Intercorporate Equity Investments

Revsine/Collins/Johnson/Mittelstaedt: Chapter 16

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.

Learning objectives
1. How a company benefits from owning another companys common stock. 2. How and why an investors ownership share determines the accounting treatment for equity investments. 3. How the accounting for short-term speculative investments differs from the accounting for long-term investments. 4. The equity accounting method and when to use it. 5. Fair Value election for equity method investments. 6. What consolidated financial statements are, and how they are compiled.

RCJM: Chapter 16

2009

Learning objectives:
Concluded
7. What goodwill is and when it is shown on financial statements. 8. How the purchase and acquisition methods of reporting mergers and acquisitions complicates financial analysis. 9. What special purpose entities are and when they must be consolidated. 10. How foreign subsidiaries are treated when financial statements in U.S. dollars are prepared. 11. How businesses combined in prior years have been accounted for under the pooling of interests method.
3

RCJM: Chapter 16

2009

Overview

Financial Reporting Alternatives for Intercorporate Equity

RCJM: Chapter 16

2009

Minority passive investment:

When trading securities are sold, a realized gain or loss is recorded.
Realized gain or loss

Trading securitiesmark-to-market accounting

Selling price

Most recent mark-to-market price

Heres what happens when Company B preferred stock is sold:

RCJM: Chapter 16

2009

Minority passive investment:

Available-for-sale securities

Mark-to-market accounting is used, but the adjustment is not included in income. Instead, the upward or downward adjustment to reflect fair value is a direct (net of tax) credit or debit to a special owners equity account. This special owners equity account is one of the Other comprehensive income components described in Chapter 2.

RCJM: Chapter 16

2009

Minority active investments:

Equity method
When the ownership percentage equals or exceeds 20%, GAAP presumes two elements:
1. The investor can exert influence over the company. 2. The investment represents a continuing relationship between the two companies.

The accounting approach used for minority passive investments is no longer suitable.
RCJM: Chapter 16 2009 7

Majority ownership
When the ownership percentage exceeds 50% of the voting shares, GAAP presumes the parent controls the subsidiary. The financial statements of the subsidiary are then combinedline by linewith those of the parent using a process called consolidation. This consolidation process occurs each reporting period.

If the ownership percentage is exactly 50% of the voting shares, the equity method is used and no line-by-line consolidation is necessary.

RCJM: Chapter 16

2009

Accounting goodwill
Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business.
$0.5 million
$1.5 million $10 million $8 million
Net asset BV Goodwill Excess of net asset FMV over BV

Purchase price

Allocation

Prior to 2002, acquired goodwill in the U.S. was amortized to income over a period not exceeding 40 years. SFAS No. 142 no longer permits amortization but instead requires periodic impairment tests.
RCJM: Chapter 16 2009 9

Accounting goodwill:
Impairment

SFAS No. 142 Goodwill Impairment Test

RCJM: Chapter 16

2009

10

Variable Interest Entities

A corporation, partnership, trust or other legal structure. Does not have equity investors with voting rights, or FAS Interpretation 46 requires the VIE to be consolidated on the books of the primary beneficiary when:

Has equity investors that do not provide sufficient financial resources for the entity to support its activities. Major uses include selling receivables, securitizing loans and mortgages, synthetic leases, take-or-pay contracts.

The company is subject to the majority of the risk of loss from the VIEs activities.

Or

The company is entitled to receive a majority of the VIEs residual returns.

RCJM: Chapter 16

2009

11

Accounting for foreign subsidiaries:

Overview
All majority-owned subsidiariesforeign and domesticmust be consolidated.
An additional complication arises when consolidating a foreign subsidiary because the financial records are expressed in the foreign currency. One of two procedures is used, depending on the operating characteristics of the foreign subsidiary:
Temporal method (remeasured)
Functional currency choice

Foreign sub is not self-sufficient

Current rate method (translated)

Foreign sub has self-contained foreign operations

RCJM: Chapter 16

2009

12

Accounting for foreign subsidiaries:

Summary

Translation Approach Used in SFAS NO.52

RCJM: Chapter 16 2009 13

Summary
Financial reporting for intercorporate equity investments depends on the size of the parent companys ownership shares. When the ownership share is less than 20% (minority passive investment), mark-to-market accounting is used. When the ownership share is from 20% to 50% (minority active investment), the equity method is used. SFAS No. 159 allows firms to elect the fair value option for equity investments. Unrealized gains and losses resulting from market value changes are reported on the investors income statement.

RCJM: Chapter 16

2009

14

Summary concluded
Consolidated financial statements are required when one entity acquires more than 50% of another entity. Goodwill is typically recorded in business combinations using the purchase method, and is not amortized, but is subject to annual impairment tests. Purchase and acquisition methods of accounting complicate financial analysis because of the differing treatment of subsidiarys net income.

When freestanding foreign subsidiaries are consolidated with at U.S. company, the current rate method for foreign currency translation is used. When the foreign subsidiary is not freestanding, the temporal method is used.
RCJM: Chapter 16 2009 15