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Intercorporate Investments
5
CHAPTER
Investment
Investment securities
securities (also
(also called
called marketable
marketable
securities)
securities) are
are of
of two
two types:
types:
Debt
Debt Securities
Securities
•• Government
Government or
or corporate
corporate debt
debt obligations
obligations
Equity
Equity Securities
Securities
•• Corporate
Corporate stock
stock that
that is
is readily
readily marketable.
marketable.
Investment Securities
Classification
Investment Securities
Ownership Less than 20% Less than 20% Between 20% and 50% About 50%
Purpose Long- or Short-term Degree of business Full business
intermediate- investment or control control
term investment trading
Valuation Basis Fair value Fair value Equity method Consolidation
Balance Sheet Fair value Fair value Acquisition cost adjusted Consolidated
Asset Value for proportionate share balance sheet
of investee’s retained
earnings and appropriate
amortization
Income In comprehensive In income Not recognized Not recognized
Statement: income
Unrealized Gains
Income Recognize Recognize Recognize proportionate Consolidated
Statement: Other dividends and dividends and share of investee’s net income
Income Effects realized gains realized gains income less appropriate statement
and losses in and losses in amortization in income
income income
Investment Securities
Analyzing Investment Securities
At
At least
least three
three main
main objectives:
objectives:
(1)
(1) to
to separate
separate operating
operating from
from investing
investing (and
(and
financing)
financing) performance
performance
(2)
(2) to
to evaluate
evaluate investment
investment performance
performance and
and
risk
risk
(3)
(3) to
to analyze
analyze accounting
accounting distortions
distortions due
due to
to
accounting
accounting rules
rules and
and
/or
/or earnings
earnings management
management
involving
involving investment
investment
securities
securities
Investment Securities
Separating Operating from Investing Assets and Performance
Determine
Determinewhether
whetherinvestment
investmentsecurities
securities(and
(andrelated
relatedincome
income
streams)
streams)are
areinvesting
investingor
oroperating
operatingin
innature—based
nature—basedon onanan
assessment
assessmentof ofwhether
whethereach
eachinvestment
investmentisisstrategic
strategicor
ormade
made
purely
purelyfor
forthe
thepurpose
purposeofofinvestment
investment
Remove
Removeallallgains
gains(losses)
(losses)relating
relatingto
toinvesting
investingactivities—
activities—
including
includingdividends,
dividends,interest
interestincome,
income,andandrealized
realizedand
and
unrealized
unrealizedgains
gainsand
andlosses—when
losses—whenevaluating
evaluatingthe
theoperating
operating
performance
performanceof ofaacompany
company
Separate
Separateoperating
operatingand
andnon-operating
non-operating
assets
assetswhen
whendetermining
determiningoperating
operating
return
returnon
oninvestment
investment
Investment Securities
Analyzing Accounting Distortions from
Investment Securities
Potential
Potential accounting
accounting distortions
distortions an
an analyst
analyst
must
must be
be alert
alert to:
to:
•• Classification
Classification based
based onon intent
intent
•• Opportunities
Opportunities for
for gains
gains trading
trading
•• Liabilities
Liabilities recognized
recognized atat cost
cost
Auditors
•• Inconsistent
Inconsistent definition
definition of
of equity
equity
securities
securities
Intercorporate Investments
Equity Method Accounting
Equity
Equity method
method accounting
accounting—reports
—reportsthe
theparent’s
parent’s
investment
investmentininthe
thesubsidiary,
subsidiary, and
and the parent’s
the parent’s share
shareof
of
the
thesubsidiary’s
subsidiary’sresults,
results,asasline
line
items
itemsin
inthe
theparent’s
parent’sfinancial
financial
statements
statements(referred
(referred to
toas
as
one-line
one-lineconsolidation)
consolidation)
Note:
Note: Generally
Generallyused
usedforfor
investments
investmentsrepresenting
representing
20
20toto50
50percent
percent of
of the
thevoting
votingstock
stock
of
of aacompany’s
company’s equity
equity securities--main
securities--main difference
difference
between
betweenconsolidation
consolidationand and equity
equity method
methodaccounting
accounting
rests
restsininthe
thelevel
levelof
ofdetail
detail reported
reportedinin financial
financial
statements
statements
Intercorporate Investments
Equity Method Accounting
Investment
Investment account:
account:
Initially
Initially recorded
recorded atat acquisition
acquisition cost
cost
Increased
Increased by by %
% share
share of
of investee
investee earnings
earnings
Decreased
Decreased by by dividends
dividends received
received
Intercorporate Investments
Equity Method Accounting
Income:
Income:
Investor
Investor reports
reports %% share
share of
of investee
investee company
company
earnings
earnings asas “equity
“equity earnings”
earnings” in in its
its income
income
statement
statement
Dividends
Dividends are
are reported
reported as
as aa reduction
reduction of of the
the
investment
investment account,
account, not
not as
as income
income
Equity Method Mechanics
Assume Synergy,
that Global
Inc. Corp. acquires for cash a 25% interest in
Synergy, Inc. for $500,000, representing one-fourth of Synergy’s
stockholders’
Current assets equity as of the acquisition date.
700,000
PP&E 5,600,000
Acquisition
Total assets entry: 6,300,000
Investment 500,000
Current liabilities 300,000
Cashdebt
Long-term 500,0004,000,000
Stockholders’ Equity 2,000,000
Total liabs and equity 6,300,000
Equity Method Mechanics
Investment
Subsequent 25,000
to the acquisition date, Synergy reports net
income of $100,000
Equity earnings and pays dividends of $20,000.
25,000
(to Global records its proportionate
record proportionate share of investeeshare of Synergy’s
company earnings)
earnings and the receipt of dividends as follows:
Cash 5,000
Investment 5,000
(to record receipt of dividends)
Investment balance =
% Share of Investee Equity
Business
Businesscombinations—refer
combinations—referto tothe
themerger,
merger,acquisition,
acquisition,reorganization,
reorganization,
or
orrestructuring
restructuringof
oftwo
twoor
ormore
morebusinesses
businessesto
toform
formanother
anotherbusiness
businessentity
entity
Motivations
• enhance company image and growth potential
• acquiring valuable materials and facilities
• acquiring technology and marketing channels
• securing financial resources
• strengthening management
• enhancing operating efficiency
• encouraging diversification
• rapidity in market entry
• achieving economies of scale
• acquiring tax advantages
• management prestige and perquisites
• management compensation
Business Combinations
On
Onthe
thedate
dateofof the
the acquisition,
acquisition, the
thebook
book value
valueofof Micron
Micron isis
$620,000.
$620,000. Synergy
Synergyis iswilling
willingto
topay
paythe
themarket
market price
price ofof
$770,000
$770,000because
becauseitit feels
feelsthat
that Micron’s
Micron’sproperty,
property,plant,
plant,
and
andequipment
equipment (PP&E)
(PP&E) isisundervalued
undervaluedby by$20,000,
$20,000,itit has
has
an
anunrecorded
unrecordedtrademark
trademarkworth
worth$30,000
$30,000 and
andintangible
intangible
benefits
benefitsof
of the
thebusiness
businesscombination
combination(corporate
(corporate
synergies,
synergies, market
marketposition,
position,and
andthethelike)
like)are
arevalued
valuedat at
$100,000.
$100,000.
Intercorporate Investments
Consolidation Illustration
The
Thepurchase
purchaseprice
priceis,
is,therefore,
therefore,allocated
allocatedas
asfollows:
follows:
Purchase
Purchaseprice
price 770,000
770,000
Book
Bookvalue
valueof
ofMicron
Micron 620,000
620,000
Excess
Excess 150,000
150,000
Excess
Excessallocated
allocatedtoto–– useful
usefullife
life annual
annual
deprec/amort.
deprec/amort.
Undervalued
UndervaluedPP&E
PP&E 20,000
20,000 10
10 2,000
2,000
Trademark
Trademark 30,000
30,000 55 6,000
6,000
Goodwill
Goodwill 100,000
100,000 indefinite
indefinite -0-
-0-
150,000
150,000
Intercorporate Investments
Synergy Corp. and subsidiary trial balances and consolidated financial statements for year-ended December 31, Year 2. Prepared
under the purchase accounting method
Synergy Micron Debits Credits Consolidated
Revenues 610,000 370,000 980,000
Oper. expenses (270,000) (140,000) (410,000)
Deprec. Expense (115,000) (80,000) [4] 2,000 (197,000)
Amort. Expense - - [4] 6,000 (6,000)
Investment income 142,000 - [3] 142,000 -
Net Income 367,000 150,000 367,000
Retained Earn.,1/1 680,000 490,000 [1] 490,000 680,000
Net Income 367,000 150,000 367,000
Dividends Paid (90,000) (90,000)
Ret.Earn.,12/31 957,000 640,000 957,000
Cash 105,000 20,000 125,000
Receivables 380,000 220,000 600,000
Inventory 560,000 280,000 840,000
Invest. in Micron 912,000 - [1] 620,000 -
[2] 150,000
[3] 142,000
PP&E ( net) 1,880,000 720,000 [2] 20,000 [4] 2,000 2,618,000
Trademark - - [2] 30,000 [4] 6,000 24,000
Goodwill [2] 100,000 100,000
Total assets 3,837,000 1,240,000 4,307,000
Liabilities 780,000 470,000 1,250,000
Common Stock 800,000 100,000 [1] 100,000 800,000
Add'l. Pd-In Cap. 1,300,000 30,000 [1] 30,000 1,300,000
Retained Earnings 957,000 640,000 957,000
Tot. Liab & Eq. 3,837,000 1,240,000 920,000 920,000 4,307,000
Intercorporate Investments
Synergy Corp and Micron Company
Consolidated Income Statement Steps
Replace $620,000 of the investment account with the book value of the
assets acquired. If less than 100% of the subsidiary is owned, the
credit to the investment account is equal to the percentage of the
book value owned and the remaining credit is to a liability account,
minority interest.
Background
Market risks
——they
theycan
canexpose
exposecompanies
companiesto toconsiderable
considerable
risk
riskbecause
becauseititcan
canbe
bedifficult
difficultto
tofind
findaa
derivative
derivativethat
thatentirely
entirelyhedges
hedgesthe therisks
risksor
or
because
becausethetheparties
partiestotothe
thederivative
derivativecontract
contract
fail
failto
tounderstand
understandthe therisk
riskexposures
exposures
Derivative Securities
Definitions
Derivative
Derivativeisisaacontract
contractpossessing
possessingeacheachof ofthe
thefollowing
followingcharacteristics:
characteristics:
••One
Oneorormore
moreunderlying
underlyingindexes
indexesandandoneoneor ormore
morenotional
notionalamounts
amounts
(and/or
(and/orpayments)—the
payments)—theunderlying
underlyingindexes
indexesand andthe
thenotional
notionalamounts
amounts
determine
determinethethesettlement
settlementamount,
amount,ififany.
any.
••No
Noinitial
initialnet
netinvestment
investmentor oran
aninitial
initialnet
netinvestment
investmentlesslessthan
thanthat
that
required
requiredforforaanormal
normaltransaction
transactionyielding
yieldingsimilar
similarresponses
responsesto to
market
marketrisk
riskchanges.
changes.
••Permits
Permitsaanet
netsettlement.
settlement.
Underlying
Underlyingindex,index,or orsimply
simplyunderlying
underlying(also(alsocalled
calledaaprimitive),
primitive),isisthe
the
main
maindriver
driverofofderivative
derivativevalue--it
value--itcan
canbebeanyanyeconomic
economicvariable
variablesuch
suchas asaa
commodity
commodityprice,price,security
securityprice,
price,index,
index,interest
interestrate,
rate,or
orexchange
exchangerate rate
Notional
Notionalamount
amountis isthe
thenumber
numberof ofunits—expressed
units—expressedin infigures,
figures,weight,
weight,
volume,
volume,dollars,
dollars,ororother
otherunit
unitmeasure—as
measure—asspecified
specifiedininthe
thecontract
contract
Net
Netsettlement
settlementis isaacash
cashresolution
resolutionforforthe
thecontracting
contractingparties
partiesin inlieu
lieuof
of
settling
settlingupupininfull
fullamounts
amounts(or (orquantities)
quantities)
Derivative Securities
Classification of Derivatives
Derivatives
Hedge Speculative
Foreign currency Derivative (and cumulative Unrealized gains and losses reported in
hedge of net unrealized gain or loss) other comprehensive income as part of
investment in recorded at fair value (part of translation adjustment
foreign operation cumulative translation
adjustment in accumulated
comprehensive income)
Derivative Securities
Analysis of Derivatives
Identify
IdentifyObjectives
Objectivesfor forUsing
UsingDerivatives—risk
Derivatives—riskassociated
associatedwith
withderivatives
derivativesisis
much
muchhigher
higherforforspeculation
speculationthanthanfor
forhedging;
hedging;many
manycompanies
companiesimplicitly
implicitlyspeculate
speculate
with derivatives
with derivatives
Risk
RiskExposure
Exposureand andEffectiveness
Effectivenessof ofHedging
HedgingStrategies—evaluate
Strategies—evaluatethe the
underlying
underlying risks, the risk management strategy, the activities to hedge its risks,and
risks, the risk management strategy, the activities to hedge its risks, and
the effectiveness of hedging operations; also consider counterparty
the effectiveness of hedging operations; also consider counterparty risk risk
Transaction
TransactionSpecific
Specificversus
versusCompanywide
CompanywideRisk RiskExposure—evaluate
Exposure—evaluate
companywide
companywide effects of derivatives; hedging specific riskexposures
effects of derivatives; hedging specific risk exposuresto totransactions,
transactions,
commitments,
commitments, assets, and/or liabilities does not necessarily ensure hedgingof
assets, and/or liabilities does not necessarily ensure hedging of
companywide
companywide risk risk
Inclusion
Inclusionin inOperating
Operatingor orNonoperating
NonoperatingIncome—to
Income—tothe the
extent derivatives are hedges, then unrealized and
extent derivatives are hedges, then unrealized and realizedrealized
gains
gainsand
andlosses
lossesshould
shouldbebeexcluded
excludedfromfromoperating
operatingincome
income
and
and their fair values should be excluded from operatingassets
their fair values should be excluded from operating assets
(Appendix 5A)
International Activities
Analysis
Analysisobstacles
obstacleswith
withcompanies
companiesthat
thatoperate
operatein
inmore
morethan
thanone
onecountry
countrysubdivide
subdivide
into
intotwo
twocategories:
categories:
•• Obstacles
Obstaclesdue
dueto
todifferences
differencesinin
accounting
accountingpractices
practicespeculiar
peculiarto
to aacountry
country
where
whereoperations
operationsexist
exist
•• Obstacles
Obstaclesarising
arisingfrom
fromtranslation
translationof
ofassets,
assets,liabilities,
liabilities,and
and
equities
equitiesinto
intothe
thehome-country
home-countrymeasuring
measuringunit
unit
International Activities
Translation of Foreign Currencies
Current
Currentrate
ratemethod—translates
method—translatesall
allassets
assetsand
andliabilities
liabilitiesat
atcurrent
currentrates
rates
Temporal
Temporalmethod—translates
method—translates
cash,
cash,receivables,
receivables,payables,
payables,and and
other
otherassets
assetsandandliabilities
liabilities
measured
measuredat atpresent
presentororfuture
future
prices
pricesat
atcurrent
currentrates,
rates,and
andassets
assets
and
andliabilities
liabilitiesmeasured
measuredat atpast
pastprices
prices(historical
(historicalcosts)
costs)at
athistorical
historicalrates
rates
International Activities
Accounting using the Current Rate Method
Major
Majorprovisions
provisionsof ofaccounting
accountingfor forforeign
foreigncurrency
currencytranslation
translationusing usingaathe the
Current
CurrentRate RateMethod
Methodare: are:
•• Translation
Translation requiresidentifying
requires identifyingthe thefunctional
functionalcurrency
currencyof ofthetheentity—
entity—
generally
generallythethecurrency
currencyof ofthe
thecountry
countryin inwhich
whichthe thesubsidiary
subsidiaryisislocated;
located;allall
financial
financialstatement
statementelements
elementsof ofthe
theforeign
foreignentity
entityarearemeasured
measuredusing usingthe
the
functional
functionalcurrency,
currency,but butin
inconformity
conformitywith withthe
theparent’s
parent’saccounting
accountingpractices
practices
•• Translation
Translation from the functional currency into the reporting currencyisisrequired,
from the functional currency into the reporting currency required,
ififthey
theyare
aredifferent—this
different—thistranslation
translationoccurs
occursat thecurrent
atthe currentexchange
exchangerate,rate,except
except
for
forrevenues
revenuesand andexpenses
expensesthat thatare
aretranslated
translatedat theaverage
atthe averagecurrentcurrentexchange
exchange
rate
rateduring
duringthe
theperiod
period
•• Translation
Translation adjustmentsare
adjustments arenot
notincluded
includedin inincome—they
income—theyare arereported
reportedand and
accumulated
accumulatedas asaaseparate
separatecomponent
componentof ofequity
equityuntil
untilsuch
suchtimetimethetheparent
parentsells
sells
or
orcompletely
completelyor orsubstantially
substantiallyliquidates
liquidatesthe thenetnetinvestment
investmentin inthe
theforeign
foreignentity;
entity;
translation
translation adjustments are removed from equity and included as gains orlosses
adjustments are removed from equity and included as gains or losses
in
indetermining
determiningincome
incomefor forthe
theperiod
periodwhen whensuchsuchsale
saleororliquidation
liquidationoccurs
occurs
•• Exchange
Exchangegains
gainsandandlosses
lossesattributable
attributableto tointercompany
intercompanyforeign foreigncurrency
currency
transactions,
transactions,andandbalances
balancesthatthatareareof ofaatrading
tradingnature,
nature,areareincluded
includedin inincome;
income;
but those attributable to long ‑term financing or capital transactions,
but those attributable to long‑term financing or capital transactions, where where
settlement
settlementisisnotnotexpected
expectedfor forthe
theforeseeable
foreseeablefuture,
future,are
arereported
reportedas asaaseparate
separate
component
componentof ofequity
equity
International Activities
Summary of Translation Methods
Functional Currency Local Currency $US
Translation method Current Rate Method Temporal method
Account Exchange Rated used for Translation
Cash & securities current current
Inventory current historical
PP&E & Intangibles current historical
Current Liabilities current current
Long-Term Liabilities current current