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?

Accounting for Investments GAAP identifies three levels of influence/control: GAAP identifies three levels of influence/control: Passive Passive Significant influence Significant influence Control Control

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

Control 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. 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.

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

Accounting Treatment and Financial Statement Effects

Passive - No ready market Account for at cost Account for at cost No mark-to-market No mark-to-market

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.

Passive - 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 Record at cost Record at cost 12/21/98 Market value rises to $18 12/21/98 Market value rises to $18 Mark-to-market Mark-to-market 02/20/99 Sell each 02/20/99 Sell each Gain (loss) = Sales price – Book Value Gain (loss) = Sales price – Book Value

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.

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.

Equity Method Investments 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 Initially record investment at cost. Initially record investment at cost. Increase asset to reflect proportionate share of net income. Essentially treats their income as yours. Increase asset to reflect proportionate share of net income. Essentially treats their income as yours. Dividends decrease investment. Treated as a return of investment. They are not considered income. Dividends decrease investment. Treated as a return of investment. They are not considered income. 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 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.

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

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.

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 Assets - Tangible 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.

Acquired Assets - Intangible 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

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. 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. 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.

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.

Pooling Accounting for Business Combinations The main difference between the pooling (no longer allowed) and purchase methods is in the amount recorded as the initial investment in the acquired company. The main difference between the pooling (no longer allowed) and purchase methods is in the amount recorded as the initial investment in the acquired company. Under the purchase method the investment account is recorded at the fair market value of the acquired company on the date of acquisition. Under the purchase method 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 was 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 was created. Further, since goodwill amortization was required under previous GAAP, subsequent income was larger under pooling because no amortization arose.

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 are 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 are 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 are nearly always overstated due to the lower depreciation. Incomes of companies using pooling are nearly always overstated due to the lower depreciation.

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