13 CHAPTER Analysis of Intercorporate Investments

Question :  Items related to security investment  Differences between the long-term equity investments on the balance sheet of parent and consolidated financial statements  China: 投资收益 <> 红利

Introduction  Enterprises invest in the securities of other companies for various reasons:  Dividends or interest income;  capital gains;  Risk sharing;  participation in new markets;  Precursor to an acquisition.

 Financial reporting of intercorporate investments depends primarily on the degree of investor influence or control over the investee. Percentage of ownership in the investee firm is often used as a practical gudeline to measure significant influence or control:

Intercorporate Investments OwnershipDegree of influenceReporting method <20%No significant influence Cost or market 20-50%Significant influence Equity method >50%Controlconsolidation China: Fair Value

Investments in securities  Generally, when the investment are small relative to the capital of the investee, the investor is unlikely to influence the activities of the investee.  Over the life of the investment, the total return earned on the investment equals:  Dividends and interest received + capital gain or loss

 The following accounting methods used to report the investments in securities of other entities recognize dividends and interest as part of income in the year they are earned; they differ as to when changes in the market value o the asset are recognized:  Cost method: recognizes changes in market value only in the period the securities are sold;  Market method: recognizes changes in market prices in the period they occur;  Lower of cost or market: recognizes price changes prior to sale only when the market value declines below original cost.

Example:  Company Purchases 1share(out of 100 shares outstanding) of company S for $100.  Company S reports net income of $25 per share for period 1 and declares dividends of 10$ per share on its common stock.  The market value of Company S’s share rises to $135 per share at the end of period 1.  Company P sell its share of Company S for $120 during period 2.

Cost method:  At acquisition, Company P reports:  Investment in Company S $100  For period 1:  Dividend received $10  At end of period 1, does not record the increase in market price of the shares of company S.  When the security is sold in period 2:  Gain = =20  Total return= 10+20=30

Market method:  Under the market method, securities with a public market are carried at their current market value. Unrealized changes in market value (from period to period) are included in net income along with dividends, interest, and realized gains and losses.  Period 1:  Return= 10+35=45  Period 2:  Return=-15 (loss)  Total return= 30

Lower of cost or market method:  LOCOM takes a conservative approach and recognizes unrealized losses (but not gains) and recoveries of previously recognized unrealized losses.  No market value change is recognized in period 1;  When market value is below cost, LOCOM produces the same result as the market method.  The method can be summarized as follows: MethodBalance sheet (carrying value) Income statement (recognized as income) cost Dividends and interest Realized gains and losses marketMarket VALUEDividends and interest Realized and unrealized gains and losses LOCOM Dividends and interest Realized gains and losses Unrealized losses and recoveries

Investment in shares:

Accounting for Investments GAAP identifies three levels of influence/control:  Passive. In this case the purchasing company is merely an investor and cannot exert any influence over the investee company. Its goal for the investment is to realize dividend and capital gain income. Generally, passive investor status is presumed if the investor company owns less than 20% of the outstanding voting stock of the investee company.  Significant influence. In certain circumstances, a company can exert significant influence over, but not control, the activities of the investee company. This level of influence may result from the percentage of voting stock owned. It may also result from legal agreements, such as a license to use technology, a formula, or a trade secret like production know-how. It also may be that the investor company is the sole supplier or customer of the investee. Generally, significant influence is presumed if the investor company owns 20-50% of the voting stock of the investee company.  Control. When a company has control over another, it has the ability to elect a majority of the board of directors and, as a result, the ability to affect its strategic direction and hiring of executive management. Control is generally presumed if the investor company owns more than 50% of the outstanding voting stock of the investee company. Control can occur at less than 50% stock ownership as well, by virtue of legal agreements, technology licensing, and similar. Once the level of influence/control is determined, the appropriate accounting method is applied as outlined in the Investment Map

Accounting Treatment and Financial Statement Effects

Passive Investments - Market Method Initially record at purchase price (fair market value on purchase date) Gain (loss) on sale = Proceeds – Book value of investment During holding period, investment is recorded at current market value ( “ marked-to-market ” )

Are Changes in Asset Value Income? Changes in the carrying amount of the investment (asset) has a corresponding effect on equity: Assets  = Liabilities + Equity  The central issue in the accounting for investments is whether this change in equity is income. The answer depends on the investment classification.

Investment Classifications GAAP allows for two possible classification is equity investments: Available-for-sale. Investments in securities that management intends to hold for capital gains and dividend income; although it may sell them if the price is right. Trading. Investments in securities that management intends to actively trade (buy and sell) for trading profits as market prices fluctuate.

Financial Statement Effects

Bond Investment Classifications Available-for-sale. Investments in securities that management intends to hold for capital gains and dividend income; although it may sell them if the price is right. Trading. Investments in securities that management intends to actively trade (buy and sell) for trading profits as market prices fluctuate. Held-to-maturity. Investments in debt securities that management intends to hold until maturity. Since debt securities yield their face value at maturity, market fluctuations during intervening years are less relevant for this investment strategy.

Held To Maturity Investments

U.S accounting standards for investments in securities  Securities with no readily available market price: cost method.  Securities that have a public market or readily determined fair value must classified into three categories: Balance sheetIncome statement Held to maturityCostInterest Realized gains and losses Available for saleMarket valueDividends and interest Realized gains and losses tradingMarket valueDividends and interest Realized gains and losses Unrealized gains and losses

Equity Method Investments Equity Method accounting is required for investments in which the investor company can exert “ significant influence ” over the investee. Significant influence is the ability of the investor to affect the financial or operating policies of the investee. Ownership levels of 20-50% of the outstanding common stock of the investee company presume significant influence. Significant influence can also exist when ownership is less than 20% if, for example,  the investor company is able to gain a seat on the board of directors of the investee company by virtue of its equity investment, or  when the investor controls technical know-how or patents that are used by the investee company, or  when the investor company is able to exert control by virtue of legal contracts between it and the investee company.

Accounting for Equity Method Investments Investments are initially recorded at their purchase cost Investments are initially recorded at their purchase cost Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (they are not recorded as income) Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (they are not recorded as income) The investor reports income equal to its percentage share of the reported income of the investee; the investment is increased (decreased) in the amount of income (loss) recorded The investor reports income equal to its percentage share of the reported income of the investee; the investment is increased (decreased) in the amount of income (loss) recorded The investment is not reported at market value The investment is not reported at market value

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

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

Equity Method Accounting Companies sometimes pay more than book value when acquiring equity interest in other companies. For example, if HP paid $400 for its 30% stake in Mitel, HP would  Report its investment at its $400 purchase price  It would increase and decrease that investment by 30% of Mitel ’ s increases and decreases in its stockholders ’ equity.  If the $100 excess purchase cost ($400-$300) is treated as goodwill, as is common, it remains on HP ’ s balance sheet without adjustment unless it becomes impaired  Absent any goodwill impairment, the carrying amount of the investment on HP ’ s balance sheet always equals $100 plus 30% of Mitel ’ s stockholders ’ equity.

Investments with Control — Consolidation Accounting  H-P ’ s footnote on consolidated entities:  Accounting for business combinations (acquisitions) involves one additional step to equity method accounting.  Consolidation accounting replaces the investment balance with the assets and liabilities to which it relates, and it replaces the equity income reported by the investor company with the sales and expenses of the investee company to which it relates.

Consolidation Accounting

Acquired Intangible Assets Tangible assets and liabilities assumed are valued at their fair market values on the acquisition date. These amounts for assets and liabilities are initially recorded on the consolidated balance sheet. The remaining purchase price is then allocated to acquired identifiable intangible assets, which include the following:  Marketing-related assets like trademarks and internet domain names  Customer-related assets like customer lists, production backlog, and customer contracts  Artistic-related assets like plays, books, and video  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

Impairment of Goodwill Goodwill recorded in the consolidation process has an indefinite life and is not amortized. It is, however, subject to annual review for impairment. This review is a two-step process.  First, the fair market value of the investee company is compared with the book value of its associated investment account on the investor ’ s books. The fair market value of the investee company can be determined using a number of alternative methods, such as quoted market prices of comparable businesses or a discounted free cash flow valuation method.  Second, if the current market value is less than the investment balance, goodwill is deemed to be impaired and an impairment loss is computed and recorded in the consolidated income statement.

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. 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:

Limitations of Consolidated Financial Statements Consolidation income does not imply that cash is received by the parent company Comparisons across companies are often complicated by the mix of subsidiaries included in the financial statements Segment profitability can be affected by intercorporate transfer pricing and allocation of overhead

1. A minority passive investment is one in which the shareholder has no ability to influence the acquired company. 2. Trading securities are typically purchased by the investor to generate profits on holding gains. 3. Unrealized gains and losses on available-for-sale securities are reported as a component of other comprehensive income. 4. When the ownership percentage of stock exceeds 20 percent, GAAP presumes that the investor is able to exert significant influence over the investee company. 5. An investor would be willing to pay more than book value for an interest in a company as a result of goodwill. 6. When two companies form a joint venture and each company owns exactly 50% of the joint venture, both parent ’ s consolidate one half of the joint venture. True-False

7. Equity securities designated by the investor to be held for a short period of time are classified as a.available-for-sale securities. b.trading securities. c.mark-to-market securities. d.adjusted historical cost securities. 8. Minority passive equity securities designated by the investor to be held for the long-term are a.trading securities. b.available-for-sale securities. c.mark-to-market securities. d.adjusted historical cost securities.

9. The unrealized holding gain or loss on trading securities is recorded as a.revenue on the income statement in the period after the security price change. b.revenue on the income statement in the period of the security price change. c.deferred revenue on the balance sheet in the period prior to the security price change. d.deferred revenue on the balance sheet. 10. Unrealized gains and losses on available-for-sale securities a.increase income in the period of price change. b.decrease income in the period of price change. c.have no effect on income in the period of price change. d.increase cash flow.