Chapter 18: Intercorporate Equity Investments Relevant circumstances Consolidation Pooling of interests Purchase method New entity approach Pro rata Equity method Fair value method

Reporting on Intercorporate Equity Investments 1.Consolidated reporting as if the two separate legal entities are one accounting entity using either the purchase or pooling method (as appropriate) 2.Nonconsolidation using the equity method of accounting 3.Nonconsolidation using the fair (market) value approaches

Finite Uniformity for Intercorporate Investments Ownership of Voting Stock Accounting Method >50% Consolidate per ARB 51, APB Opinion No. 16, APB Opinion No % to 50%Equity Accounting per APB Opinion No. 18 >20% Fair (market) value for both trading securities and available-for-sale securities...

Relevant Circumstances The relevant circumstances that justify differential accounting for intercorporate equity investments depend on the level of influence held by the investor

Three Levels of Control Majority owned company: owner has effective control Majority owned company: control is only temporary or the majority owner does not have effective control Less-than-majority-owned companies: relevant circumstance is whether the investor can exercise significant influence over operating and financial policies

Consolidation A technique in which two or more entities are reported as if they are one common accounting entity Also called a business combination

Consolidation Terms Combined enterprise Constituent companies Combinor Combinee

Consolidation Central accounting issue is the valuation of the assets and liabilities of the separate entities being combined for reporting purposes FASB (1976) outlined three possible methods of accounting 1. pooling of interests accounting 2. purchase accounting 3. new entity approach

Divestitures Sell-off Spin-off Split-off Split-up

Pooling of Interests Based on the premise that no substantive transaction occurs between the constituent companies Is argued to be simply the formal unification of two previously separate ownership groups Desirability of pooling is to avoid certain ramifications of purchase accounting

Purchase Method Assumption is that the combinor is a parent company that purchases the combinee (subsidiary) and must account for the purchase as it would for the acquisition of any asset The asset, investment in the combinee company, is recorded by the combinor at the latter’s cost determined as of the date the combination is consummated

New Entity Approach Regard the combined enterprise as an entirely new entity Results in the use of current values for the assets and liabilities of all the separate entities as of the date the combination is consummated

Pro Rata Consolidation ( 4 th method) Consolidation of assets and liabilities occurs only to the extent of the stock acquired by the parent An arbitrary distinction at the 50 % point where control is assumed does not exist

Equity Method Used whenever the investor has the ability to exercise significant influence over the investee A one-line consolidation takes place The investment account simply mirrors the net change in investee book value

Fair Value Method Market value applies where no significant influence exists and market values are readily determinable for investments of approximately 20 percent or less Increases or decreases in market value may or may not go through income depending upon management’s intention to sell them in the near term

SFAS No. 94 Asserts, rather than demonstrates, that consolidated reporting (and the fictional accounting entity thus created) is more relevant to investors than are separate entity statements in which the reporting entity is the legal entity

Chapter 18: Intercorporate Equity Investments Relevant circumstances Consolidation Pooling of interests Purchase method New entity approach Pro rata Equity method Fair value method