
the acquiree and fair value of the acquirees identifiable net assets.
22
ACCOUNTING FOR BUSINESS COMBINATIONS

Noncontrolling interests are shown as a separate component of equity
on the balance sheet and a separate line item in the income statement.
IFRS and U.S. GAAP differ on the measurement of noncontrolling
interest:
- Under IFRS, the value of the noncontrolling interest is either its fair
value (full goodwill method) or the noncontrolling interests
proportionate share of the acquirees identifiable net assets (partial
goodwill method).
- Under U.S. GAAP, the parent must use the full goodwill method and
measure the noncontrolling interest at fair value.
23
100% ACQUISITION: EXAMPLE

Franklin Co. acquired 100% of Jefferson, Inc. by issuing 1,000,000 shares of its 1 par
common stock (15 market value). Immediately before the transaction, the two
companies had the following information:
Show the postcombination balance sheet using the acquisition method.

24
100% ACQUISITION: EXAMPLE

The postacquisition balance sheet of the combined entity:
Franklin Consolidated Balance Sheet ( thousands)
Cash and receivables
Inventory
PP&E (net)
Goodwill
Total assets
Current payables
Long-term debt
Total liabilities
Capital stock (1 par)
Additional paid in capital
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity
10,300
15,000
31,500
9,600
66,400
8,600
17,800
26,400
6,000
20,000
14,000
40,000
66,400
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LESS THAN 100% ACQUISITION: EXAMPLE

On 1 January 2009, Parent Co. acquired 90% of Subsidiary Co. in exchange
for shares of Parent Co.s no par common stock with a fair value of 180,000.
The fair market value of the subsidiarys shares on the date of transaction was
200,000. Below is selected financial information from the two companies
immediately before the parent recorded the acquisition:
26

1. Calculate the value of PP&E (property, plant, and equipment) on the
consolidated balance sheet under both IFRS and U.S. GAAP.
235,000 + 155,000 = 390,000
2. Calculate the value of goodwill and the value of the noncontrolling

interest at the acquisition date under the full goodwill method.
Fair value of subsidiary
200,000
Fair value of subsidiarys identifiable net assets
160,000
Goodwill
40,000
The value of noncontrolling interest = 10% 200,000 = 20,000
27

3. Calculate the value of goodwill and the value of the noncontrolling
interest at the acquisition date under the partial goodwill method.
Purchase price
180,000
90% of fair value of subsidiarys identifiable net

assets
144,000
Goodwill
36,000
Value of noncontrolling interest = 10% 160,000 = 16,000
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MORE ON GOODWILL
Because the full goodwill method and the partial goodwill method
result in different total assets and stockholders equity, the impact of
these methods on financial ratios would differ.
Goodwill is not amortized, but it is tested for impairment.
- Under IFRS, goodwill is impaired when the recoverable value of a
business unit is below the carrying value (one-step approach).
- Under U.S. GAAP, goodwill is impaired when the carrying value of
a business unit exceeds its fair value. The amount of impairment
loss is the difference between the implied fair value of the reporting
units goodwill and its carrying amount (two-step approach).
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VARIABLE INTEREST AND

SPECIAL PURPOSE ENTITIES
A VIE (variable interest entity) or SPE (special purpose entity) is an
enterprise that is created to accommodate specific needs of the
sponsoring entity. It may be used to securitize receivables, lease
assets, and so on.
In the past, sponsors were able to avoid consolidating SPEs on their
financial statements because they did not have control (i.e., own a
majority of the voting interest) of the SPE.
By avoiding consolidation, sponsors did not have to report the assets
and the liabilities of the SPE; financial performance as measured by
unconsolidated financial statements was potentially misleading. The
benefit to the sponsoring company was improved asset turnover, lower
operating and financial leverage, and higher profitability.
30
VARIABLE INTEREST AND

SPECIAL PURPOSE ENTITIES
Under IFRS, a SPE must be consolidated if the substance of the
relationship indicates control.
Under U.S. GAAP, the primary beneficiary of a VIE (which is often the
sponsor) must consolidate it as its subsidiary regardless of how much
of an equity investment it has in the VIE.
- VIE, a more general term than SPE, refers to an entity that is
financially controlled by one or more parties that do not hold a
majority voting interest.
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SPE: EXAMPLE
Odena wants to raise 55 million in capital by borrowing against its financial
receivables. To accomplish this objective, Odena can choose between the
following:
- Alternative 1: Borrow directly against the receivables
- Alternative 2: Create a SPE, invest 5 million in the SPE, have the SPE
borrow 55 million, and then use the funds to purchase 60 million of
receivables from Odena.
Using the financial information provided, describe the effect of each
alternative on Odena, assuming Odena will not have to consolidate the
SPE.
32
SPE: EXAMPLE
33
SUMMARY OF ACCOUNTING TREATMENT

FOR INTERCORPORATE INVESTMENTS
Type
Influence
Typical ownership %
Financial Assets
Associates
Combinations
Joint
Ventures
None/Little
Significant
Controlling
Shared
< 20%
20%50%
> 50%
Varies
Depends on the intent:

Held-to-maturity (debt
only): amortized cost
Accounting treatment
Held for trading:

fair value, changes
recognized in P/L
Available-for-sale:
Fair value, changes
recognized in equity
Equity
method
Equity
method
(U.S. GAAP & IFRS)
Consolidation
or
proportionate
consolidation
(IFRS Only)
Designated at fair value:

fair value, changes
recognized in P/L
34

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CHAPTER 15

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CLASSIFYING INTERCORPORATE INVESTMENTS

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Has intent and ability to

Reported at amortized cost.

Available for sale

Does not intend to sell in

Recorded at fair value.

Held for trading

Intends to sell in the near

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INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE

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INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE

Interest income: 13,500

Interest income: 13,500

Reported at fair value:

Interest income: 13,500

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Reported at fair value:

INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE

352,000 297,000 = 55,000

Fair value through profit or loss

352,000 350,000 = 2,000

(352,000 350,000) + 53,000

3. How would this investment appear on the balance sheet at

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EQUITY METHOD: EXAMPLE

Calculate the investment in Williams that appears on Branchs balance

200,000 + 20% (900,000 350,000) = 310,000

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Plant and equipment

30% of book value of Brown (30% 220,000)

Excess purchase price

Attributable to net assets:

Land (30% 20,000)

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FAIR VALUE OPTION AND IMPAIRMENT

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TRANSACTIONS WITH ASSOCIATES

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ACCOUNTING FOR JOINT VENTURE

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EQUITY METHOD VS.

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EQUITY METHOD VS.

Net profit margin

Analysts will observe differences in performance ratios based on the

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ACCOUNTING FOR BUSINESS COMBINATIONS

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ACCOUNTING FOR BUSINESS COMBINATIONS

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100% ACQUISITION: EXAMPLE

Show the postcombination balance sheet using the acquisition method.

100% ACQUISITION: EXAMPLE

LESS THAN 100% ACQUISITION: EXAMPLE

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LESS THAN 100% ACQUISITION: EXAMPLE

2. Calculate the value of goodwill and the value of the noncontrolling