1. Chapter 14 INTERCORPORATE INVESTMENTS
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LEARNING OUTCOMES
Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.

2. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 717–720
Examples of intercorporate investments include
IBM’s acquisition of a sizable portion of Intel’s stock to ensure a supply of components.
Coca-Cola’s acquisition of a bottling company to gain cost advantage.
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3. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 718–720
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4. 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 term (i.e., held for trading ) or has otherwise elected fair value accounting.
Changes in value are recognized in profit or loss on income statement.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 720–722
Investments in financial assets can be categorized based on intent.
The three basic categories of investments in financial assets (based on the investor’s intent to hold): (1) held to maturity, (2) fair value through profit or loss, and (3) available for sale.
IFRS uses the terminology designated as fair value through profit or loss.
Regardless of classification, dividends and interest received are on the income statement.
Copyright © 2013 CFA Institute

5. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5).
Pages 723–729
Impairment losses on available-for-sale (AFS) equity securities cannot be reversed. However, impairment losses on AFS debt securities can be reversed if a subsequent increase in fair value can be objectively related to an event occurring after the impairment loss was recognized in profit and loss.
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6. 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 Baxter’s 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
End of Year
Interest Payment
Interest Income
Amortization
Carrying Value
£300,000 1*
£16,500
£13,500
£3,000
297,000 2
16,500
13,365
3,135 3
13,224
3,276
290,589
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 727–728
- From Example 14-1, page 727, in text
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7. Investments in financial assets: Example
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-to-maturity
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
Available-for-sale
£53,000 unrealized gain (net of tax) reported as OCI
Designated at fair value
Interest income £13,500
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 727–728
- From Example 14-1, page 727, in text
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8. Investments in financial assets: Example
How would the gain be recognized if the debt securities were sold on January 2009 for £352,000?
How would this investment appear on the balance sheet at December 2009?
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
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 727–728
If Baxter had invested in Cartel’s equity securities instead of its debt securities, the analysis would change in the following ways:
there would not be a held-to-maturity option and
dividend income (if any) would replace interest income.
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.
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9. 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 investee’s income is at least partially attributed to the influence of the investor. As such, the investor recognizes a proportionate amount of investee’s income.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 729–742
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10. Equity method
The investor’s share of the investee’s 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 investor’s share of post-acquisition income less any dividends paid.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 729–742
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11. Equity method: example
Branch Inc. purchases a 20% interest in Williams Inc. for €200,000 on 1 January Williams reports income and dividends as follows:
Calculate the investment in Williams that appears on Branch’s balance sheet as of the end of 2010:
Income
Dividends
2008
€200,000
€50,000
2009
300,000
100,000
2010
400,000
200,000
€900,000
€350,000
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 730–731
Investment in Williams as of the end of 2010 = Initial cost + Share of post acquisition income – Dividends received.
€200, % × (€900,000 – €350,000) = €310,000
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12. Investments in associates: when investment costs > book value of investee
When investment costs exceed the investor’s proportionate share of the investee’s 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 733–734
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13. 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 Brown’s 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.
Book Value
Fair Value
Current assets
€10,000
Plant and equipment
190,000
220,000
Land
120,000
140,000
€320,000
€370,000
Liabilities
100,000
Net assets
€220,000
€270,000
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 734–735
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14. Investments in associates: 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
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 734–735
Using the example above, assuming a 10-year useful life for plant and equipment, and using straight-line method for depreciation, the annual amortization for plant and equipment is €900 (= €9,000/10). Land and goodwill have indefinite useful life and thus are not amortized.
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15. 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 investment’s 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.
LOS. Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Page 738
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16. Transactions with associates
An investor company can influence the terms and timing of transactions with its associates. Thus, the investor company’s 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 investor’s ownership of the investee.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) al purpose and variable interest entities.
Pages 739–741
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17. 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 venturer’s 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.
LOS. Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Pages 742–746
In contrast to proportionate consolidation, the equity method results in a single line item (equity in income of the joint venture) on the income statement and a single line item (investment in joint venture) on the balance sheet.
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18. 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.
LOS. Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Pages 742–746
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19. Equity method vs. proportionate consolidation: Example
LOS. Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.
Pages 744–746
Notice that net income is €320,000 using either the equity method or proportionate consolidation. But sales, cost of sales, and expenses are different because under the equity method, the net effect of sales, cost of sales, and expenses is reflected in the €60,000 equity in joint venture income.
On the balance sheet, the line item “investment in joint venture” observed under the equity method is replaced by the proportionate share of each balance sheet account in the proportionate consolidation method. The single line item is replaced with a line-by-line consolidation. In other words, because the venturer has a 50% interest in the joint venture, 50% of joint venture assets and liabilities are included in the proportionate balance sheet.
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20. Equity method vs. proportionate consolidation: example
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 entity’s operation when those operations include interests in one or more jointly controlled entities.
Equity
Method
Proportionate Consolidation
Net profit margin
32.0%
26.7%
Return on assets
11.2%
10.7%
Debt/Equity
1.65
1.80
LOS. Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.
Pages 744–746
The ratios are calculated based on the numbers on the previous slide.
Copyright © 2013 CFA Institute

21. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Page 746
Merger: Company A + Company B = Company A
Acquisition: Company A + Company B = (Company A + Company B)
Consolidation: Company A + Company B = Company C
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22. 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 acquirer’s share of acquiree’s assets and liabilities.
- “Full goodwill” under U.S. GAAP: the difference between total fair value of the acquiree and fair value of the acquiree’s identifiable net assets.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 747–752
Business combinations used to be accounted for either as a purchase transaction or as a pooling of interests. The accounting standards that currently govern business combinations are reflective of the joint project between IASB and FASB to converge on a single set of high-quality accounting standards.
IFRS also permits the “full goodwill” option on a transaction-by-transaction basis.
Copyright © 2013 CFA Institute

23. 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 interest’s proportionate share of the acquiree’s 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 746–750
Copyright © 2013 CFA Institute

24. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 750–752
Copyright © 2013 CFA Institute

25. 100% acquisition: example
The postacquisition balance sheet of the combined entity: Franklin Consolidated Balance Sheet (€ thousands)
Cash and receivables
€10,300
Inventory
15,000
PP&E (net)
31,500
Goodwill
9,600
Total assets
€66,400
Current payables
€8,600
Long-term debt
17,800
Total liabilities
€26,400
Capital stock (€1 par)
€6,000
Additional paid in capital
20,000
Retained earnings
14,000
Total stockholders’ equity
€40,000
Total liabilities and stockholders’ equity
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 750–752
Purchase price (fair value of stock issued): €15,000,000
Less the fair value of identifiable net assets –€5,400,000
Equal to goodwill €9,600,000
Assets and liabilities are combined using book values of Franklin plus fair values for the assets and liabilities acquired from Jefferson. For example, the book value of Franklin’s inventory (€12,000,000) is added to the fair value of inventory acquired from Jefferson (€3,000,000) for a combined inventory of €15,000,000.
Prior to the transaction, Franklin had 5,000,000 shares of €1 par stock outstanding (€5,000,000). The combined entity reflects the Franklin capital stock outstanding of €6,000,000 (€5,000,000 plus the additional 1,000,000 shares of €1 par stock issued to effect the transaction).
Franklin’s additional paid-in capital of €6,000,000 is increased by the €14,000,000 additional paid-in capital from the issuance of the 1,000,000 shares (€15,000,000 less par value of €1,000,000) for a total of €20,000,000.
At the acquisition date, only the acquirer’s retained earnings are carried to the combined entity. Earnings of the target are included on the consolidated income statement and retained earnings only in postacquisition periods.
Copyright © 2013 CFA Institute

26. 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 subsidiary’s 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:
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 754–756
Copyright © 2013 CFA Institute

27. Less than 100% acquisition: example
Calculate the value of PP&E (property, plant, and equipment) on the consolidated balance sheet under both IFRS and U.S. GAAP.
Calculate the value of goodwill and the value of the noncontrolling interest at the acquisition date under the full goodwill method.
€235,000 + €155,000 = €390,000
Fair value of subsidiary
€200,000
Fair value of subsidiary’s identifiable net assets
160,000
Goodwill
€40,000
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 754–756
Solution to 1: Under the acquisition method, as long as the parent has control over the subsidiary, it would include 100% of the subsidiary’s assets and liabilities at fair value on the consolidated financial statements.
Solution to 2:
Under the full goodwill method, goodwill on the consolidated balance sheet would be the difference between the fair value of the subsidiary and the fair value of the subsidiary’s identifiable net assets.
The value of the noncontrolling interest is equal to the noncontrolling interest’s proportionate share of the subsidiary’s fair value.
The value of noncontrolling interest = 10% × €200,000 = €20,000
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28. Less than 100% acquisition: example
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 subsidiary’s identifiable net assets
144,000
Goodwill
€36,000
Value of noncontrolling interest = 10% × €160,000 = €16,000
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 754–756
Solution to 3:
Under the partial goodwill method (IFRS only), goodwill on the parent’s consolidated balance sheet is the difference between the purchase price and the parent’s proportionate share of the subsidiary’s identifiable assets.
The value of the noncontrolling interest is equal to the noncontrolling interest’s proportionate share of the fair value of the subsidiary’s identifiable net assets. The noncontrolling interest’s proportionate share is 10%, and the fair value of the subsidiary’s identifiable net assets on the acquisition date is €160,000.
Copyright © 2013 CFA Institute

29. 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 unit’s goodwill and its carrying amount (two-step approach).
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 757–759
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30. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 764–773
Enron, for example, used SPEs to obtain off-balance-sheet financing and artificially improve its financial performance. Its subsequent collapse was partly attributable to its guarantee of the debt of the SPEs it had created.
Copyright © 2013 CFA Institute

31. 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.
LOS. Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
Pages 764–773
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32. 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.
LOS. Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.
Pages 769–772
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33. SPE: Example
LOS. Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.
Pages 769–772
Column 2 contains financial statement information provided by the example. Columns 3 and 4 contain financial statement information if Odena chooses Alternative 1 and Alternative 2, respectively.
Alternative 1:
Odena’s cash will increase by €55 million (to €85 million) and its debt will increase by €55 million (to €75 million). Its sales and net income will not change.
From a ratio perspective, Odena’s equity-to-total-assets ratios would be lower, but its debt-to-equity and current ratios would be higher. However, profitability ratios, such as return on assets and return on total capital, would be lower.
Alternative 2:
Odena’s accounts receivable will decrease by €60 million and its cash will increase by €55 million (it invests €5 million in cash in the SPE). However, if Odena is able to sell the receivables to the SPE for more than their carrying value (for example, €65 million), it would also report a gain on the sale in its profit and loss.
From a ratio perspective, Odena’s debt-to-equity and equity-to-total-assets ratios would be unaffected by the sale; however, its accounts receivable turnover ratio would improve. In addition, if the receivables are transferred (sold) at a gain, Odena’s profitability ratios (net profit margin, return on total capital, return on equity, and return on assets) would be higher.
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34. Summary of Accounting treatment for intercorporate investments
Type
Financial Assets
Associates
Combinations
Joint Ventures
Influence
None/Little
Significant
Controlling
Shared
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:
Equity method
Consolidation
Equity method (U.S. GAAP & IFRS) or
proportionate consolidation (IFRS Only)
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