Module 7 Reporting and Analyzing Intercorporate Investments

Investments A Corporation may own: *Part or all of another corporation *Investments in bonds, notes, and other securities Part of a partnership or joint venture Other non-operating assets, which are treated as investment *This module is about Intercorporate investments in stocks and bonds.

How Much Control do we have? Investment in voting shares may be Passive—little influence over another company—generally less than 20% Trading—active buying and selling Available-for-sale—could sell, but intend to hold for gain Significant influence—generally between 20% and 50%, but may be lower % for large corporations—depends on the actual circumstances. Control—Generally greater than 50% ownership

Intercorporate Investments

Passive Investments Passive investments may be stocks, bonds, or any marketable instrument including notes, futures contracts, commodities… Any dividends, interest, gains or losses on sale are recognized on the income statement Balance sheet investment account is kept at market value—this results in unrealized gains or losses. (Except for bonds “held to maturity” which are kept at amortized cost.)

Passive Investments Unrealized gains/losses: If “trading”, then income statement If “available for sale,” then equity section account “Accumulated Other Comprehensive Income” Under both U.S. GAAP and IFRS, companies classify passive instruments as trading, available-for-sale, or held-to-maturity, but under IFRS reclassifications are prohibited.

Equity Method Investments (Significant Influence) Investments are recorded at their purchase cost. Investments are recorded at their purchase cost. The investor reports income equal to its percentage share of the investee’s reported net income; The investor reports income equal to its percentage share of the investee’s reported net income; the investment account is increased by the percentage share of the investee’s income the investment account is increased by the percentage share of the investee’s income Dividends received reduce the investment balance (dividends are not reported as income). Dividends received reduce the investment balance (dividends are not reported as income). Changes in fair value do not affect the investment’s carrying value. Changes in fair value do not affect the investment’s carrying value.

Equity Method Accounting Mechanics

Consolidation Investments with Control Investor is called the “Parent” and the investee is called a “subsidiary” or “affiliate”. Investor is called the “Parent” and the investee is called a “subsidiary” or “affiliate”. Consolidated entity: Treat the parent & subsidiaries as if they were ONE company for the financial report. Consolidated entity: Treat the parent & subsidiaries as if they were ONE company for the financial report. NOTE: Each company keeps their own records, may pay taxes, issues a financial report to creditors, is legally separate, may be declared bankrupt… NOTE: Each company keeps their own records, may pay taxes, issues a financial report to creditors, is legally separate, may be declared bankrupt… Treat the purchase of subsidiary assets at market value for the consolidated entity Treat the purchase of subsidiary assets at market value for the consolidated entity Combine the assets and liabilities and eliminate: Combine the assets and liabilities and eliminate: Parent’s investment asset account and subsidiary’s owners equity accounts (may have “noncontrolling interest”) Parent’s investment asset account and subsidiary’s owners equity accounts (may have “noncontrolling interest”) Receivables/payables between parent and subsidiaries. Receivables/payables between parent and subsidiaries. Sales/expenses among parent and subsidiaries (cost of goods sold and gross profit). Sales/expenses among parent and subsidiaries (cost of goods sold and gross profit).

A Simple Consolidation Notes: 1.Penman purchased 100% of Nissim stock with no revaluation of consolidated assets. 2.The owners’ equity accounts of the parent company become the consolidated equity accounts.

Consolidation of Less than Wholly-Owned Subsidiaries Penman owns 80% of Nissim NOTES: Penman purchased 80% of Nissim stock with no revaluation

Consolidation When Purchase Price Exceeds Book Value of Stockholders’ Equity Notes: 1.Penman purchased 100% of Nissim, paying $4,000, which is $1,000 more than book equity value. 2.PPE, net book value is revalued in the acquisition.

Acquired Intangible Assets The purchase price is allocated to acquired identifiable intangible assets, which include the following: The purchase price is allocated to acquired identifiable intangible assets, which include the following: Marketing-related assets like trademarks and internet domain names Marketing-related assets like trademarks and internet domain names Customer-related assets like customer lists, production backlog, and customer contracts Customer-related assets like customer lists, production backlog, and customer contracts Artistic-related assets like plays, books, and video Artistic-related assets like plays, books, and video Contract-based assets like licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts Contract-based assets like licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts Technology-based assets like patents, computer software, databases and trade secrets Technology-based assets like patents, computer software, databases and trade secrets

P&G’s Allocation of Gillette Purchase

Impairment of Goodwill The impairment test is a two-step process. The impairment test is a two-step process. First First, if the fair value of the investee company is less than the investment balance, the investment is deemed impaired. Second Second, if impaired, the investor recomputes the goodwill account as if it were purchased at the current fair value

Goodwill Impairment Example Assume that an investment currently reported on the investor's balance sheet in the amount of $1 million has a current fair market value of $900,000. Assume that an investment currently reported on the investor's balance sheet in the amount of $1 million has a current fair market value of $900,000. Further assume that the fair market value of the net assets of the investee company is $700,000 and the current value of goodwill on the consolidated balance sheet is 300,000. Further assume that the fair market value of the net assets of the investee company is $700,000 and the current value of goodwill on the consolidated balance sheet is 300,000. This indicates an impairment loss of $100,000, which is computed as follows: This indicates an impairment loss of $100,000, which is computed as follows:

Sales of Subsidiaries – Discontinued Operations

Limitations of Consolidated Financial Statements Consolidated statements do not imply that: Consolidated statements do not imply that: The cash of foreign subsidiaries is in or can be brought to the USA. The cash of foreign subsidiaries is in or can be brought to the USA. The consolidated earnings or cash flow from operations can be invested in the USA. The consolidated earnings or cash flow from operations can be invested in the USA. Companies with financial subsidiaries may be difficult to analyze. Companies with financial subsidiaries may be difficult to analyze.

Global Accounting: Consolidation Consolidation accounting standards were developed jointly by the FASB and the IASB. Consolidation accounting standards were developed jointly by the FASB and the IASB. Yet, a few differences remain: Yet, a few differences remain: Contrary to US GAAP, under IFRS, parent and subsidiaries’ accounting policies must conform. Contrary to US GAAP, under IFRS, parent and subsidiaries’ accounting policies must conform. Contrary to US GAAP, under IFRS, fair-value impairments for intangible assets, excluding goodwill, can be later reversed (that is, written back up after being written down). Contrary to US GAAP, under IFRS, fair-value impairments for intangible assets, excluding goodwill, can be later reversed (that is, written back up after being written down).