© 2005 by Robert F. Halsey, all rights reserved Inter-corporate investments  Market value accounting (minority passive investments) Accounting Met Life mini-case  Equity method accounting (significant influence) Accounting Coca Cola mini-case

© 2005 by Robert F. Halsey, all rights reserved Degree of Ownership Minority Majority Passive- market method Securities available for sale (Unrealized gains and losses to stockholder's equity) Trading securities (Unrealized gains and losses to Income Statement) Significant Influence- Equity method Consolidate Purchase method The following is a general roadmap of the accounting for marketable securities: >50% <50% >20% <20%

Ownership percentage Required accounting method Balance sheetIncome statement Held-to- maturity bonds or equities w/ no public market CostReport investments at cost plus (less) unamortized premium (discount) Income is interest received minus (plus) amortization of premium (discount) < 20% and marketable “Passive” MarketInvestment reported at FMV Change in FMV is either in OCI (AFS) Income (Trading) Dividends are income 20 – 50 % “Significant Influence” EquityReport investments at cost – dividends received  proportionate chare of investee income Dividends reported as reduction of investment Report income equal to proportionate share of investee profits > 50% “Control” ConsolidateReport balance sheet of subsidiary together w/ parent Report income statement of subsidiary together w/ parent

© 2005 by Robert F. Halsey, all rights reserved Minority Passive Investments – Market Method  Investor owns < 20% of investee  Classify portfolio as “available-for-sale” or “trading.” This classification dictates the accounting treatment Record dividends received as income Mark investments to market at each statement date  A = L + E  ΔA  = L + ΔE   Q: Is ΔE income?  A: AFS, no – record in OCI  Trading, yes – record in net income  Equity increases either way. The issue is whether profit is affected.

© 2005 by Robert F. Halsey, all rights reserved Met Life mini-case

Met Life B/S

Met Life Income Statement

Met Life’s Statement of Stockholders’ Equity

Met Life’s Investment Footnote

© 2005 by Robert F. Halsey, all rights reserved Significant influence – Equity Method  Investor owns > 20% and less than 50%. The key is the ability to exert “significant influence.”  Dividends treated as a return of investment (reduce investment balance) rather than income  Report income equal to percentage interest in investee profits  Investment recorded at cost + profit recognized – dividends received.

Assume that HP acquires a 30% interest in Mitel Networks. On the date of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP purchases its 30% stake for $300 (at book value). Transaction or eventBalance Sheet Income Statement Cash Asset + Other Assets =Liabs+ Cont. cap Ret. Earn RevenuesExp 1. 30% investment in Mitel (300) Mitel reports $100 income Mitel pays $20 dividends, $6 to HP 6(6) 4. HP’s ending balance of its investment account 324

Investment balance parallels SE of Investee Co. Investor – 30% Investee profit30 profit20 div6 div (1080 *.3 = 324)

Footnote Disclosures - SBC $11, ,913 Notes / R $ 5,090 Equity Inv.

$3,300 + $22,226 - $3,187 - $13,855 = $8,484 x 60% = $5,090 $1,022 x 60% = $613

© 2005 by Robert F. Halsey, all rights reserved Coca-Cola mini-case

© 2005 by Robert F. Halsey, all rights reserved

Analysis Implications of Equity Method Investments  Income does not equal Cash Flow Regulations. Regulatory authorities can sometimes intervene in an investee company’s dividend policy. International. An investee company may operate in a country where restrictions exist on remittance of earnings or where the value of currency can deteriorate rapidly. Political risks can further inhibit access to earnings. Restrictions. Dividend restrictions in loan agreements can limit the ability of the investee company to make dividend payments from retained earnings. Power. Presence of a stable or powerful minority interest can reduce the investor company’s ability to set dividend or other policies of the investee company.

© 2005 by Robert F. Halsey, all rights reserved Analysis Implications of Equity Method Investments  Net operating profit margin (NOPM NOPAT/Sales). Most analysts include equity income in NOPAT since it relates to operating investments. The reported NOPM is, thus, overstated due to nonrecognition of investee sales and the recognition of investee income.  Net operating asset turnover (NOAT Sales/Average NOA). The equity investment balance is typically included in operating assets. This means that NOAT is understated due to nonrecognition of investee sales and overstated by nonrecognition of investee assets in excess of the investment balance. The net effect is, therefore, indeterminate (NOAT is overstated provided NOA exceeds sales, and understated otherwise.)  Financial leverage (FLEV Net financial obligations/Average equity). Financial leverage is understated due to nonrecognition of investee liabilities and the recognition of investee equity (the proportionate share of investee earnings is included in SBC’s income).  Although ROE components are affected, ROE is unaffected since income and equity are unaffected.  Book value does not equal market value. There can be significant unrealized gains in the equity method investment.

© 2005 by Robert F. Halsey, all rights reserved Summary: exclusion of debt from B/S  Operating leases Leased asset/liability not recorded on B/S  Equity method investments Only record percentage of equity owned as an investment, not full or proportionate assets and liabilities  SPEs A/R securitization / synthetic leases  Executory contracts (product financing agreements) Transfer of manufacturing assets to a SPE or other party with purchase agreement for output

© 2005 by Robert F. Halsey, all rights reserved Consolidation Accounting Preview  Equity accounting is used by the parent for any investment with “significant influence,” usually > 20%  Consolidation is required is investor has “control,” usually > 50%  The consolidation process replaces the equity investment with the balance sheet of the investee company.  Also, equity income is replaced with revenues and expenses to which it relates.  Balance sheets and Income Statements are added together  Total stockholders’ equity remains the same as does net income.

© 2005 by Robert F. Halsey, all rights reserved