Module 6 Reporting and Analyzing Intercorporate Investments

Equity Securities What is an equity investment? What is an equity investment? Why would a firm invest in the equity of another firm? Why would a firm invest in the equity of another firm?

Intercorporate Investments

Some terms Mark-to-market Mark-to-market Realized Realized Recognized Recognized Ready market Ready market Trading security Trading security Available for sale security Available for sale security

Under 20% - No ready market Account for at cost Account for at cost No mark-to-market No mark-to-market

Under 20% - Ready market Trading or Available for sale depending on management’s intentions Trading or Available for sale depending on management’s intentions Both are marked-to-market Both are marked-to-market For trading securities the gain/loss is recognized prior to be realized (on income statement) For trading securities the gain/loss is recognized prior to be realized (on income statement) For available for sale securities recognition is at realization. Until then the holding gain/loss is kept in an the equity section of the balance sheet (not on income statement) For available for sale securities recognition is at realization. Until then the holding gain/loss is kept in an the equity section of the balance sheet (not on income statement)

Example of Trading and Available for sale 10/1/98 Buy 10 $15 each 10/1/98 Buy 10 $15 each 12/21/98 Market value rises to $18 12/21/98 Market value rises to $18 02/20/99 Sell each 02/20/99 Sell each

Accounting for Investments GAAP identifies three levels of influence/control: 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. 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. 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. 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 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) Initially record at purchase price (fair market value on purchase date) Gain (loss) on sale = Proceeds – Book value of investment Gain (loss) on sale = Proceeds – Book value of investment During holding period, investment is recorded at current market value (“marked- to-market”) 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: 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 central issue in the accounting for investments is whether this change in equity is income. The answer depends on the investment classification. The answer depends on the investment classification.

Investment Classifications GAAP allows for two possible classification is equity investments: 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. 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. 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. 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. 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 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.

American Express Stockholders’ Equity

Held To Maturity Investments

Equity Method Investments Equity Method accounting is required for investments in which the investor company can exert “significant influence” over the investee. 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. 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. 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, 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 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 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. 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 costInvestments 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) recordedThe 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 valueThe 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 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) 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. 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 For example, if HP paid $400 for its 30% stake in Mitel, HP would Report its investment at its $400 purchase price 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. 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 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. 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.

Effects of Equity Method Investments on ROE Net operating profit margin (NOPM=NOPAT/Sales). If equity income is treated as operating (usually the case), NOPM is overstated due to nonrecognition of investee sales and recognition of investee incomeNet operating profit margin (NOPM=NOPAT/Sales). If equity income is treated as operating (usually the case), NOPM is overstated due to nonrecognition of investee sales and recognition of investee income Net operating asset turnover (NOAT=Sales/Avg. NOA). If the equity investment is treated NOPAT is treated as an operating asset (usually the case), NOAT is understated due to nonrecognition of investee sales and overstated by nonrecognition of investee assets in excess of the investment balance. The net effect is indeterminate (overstated if NOA>Sales, and understated otherwise.Net operating asset turnover (NOAT=Sales/Avg. NOA). If the equity investment is treated NOPAT is treated as an operating asset (usually the case), NOAT is understated due to nonrecognition of investee sales and overstated by nonrecognition of investee assets in excess of the investment balance. The net effect is indeterminate (overstated if NOA>Sales, and understated otherwise. Financial leverage (FLEV=Avg. NFO/Avg. equity). Financial leverage is understated doe to nonrecognition of investee liabilities and recognition of investee equity.Financial leverage (FLEV=Avg. NFO/Avg. equity). Financial leverage is understated doe to nonrecognition of investee liabilities and recognition of investee equity.

Equity Method (20% – 50%) If holdings constitute significant influence, assumed at 20% or more. If holdings constitute significant influence, assumed at 20% or more. Initially record investment at cost. Initially record investment at cost. Increase (dr) to reflect proportionate share of net income. Essentially treats their income as yours. Increase (dr) to reflect proportionate share of net income. Essentially treats their income as yours. Dividends decrease investment. Treated as a return of investment. Dividends decrease investment. Treated as a return of investment. No mark-to-market No mark-to-market Income recognized rarely equals either cash flow or actual change in market value. Income recognized rarely equals either cash flow or actual change in market value.

Equity Method example Large Corp purchases 30% of Small Corp for $9 when equity balance of Small is $30 Large Corp purchases 30% of Small Corp for $9 when equity balance of Small is $30 In year 1 Small has income of $20 and pays dividends of $10 In year 1 Small has income of $20 and pays dividends of $10 In year 2 Small has a loss of $10 and pays dividends of $20 In year 2 Small has a loss of $10 and pays dividends of $20

Equity method Why would a firm prefer using the equity method over consolidation? Why would a firm prefer using the equity method over consolidation?

Investments with Control — Consolidation Accounting H-P’s footnote on consolidated entities: H-P’s footnote on consolidated entities: Accounting for business combinations (acquisitions) involves one additional step to equity method accounting. 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 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. 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: 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 Marketing-related assets like trademarks and internet domain names Customer-related assets like customer lists, production backlog, and customer contracts Customer-related assets like customer lists, production backlog, and customer contracts Artistic-related assets like plays, books, and video Artistic-related assets like plays, books, and video Contract-based assets like licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts 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 Technology-based assets like patents, computer software, databases and trade secrets

HP’s Allocation of Compaq Purchase

Consolidation with Purchase Price Above Book Value

GE’s Consolidating Balance Sheet

HP’s Acquired Intangible Assets

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. 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. 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. 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. 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: 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:

Intel’s Goodwill Write-Off

Purchased In-Progress R&D (IPR&D) IPR&D refers to the value of those acquired projects that have not reached technological feasibility at the acquisition date and for which no alternative uses exist. They might be useful to the investor, but not in their present stage of development. The IPR&D value is often computed as the present value of their estimated (by the investor) prospective cash flows. IPR&D refers to the value of those acquired projects that have not reached technological feasibility at the acquisition date and for which no alternative uses exist. They might be useful to the investor, but not in their present stage of development. The IPR&D value is often computed as the present value of their estimated (by the investor) prospective cash flows. An investor company must value the IPR&D assets of an investee company before writing them off. An investor company must value the IPR&D assets of an investee company before writing them off. However, there is no guidance on how to value IPR&D. However, there is no guidance on how to value IPR&D. Hewlett-Packard, in its $24.1 billion acquisition of Compaq Computer, allocated $735 million to IPR&D, which it immediately expensed in its 2002 income statement. Hewlett-Packard, in its $24.1 billion acquisition of Compaq Computer, allocated $735 million to IPR&D, which it immediately expensed in its 2002 income statement.

Stock Sales by Subsidiaries Stock sales by subsidiaries result in an increase in the sub’s stockholders’ equity and a corresponding increase in the parent company’s investment account under equity method accounting. Stock sales by subsidiaries result in an increase in the sub’s stockholders’ equity and a corresponding increase in the parent company’s investment account under equity method accounting. Under GAAP, the increase in the investment as a result of subsidiary IPOs can be treated either as a “gain” or as an increase in additional paid-in-capital. Under GAAP, the increase in the investment as a result of subsidiary IPOs can be treated either as a “gain” or as an increase in additional paid-in-capital.

Stock Sales by Subsidiaries Reported as a gain” Reported as a gain” Reported as an increase in paid-in capital: Reported as an increase in paid-in capital:

Limitations of Consolidated Financial Statements Consolidation income does not imply that cash is received by the parent company 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 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 allocaiton of overhead Segment profitability can be affected by intercorporate transfer pricing and allocaiton of overhead

Pooling Accounting for Business Combinations Prior to 2001, companies had a choice in their accounting for business combinations. They could use the purchase method as described in this module, or they could use the pooling-of- interests (pooling) method. Prior to 2001, companies had a choice in their accounting for business combinations. They could use the purchase method as described in this module, or they could use the pooling-of- interests (pooling) method. The main difference between the pooling and purchase methods is in the amount recorded as the initial investment in the acquired company. The main difference between the pooling and purchase methods is in the amount recorded as the initial investment in the acquired company. Under the purchase method, as we showed, the investment account is recorded at the fair market value of the acquired company on the date of acquisition. Under the purchase method, as we showed, the investment account is recorded at the fair market value of the acquired company on the date of acquisition. Under the pooling method, this account is recorded using the book value amounts from the acquired company. Under the pooling method, this account is recorded using the book value amounts from the acquired company. As a result, no goodwill is created. Further, since goodwill amortization was required under previous GAAP, subsequent income was larger under pooling because no amortization arose. As a result, no goodwill is created. Further, since goodwill amortization was required under previous GAAP, subsequent income was larger under pooling because no amortization arose. This feature spawned the widespread use of pooling, especially for high tech companies. This feature spawned the widespread use of pooling, especially for high tech companies.

Pooling Accounting for Business Combinations Acquisitions previously accounted for under pooling remain unaffected under current GAAP. Accordingly, we must be aware of at least two effects: Acquisitions previously accounted for under pooling remain unaffected under current GAAP. Accordingly, we must be aware of at least two effects: Assets were usually understated when using pooling since investee companies were recorded at book rather than market value. This means that such companies’ asset turnover ratios are overstated. Assets were usually understated when using pooling since investee companies were recorded at book rather than market value. This means that such companies’ asset turnover ratios are overstated. Incomes of companies using pooling were nearly always overstated due to the elimination of goodwill amortization. This continues to create difficulties for comparisons across companies that applied different accounting methods. Incomes of companies using pooling were nearly always overstated due to the elimination of goodwill amortization. This continues to create difficulties for comparisons across companies that applied different accounting methods.

Business Combinations (Over 50%) 2 companies brought together as single accounting entity. 2 companies brought together as single accounting entity. Results in a combination of both the investor and investment firm’s financial statements. Results in a combination of both the investor and investment firm’s financial statements. Purchase method must be used for acquisition of another company. Purchase method must be used for acquisition of another company. Prior to 2002 and outside of U.S., under certain conditions the pooling of interests method was/is used. Prior to 2002 and outside of U.S., under certain conditions the pooling of interests method was/is used.