Reporting and Reporting and Analyzing Analyzing

Intercorporate Intercorporate InvestmentsInvestments Reporting and Reporting and

Analyzing Analyzing Intercorporate Intercorporate InvestmentsInvestments

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ICMAP STAGE 1,2,3,4ICMAP STAGE 1,2,3,4 ICAP MODULE A,B,C,DICAP MODULE A,B,C,D MA-ECONOMICSMA-ECONOMICS PIPFA-COMPLETEPIPFA-COMPLETE ACCOUNTING-BBA & MBAACCOUNTING-BBA & MBA ACCOUNTING O/A LEVELSACCOUNTING O/A LEVELS B.COM & M.COMB.COM & M.COM

Equity SecuritiesEquity Securities What is an equity investment?What is an equity investment?

Why would a firm invest in the equity Why would a firm invest in the equity of another firm?of another firm?

Accounting for InvestmentsAccounting for Investments GAAP identifies three levels of GAAP identifies three levels of

influence/control:influence/control:– PassivePassive– Significant influenceSignificant influence– ControlControl

Accounting Treatment and Accounting Treatment and Financial Statement EffectsFinancial Statement Effects

Intercorporate InvestmentsIntercorporate Investments

PassivePassive PassivePassive. In this case the purchasing . In this case the purchasing

company is merely an investor and cannot company is merely an investor and cannot exert any influence over the investee exert any influence over the investee company. Its goal for the investment is to company. Its goal for the investment is to realize dividend and capital gain income. realize dividend and capital gain income. Generally, passive investor status is Generally, passive investor status is presumed if the investor company owns presumed if the investor company owns less than 20% of the outstanding voting less than 20% of the outstanding voting stock of the investee company.stock of the investee company.

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ECONOMICSECONOMICS

ICMAP STAGE 1ICMAP STAGE 1PIPFA FOUNDATIONPIPFA FOUNDATIONICAP MODULE BICAP MODULE BMA-ECONOMICSMA-ECONOMICSB.COMB.COM

Significant influenceSignificant influence Significant influenceSignificant influence. In certain . In certain

circumstances, a company can exert circumstances, a company can exert significant influence over, but not control, significant influence over, but not control, the activities of the investee company. the activities of the investee company. Generally, significant influence is Generally, significant influence is presumed if the investor company owns presumed if the investor company owns 20-50% of the voting stock of the investee 20-50% of the voting stock of the investee company.company.

ControlControl– ControlControl. When a company has control . When a company has control

over another, it has the ability to elect a over another, it has the ability to elect a majority of the board of directors and, majority of the board of directors and, as a result, the ability to affect its as a result, the ability to affect its strategic direction and hiring of strategic direction and hiring of executive management. Control is executive management. Control is generally presumed if the investor generally presumed if the investor company owns more than 50% of the company owns more than 50% of the outstanding voting stock of the investee outstanding voting stock of the investee company. company.

Some termsSome terms Mark-to-marketMark-to-market RealizedRealized RecognizedRecognized Ready marketReady market Trading securityTrading security Available for sale securityAvailable for sale security

Passive - No ready marketPassive - No ready market Account for at costAccount for at cost No mark-to-marketNo mark-to-market

Investment ClassificationsInvestment Classifications GAAP allows for two possible classification GAAP allows for two possible classification

is equity investments:is equity investments: Available-for-saleAvailable-for-sale. Investments in . Investments in

securities that management intends to securities that management intends to hold for capital gains and dividend income; hold for capital gains and dividend income; although it may sell them if the price is although it may sell them if the price is right.right.

TradingTrading. Investments in securities that . Investments in securities that management intends to actively trade management intends to actively trade (buy and sell) for trading profits as market (buy and sell) for trading profits as market prices fluctuate.prices fluctuate.

Passive - Ready marketPassive - Ready market Trading or Available for sale depending on Trading or Available for sale depending on

management’s intentionsmanagement’s intentions Both are marked-to-marketBoth are marked-to-market For trading securities the gain/loss is For trading securities the gain/loss is

recognized prior to being realized (on recognized prior to being realized (on income statement)income statement)

For available for sale securities recognition For available for sale securities recognition is at realization. Until then the holding is at realization. Until then the holding gain/loss is kept in an the equity section of gain/loss is kept in an the equity section of the balance sheet (not on income the balance sheet (not on income statement)statement)

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COST ACCOUNTINGCOST ACCOUNTING

ICMAP STAGE 2,3ICMAP STAGE 2,3ICAP MODULE DICAP MODULE DBBA & MBABBA & MBAPIPFAPIPFAB.COM & M.COMB.COM & M.COM

Example of Trading and Example of Trading and Available for saleAvailable for sale

10/1/98 Buy 10 shares @ $15 each10/1/98 Buy 10 shares @ $15 each Record at costRecord at cost

12/21/98 Market value rises to $1812/21/98 Market value rises to $18 Mark-to-marketMark-to-market

02/20/99 Sell 10 shares @20 each02/20/99 Sell 10 shares @20 each Gain (loss) = Sales price – Book ValueGain (loss) = Sales price – Book Value

Are Changes in Asset Value Are Changes in Asset Value Income?Income?

Changes in the carrying amount of the Changes in the carrying amount of the investment (asset) has a corresponding investment (asset) has a corresponding effect on equity:effect on equity:

Assets Assets = Liabilities + Equity = Liabilities + Equity The central issue in the accounting for The central issue in the accounting for

investments is whether this change in investments is whether this change in equity is income.equity is income.

The answer depends on the investment The answer depends on the investment classification.classification.

American Express American Express Stockholders’ EquityStockholders’ Equity

Held To Maturity Held To Maturity InvestmentsInvestments

Equity Method InvestmentsEquity Method Investments Equity Method accounting is required for Equity Method accounting is required for

investments in which the investor investments in which the investor company can exert “significant influence” company can exert “significant influence” over the investee.over the investee.

Significant influenceSignificant influence is the ability of the is the ability of the investor to affect the financial or operating investor to affect the financial or operating policies of the investee. policies of the investee.

Equity Method InvestmentsEquity Method Investments Ownership levels of 20-50% of the outstanding Ownership levels of 20-50% of the outstanding

common stock of the investee company presume common stock of the investee company presume significant influence.significant influence.

Significant influence can also exist when Significant influence can also exist when ownership is less than 20% if, for example,ownership is less than 20% if, for example,

the investor company is able to gain a seat on the the investor company is able to gain a seat on the board of directors of the investee company, or board of directors of the investee company, or

when the investor controls technical know-how or when the investor controls technical know-how or patents that are used by the investee company, or patents that are used by the investee company, or

when the investor company is able to exert control when the investor company is able to exert control by virtue of legal contracts between it and the by virtue of legal contracts between it and the investee company. investee company.

Accounting for Equity Accounting for Equity Method InvestmentsMethod Investments

Initially record investment at cost.Initially record investment at cost. Increase asset to reflect proportionate Increase asset to reflect proportionate

share of net income. Essentially treats share of net income. Essentially treats their income as yours.their income as yours.

Dividends decrease investment. Treated Dividends decrease investment. Treated as a return of investment. They are not as a return of investment. They are not considered income.considered income.

No mark-to-marketNo mark-to-market Income recognized rarely equals either Income recognized rarely equals either

cash flow or actual change in market cash flow or actual change in market value.value.

Equity Method AccountingEquity Method Accounting

Assume that HP acquires a 30% interest in Mitel Assume that HP acquires a 30% interest in Mitel Networks. On the date of acquisition, Mitel reports Networks. On the date of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP purchases its $1,000 of stockholders’ equity, and HP purchases its 30% stake for $300. 30% stake for $300.

Assume that Mitel reports net income of $100 and Assume that Mitel reports net income of $100 and pays dividends of $20 (30% or $6 to HP) pays dividends of $20 (30% or $6 to HP)

Equity Method AccountingEquity Method Accounting

Following are the balance sheet and income statement impacts for Following are the balance sheet and income statement impacts for the preceding transactions: the preceding transactions:

Your turnYour turn Initially L purchases 30% of S for $9 Initially L purchases 30% of S for $9

when the book value of S = $30when the book value of S = $301.1. S has income of $20 and pays total S has income of $20 and pays total

dividends of $10dividends of $102.2. S has a loss of $10 and pays total S has a loss of $10 and pays total

dividends of $20dividends of $20 Record L’s yearly income from S Record L’s yearly income from S

and investment in Sand investment in S

Equity methodEquity method Why would a firm prefer using the Why would a firm prefer using the

equity method over consolidation?equity method over consolidation?

Blue and Yellow = Green exampleBlue and Yellow = Green example

Equity method cautions!Equity method cautions! Income shown on income statement Income shown on income statement

is not really income.is not really income. The asset shown is not at market The asset shown is not at market

value.value. Potentially liabilities are “hidden” off Potentially liabilities are “hidden” off

balance sheet. balance sheet.

Business Combinations (Over Business Combinations (Over 50%)50%)

2 companies brought together as single 2 companies brought together as single accounting entity.accounting entity.

Results in a combination of both the Results in a combination of both the investor and investment firm’s financial investor and investment firm’s financial statements.statements.

Purchase method must be used for Purchase method must be used for acquisition of another company.acquisition of another company.

Prior to 2002 and outside of U.S., under Prior to 2002 and outside of U.S., under certain conditions the pooling of interests certain conditions the pooling of interests method was/is used.method was/is used.

Investments with Control — Investments with Control — Consolidation AccountingConsolidation Accounting

Accounting for business combinations Accounting for business combinations (acquisitions) involves one additional (acquisitions) involves one additional step to equity method accounting. step to equity method accounting.

Consolidation accounting replaces the Consolidation accounting replaces the investment balance with the assets investment balance with the assets and liabilities to which it relates, and it and liabilities to which it relates, and it replaces the equity income reported replaces the equity income reported by the investor company with the by the investor company with the sales and expenses of the investee sales and expenses of the investee company to which it relatescompany to which it relates..

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FINANCIAL ACCOUNTINGFINANCIAL ACCOUNTING

ICMAP STAGE 1,3,4ICMAP STAGE 1,3,4ICAP MODULE B,CICAP MODULE B,CPIPFAPIPFABBA & MBABBA & MBAO/A LEVELSO/A LEVELSB.COM & M.COMB.COM & M.COM

Consolidation AccountingConsolidation Accounting

Acquired Assets - TangibleAcquired Assets - Tangible Tangible assets and liabilities Tangible assets and liabilities

assumed are valued at their fair assumed are valued at their fair market values on the acquisition market values on the acquisition date. These amounts for assets and date. These amounts for assets and liabilities are initially recorded on the liabilities are initially recorded on the consolidated balance sheet. consolidated balance sheet.

Acquired Assets - IntangibleAcquired Assets - Intangible The remaining purchase price is then allocated to The remaining purchase price is then allocated to

acquired identifiable acquired identifiable intangibleintangible assets, which assets, which include the following:include the following:– Marketing-related assets like trademarks and internet Marketing-related assets like trademarks and internet

domain namesdomain names– Customer-related assets like customer lists, production Customer-related assets like customer lists, production

backlog, and customer contractsbacklog, and customer contracts– Artistic-related assets like plays, books, and videoArtistic-related assets like plays, books, and video– Contract-based assets like licensing and royalty Contract-based assets like licensing and royalty

agreements, lease agreements, franchise agreements, agreements, lease agreements, franchise agreements, and servicing contractsand servicing contracts

– Technology-based assets like patents, computer Technology-based assets like patents, computer software, databases and trade secretssoftware, databases and trade secrets

HP’s Allocation of Compaq HP’s Allocation of Compaq PurchasePurchase

Consolidation with Purchase Consolidation with Purchase Price Above Book ValuePrice Above Book Value

Pooling Accounting for Pooling Accounting for Business CombinationsBusiness Combinations

The main difference between the pooling and The main difference between the pooling and purchase methods is in the amount recorded as purchase methods is in the amount recorded as the initial investment in the acquired company. the initial investment in the acquired company. – Under the purchase method the investment Under the purchase method the investment

account is recorded at the fair market value of account is recorded at the fair market value of the acquired company on the date of the acquired company on the date of acquisition. acquisition.

– Under the pooling method, this account is Under the pooling method, this account is recorded using the recorded using the book valuebook value amounts from amounts from the acquired company. the acquired company.

– As a result, no goodwill was created. Further, As a result, no goodwill was created. Further, since goodwill amortization was required under since goodwill amortization was required under previous GAAP, subsequent income was larger previous GAAP, subsequent income was larger under pooling because no amortization arose. under pooling because no amortization arose.

Limitations of Consolidated Limitations of Consolidated Financial StatementsFinancial Statements

Consolidation income does not imply that Consolidation income does not imply that cash is received by the parent companycash is received by the parent company

Comparisons across companies are often Comparisons across companies are often complicated by the mix of subsidiaries complicated by the mix of subsidiaries included in the financial statementsincluded in the financial statements

Segment profitability can be affected by Segment profitability can be affected by intercorporate transfer pricing and intercorporate transfer pricing and allocation of overhead allocation of overhead

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