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CHAPTER 14 INTERCORPORATE INVESTMENTS Presenters name Presenters title dd Month yyyy
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. Copyright © 2013 CFA Institute 2
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. Copyright © 2013 CFA Institute 3
ACCOUNTING FOR INVESTMENTS IN FINANCIAL ASSETS TypeIntentAccounting 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 term (i.e., held for trading ) or has otherwise elected fair value accounting. Recorded at fair value. Changes in value are recognized in profit or loss on income statement. Copyright © 2013 CFA Institute 4
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. Copyright © 2013 CFA Institute 5
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: *6% × Par value (£275,000) = £16,500; 4.5% × Carrying value (£300,000) = £13,500 Copyright © 2013 CFA Institute 6 End of Year Interest Payment Interest IncomeAmortization Carrying Value 0£300,000 1*£16,500£13,500£3,000297,000 216,50013,3653,135293.865 316,50013,2243,276290,589
INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE 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? Copyright © 2013 CFA Institute 7 Income StatementBalance Sheet Statement of Owners Equity Held-to- maturityInterest income: £13,500 Reported at amortized cost: £297,000No effect Held for trading Interest income: £13,500 and £53,000 unrealized gain recognized through profit Reported at fair value: £350,000 No effect Available- for-sale Interest income: £13,500 Reported at fair value: £350,000 £53,000 unrealized gain (net of tax) reported as OCI Designated at fair value Interest income £13,500 and £53,000 unrealized gain recognized through profit Reported at fair value: £350,000No effect
INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE 2.How would the gain be recognized if the debt securities were sold on 1 January 2009 for £352,000? 3.How would this investment appear on the balance sheet at 31 December 2009? Copyright © 2013 CFA Institute 8 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 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 20–50% 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. Copyright © 2013 CFA Institute 9
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. Copyright © 2013 CFA Institute 10
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: Calculate the investment in Williams that appears on Branchs balance sheet as of the end of 2010: Copyright © 2013 CFA Institute 11 IncomeDividends 2008200,00050,000 2009300,000100,000 2010400,000200,000 900,000350,000 200,000 + 20% × (900,000 – 350,000) = 310,000
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. Copyright © 2013 CFA Institute 12
INVESTMENTS IN ASSOCIATES: 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: 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. Copyright © 2013 CFA Institute 13 Book ValueFair Value Current assets10,000 Plant and equipment190,000220,000 Land120,000140,000 320,000370,000 Liabilities100,000 Net assets220,000270,000
INVESTMENTS IN ASSOCIATES: WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE: EXAMPLE Purchase price100,000 30% of book value of Brown (30% × 220,000)66,000 Excess purchase price34,000 Attributable to net assets: Plant and equipment (30% × 30,000)9,000 Land (30% × 20,000)6,000 Goodwill19,000 34,000 Copyright © 2013 CFA Institute 14
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. Copyright © 2013 CFA Institute 15
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. Copyright © 2013 CFA Institute 16
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. Copyright © 2013 CFA Institute 17
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. Copyright © 2013 CFA Institute 18
EQUITY METHOD VS. PROPORTIONATE CONSOLIDATION: EXAMPLE Copyright © 2013 CFA Institute 19
EQUITY METHOD VS. PROPORTIONATE CONSOLIDATION: EXAMPLE Copyright © 2013 CFA Institute 20 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. Equity Method Proportionate Consolidation Net profit margin32.0%26.7% Return on assets11.2%10.7% Debt/Equity1.651.80
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. Copyright © 2013 CFA Institute 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. Copyright © 2013 CFA Institute 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. Copyright © 2013 CFA Institute 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. Copyright © 2013 CFA Institute 24
100% ACQUISITION: EXAMPLE Copyright © 2013 CFA Institute 25 The postacquisition balance sheet of the combined entity: Franklin Consolidated Balance Sheet ( thousands) Cash and receivables10,300 Inventory15,000 PP&E (net)31,500 Goodwill9,600 Total assets66,400 Current payables8,600 Long-term debt17,800 Total liabilities26,400 Capital stock (1 par)6,000 Additional paid in capital20,000 Retained earnings14,000 Total stockholders equity40,000 Total liabilities and stockholders equity66,400
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: Copyright © 2013 CFA Institute 26
LESS THAN 100% ACQUISITION: EXAMPLE 1.Calculate the value of PP&E (property, plant, and equipment) on the consolidated balance sheet under both IFRS and U.S. GAAP. 2.Calculate the value of goodwill and the value of the noncontrolling interest at the acquisition date under the full goodwill method. Copyright © 2013 CFA Institute 27 235,000 + 155,000 = 390,000 Fair value of subsidiary200,000 Fair value of subsidiarys identifiable net assets160,000 Goodwill40,000 The value of noncontrolling interest = 10% × 200,000 = 20,000
LESS THAN 100% ACQUISITION: EXAMPLE 3.Calculate the value of goodwill and the value of the noncontrolling interest at the acquisition date under the partial goodwill method. Copyright © 2013 CFA Institute 28 Purchase price180,000 90% of fair value of subsidiarys identifiable net assets 144,000 Goodwill36,000 Value of noncontrolling interest = 10% × 160,000 = 16,000
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). Copyright © 2013 CFA Institute 29
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. Copyright © 2013 CFA Institute 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. Copyright © 2013 CFA Institute 31
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. Copyright © 2013 CFA Institute 32
SPE: EXAMPLE Copyright © 2013 CFA Institute 33
SUMMARY OF ACCOUNTING TREATMENT FOR INTERCORPORATE INVESTMENTS TypeFinancial AssetsAssociatesCombinations Joint Ventures InfluenceNone/LittleSignificantControllingShared Typical ownership %< 20%20%–50%> 50%Varies Accounting treatment Depends on the intent: Held-to-maturity (debt only): amortized cost Held for trading: fair value, changes recognized in P/L Available-for-sale: Fair value, changes recognized in equity Designated at fair value: fair value, changes recognized in P/L Equity method Consolidation Equity method (U.S. GAAP & IFRS) or proportionate consolidation (IFRS Only) Copyright © 2013 CFA Institute 34
McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVESTMENTS Chapter 12.
1 Investments Sid Glandon, DBA, CPA Associate Professor of Accounting The University of Texas at El Paso.
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Chapter Six Variable Interest Entities, Intra- Entity Debt, Consolidated Cash Flows, and Other Issues Copyright © 2013 by The McGraw-Hill Companies, Inc.
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PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA APPENDIX.
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Copyright © 2009 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Consolidation of Wholly Owned Subsidiaries 4.
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Chapter Seven Consolidated Financial Statements – Ownership Patterns and Income Taxes Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction.
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