Motivations for Intercorporate Investments As a temporary investment of excess cash or part of a long-term risk-adjusted portfolio Expectations of dividends and gains As a strategic investment Develop relationships with suppliers and customers Gain access to new product or geographic markets To facilitate activity along its supply chain

Investments on the Balance Sheet Coca-Cola Company reported the following investments at December 31, 2010 and 2009 (in millions): 2010 2009 Investments Trading securities $ 209 $ 61 Available-for-sale securities 485 398 Held-to-maturity securities 111 199 Equity method investments 6,954 6,217 Other investments, principally bottling companies 631 538

Coca-Cola’s Investments Marketable securities Includes trading, available-for-sale, and held-to-maturity investments Equity method investments Investments for which Coca-Cola exerts significant influence over operations Coca-Cola’s equity method investments 23% interest in Coca-Cola Hellenic 32% interest in Coca-Cola FEMSA 30% interest in Coca-Cola Amatil

Coca-Cola’s Investments continued Joint ventures Investments for which Coca-Cola and at least one other company share ownership interest and jointly control a separate entity Controlling interest Investments for which Coca-Cola has a controlling interest in another company 2010 acquisition: Coca-Cola Enterprises (CCE)

Types of Investments for Reporting Purposes Trading Available-for-sale Held-to-maturity Equity method Derivatives (hedges) Controlling interest

This chapter assumes the company did NOT elect the fair value option. ASC Topic 825 allows companies to elect the fair value option for eligible intercorporate investments Investments reported at fair value Value changes reported as part of income Option available only for noncontrolling investments This chapter assumes the company did NOT elect the fair value option.

Learning Objective 1 Describe the reporting for trading, available-for-sale, and held-to-maturity investments in other companies.

Examples of Marketable Debt and Equity Investments Debt securities Commercial paper Corporate bonds Redeemable preferred stock Equity securities Common stock Preferred stock Put and call options

Investments Under ASC Topic 320 Readily determinable market values No significant influence over the investee Three categories: Trading investments Available-for-sale investments Held-to-maturity investments

Trading Investments Debt or equity securities Reported as current assets at fair value Income statement reporting Income statement Other Income/losses: Unrealized gains/losses on trading investments…………$ xx Realized gains/losses on trading investments……………..xx Investment income…………………………………………… xx

Accounting for Trading Investments Securities owned: Exhibit 1.1 Security Date Acquired Cost December 31, 2012 Value Date Sold Selling Price A 10/15/12 $100,000 $125,000 1/15/13 $120,000 B 500,000 485,000 496,000 C 200,000 N/A 12/5/12 214,000 $800,000 To record purchase of trading investments costing $800,000: 2012   Oct. 15 Investment in trading securities 800,000 Cash

Accounting for Trading Investments continued To record the sale of trading security C for $214,000: 2012   Dec. 5 Cash 214,000 Investment in trading securities 200,000 Realized gain on sale of trading securities (income) 14,000 To record the unrealized value change for securities A and B: Security Cost Year-end Value Unrealized Gain(loss) A $100,000 $125,000 $25,000 Gain B 500,000 485,000 $15,000 Loss 2012   Dec. 31 Investment in trading securities 25,000 Unrealized gain on trading securities (income)  2012   Dec. 31 Unrealized loss on trading securities (income) 15,000 Investment in trading securities

Accounting for Trading Investments continued To record the sale of trading securities A and B: Exhibit 1.1 Security Cost Year-end Value Date Sold Selling Price Realized Gain (Loss) A $100,000 $125,000 1/15/13 $120,000 ($5,000) B 500,000 485,000 496,000 $11,000 2013   Jan. 15 Cash 120,000 Realized loss on sale of trading securities (income) 5,000 Investment in trading securities 125,000 2013   Jan. 15 Cash 496,000 Investment in trading securities 485,000 Realized gain on sale of trading securities (income) 11,000

Accounting for Trading Investments continued Gains and losses are reported in income as the value of the securities changes No impairment testing is necessary since all changes in value flow through income No difference in accounting between a “normal” decline in value and a decline characterized as “impairment.”

Available-for-Sale Investments Debt or equity securities Balance sheet Reported as current or noncurrent assets at fair value Unrealized gains/losses reported in accumulated other comprehensive income Income statement reporting Realized gains/losses on available-for-sale investments Investment income Other comprehensive income Unrealized gains/losses on available-for-sale investments

Journal Entries for Available-for-Sale Investments AFS investments: Exhibit 1.1 Security Date Acquired Cost December 31, 2012 Value Date Sold Selling Price A 10/15/12 $100,000 $125,000 1/15/13 $120,000 B 500,000 485,000 496,000 C 200,000 N/A 12/5/12 214,000 $800,000 To record the purchase of investments costing $800,000: 2012   Oct. 15 Investment in AFS securities 800,000 Cash

Journal Entries for Available-for-Sale Investments continued To record the sale of AFS security C for $214,000: 2012   Dec. 5 Cash 214,000 Investment in AFS securities 200,000 Realized gain on sale of AFS securities (income) 14,000 To record the unrealized value change for securities A and B: Security Cost Year-end Value Unrealized Gain(loss) A $100,000 $125,000 $25,000 Gain B 500,000 485,000 $15,000 Loss 2012   Dec. 31 Investment in AFS securities 25,000 Unrealized gain on AFS securities (OCI) 2012   Dec. 31 Unrealized loss on AFS securities (OCI) 15,000 Investment in AFS securities

Journal Entries for Available-for-Sale Investments continued Security Cost 2013 Year-end Value Date Sold Selling Price Realized Gain (Loss) A $100,000 $125,000 1/15/13 $120,000 $20,000 B 500,000 485,000 496,000 $(4,000) To record the sale of AFS security A: 2013   Jan. 15 Cash 120,000 Other comprehensive income 25,000 Investment in AFS securities 125,000 Realized gain on sale (income) 20,000 To record the sale of AFS security B: 2013   Jan. 15 Cash 496,000 Realized loss on sale (income) 4,000 Investment in AFS securities 485,000 Other comprehensive income 15,000

Impairment Testing for AFS Securities Required because impairment losses go through income but “normal” declines are reported in OCI Is the security’s fair value below its cost? If so, is the decline other than temporary? Common indicator: security will be sold before value can be recovered To record the $15,000 decline in value of AFS security B at December 31, 2012 as impairment: 2012   Dec. 31 Loss on security B (income) 15,000 Investment in AFS securities

Impairment Testing of AFS Securities continued After recognition of impairment, Security B’s “cost” is $485,000. Subsequent value increases are not reported Example of loss recognition when unrealized gains/losses previously reported: AFS security, book value $200,000, original cost $160,000, fair value $90,000

Impairment Testing of AFS Securities continued Fair value ($90,000) < cost ($160,000) If the decline in value is other than temporary: Record the decline in value of the AFS security from cost to fair value as impairment loss, in income, reclassify the unrealized gain out of AOCI, and write the investment down from book value to fair value: Unrealized loss on AFS securities (OCI)   40,000 Impairment loss on AFS securities (income) 70,000 Investment in AFS securities 110,000

Held-to-Maturity Investments Debt securities only Reported at amortized cost Discount or premium amortized over time No gains or losses unless sold prior to maturity Early sale requires extreme circumstances Income Statement Other income/losses: Interest income…………………………………………………… $xx

Journal Entries for HTM Investments A company invested in a $1 million face value, 5% corporate bond on January 1, 2012 for $965,349, yielding 6%. Interest is paid annually on December 31. Maturity is December 31, 2015. To record the purchase of HTM securities: 2012   Jan. 1 Investment in HTM securities 965,349 Cash To record the receipt of interest income for 2012: $1,000,000 × 5% 2012   Dec. 31 Cash 50,000 Investment in HTM securities 7,921 Interest income 57,921 $57,921 – $50,000 $965,349 × 6%

Journal Entries for HTM Investments continued $1 million, 5% face value corporate bond for $965,349, yielding 6%. Carrying value at December 31, 2012: $965,349 + $7,921 = $973,270 To record the receipt of interest income for 2013: $1,000,000 × 5% 2013   Dec. 31 Cash 50,000 Investment in HTM securities 8,396 Interest income 58,396 $58,396 – $50,000 $973,270 × 6% Carrying value at December 31, 2013: $973,270 + $8,396 = $981,666 To record the receipt of interest income for 2014: $1,000,000 × 5% 2014   Dec. 31 Cash 50,000 Investment in HTM securities 8,900 Interest income 58,900 $58,900 – $50,000 $981,666 × 6%

Journal Entries for HTM Investments continued $1 million, 5% face value corporate bond for $965,349, yielding 6%. Carrying value at December 31, 2014: $981,666 + $8,900 = $990,566 To record the receipt of interest income for 2015: $1,000,000 × 5% 2015   Dec. 31 Cash 50,000 Investment in HTM securities 9,434 Interest income 59,434 $59,434 – $50,000 $990,566 × 6% Carrying value at December 31, 2015: $990,566 + $9,434 = $1,000,000 To record receipt of face value of bonds at maturity: 2015   Dec. 31 Cash 1,000,000 Investment in HTM securities

Impairment Testing for HTM Investments Required because normally HTM investments are carried at amortized cost Two criteria, same as for AFS securities Fair value declines below amortized cost, and Decline is judged to be other than temporary If judged to be impaired Write down the security to fair value Report the decline as an impairment loss on the income statement Ignore subsequent increases in fair value

Recording an Impairment Loss Example: An investor owns an HTM security with a current amortized cost of $981,666. At the end of 2013, the investor determines that it is probable that all amounts due according to the contractual terms of a debt security will not be collected. The current market value is $500,000. To record the impairment: 2013   Dec. 31 Impairment loss on HTM securities (income) 481,666 Investment in HTM securities

Explain the reporting for equity method intercorporate investments. Learning Objective 2 Explain the reporting for equity method intercorporate investments.

Investments with Significant Influence Two accounting options exist Elect to use the ASC Topic 825 fair value option, or Apply the equity method (ASC Topic 323) Investor must exert significant influence over operating and financing decisions of the investee

When is Significant Influence Present? Representation on the investee’s board Involvement in investee operating and financial policies Significant transactions between investor and investee Guideline: 20% to 50% ownership BUT significant influence can exist with less than 20% ownership

Accounting Using the Equity Method Investment performance reflects the investee’s performance Equity method investment Cost of investment   Investor's share of investee's income and OCI gains Investor's share of investee's losses and OCI losses Dividends declared by investee Ending balance Increases Decreases Investment changes in proportion to the investee’s retained earnings and AOCI accounts

Equity Method Example To record the purchase of equity investment: Investment cost = $2,000,000 for 30% of the investee’s stock. During the first year, the investee reports net income of $800,000, declares and pays dividends of $300,000, and has $50,000 in unrealized losses on AFS securities. To record the purchase of equity investment: Equity method investment 2,000,000   Cash To record dividends declared and paid: Cash   90,000 Equity method investment To accrue earnings of investee: Equity method investment 240,000   Equity in income of investee

Equity method example continued Investment cost = $2,000,000 for 30% of the investee’s stock. During the first year, the investee reports net income of $800,000, declares and pays dividends of $300,000, and has $50,000 in unrealized losses on AFS securities. To record investee’s OCI: Other comprehensive income   15,000 Equity method investment Change in investee’s equity = $800,000 - $300,000 - $50,000 = $450,000 Change in equity method investment = $240,000 - $90,000 - $15,000 = $135,000, or 30% of the change in the investee’s equity

Equity Method Example continued Investment cost = $2,000,000 for 30% of the investee’s stock. During the first year, the investee reports net income of $800,000, declares and pays dividends of $300,000, and has $50,000 in unrealized losses on AFS securities. Equity method investment 2,000,000  240,000 90,000 15,000 2,135,000 Equity in income of investee   240,000 Balance Sheet as long-term asset Income Statement

Equity in Net Income Adjustments to reported net income may be required If investment cost differs from investee’s book value Adjustment required: Amortize investment cost in excess of book value acquired If investor and investee transact business with each other Adjustment required: Remove intercompany profit that is not yet earned

Adjustments to Equity in Net Income Adjustments should be made for depreciation and amortization on revaluations of Tangible assets, and Limited life intangible assets Exceptions No adjustments for goodwill impairment or impairment of other indefinite life intangibles

Inventory Sales Between Investee and Investor Downstream sales Investor sells inventory to investee Upstream sales Investee sells inventory to investor Both companies record sales as if selling to outside customers Both report gross margin as part of income Results in If inventory not sold to unrelated outside party at year-end, gross margin is not yet earned Investor must remove when calculating equity in net income of investee

Example: Revaluations On January 1, 2013, Rocky Mountain reports total assets of $80 million and total liabilities of $50 million, for a net book value of $30 million. Coca-Cola paid $12 million for 30% of Rocky Mountain’s shares. Analysis indicates that Rocky Mountain has unreported technology valued at $5 million and its plant and equipment is undervalued by $1 million. Plant and equipment has a remaining life of 10 years as of January 2, 2013 and uses straight-line depreciation. The previously unreported technology is a limited life intangible asset with a 5-year life. Price paid   $12,000,000 Share of Rocky Mountain's net assets acquired: Book value (30% x $30,000,000) $9,000,000 Revaluation of plant and equipment (30% x $1,000,000) 300,000 Unreported technology (30% x $5,000,000) 1,500,000 10,800,000 Additional investment cost (goodwill) $1,200,000

Example: Unconfirmed Inventory Profits Suppose Rocky Mountain sells canned beverages to Coca-Cola upstream for $800,000 at a 20% markup on cost. Coca-Cola holds $210,000 of this inventory at year-end. Coca-Cola sells finished products to Rocky Mountain downstream for $500,000 at a 25% markup on cost. Rocky Mountain holds $100,000 of this inventory at year-end. How much is unconfirmed profit? Unconfirmed gross profit on $210,000 upstream sales: $210,000 –[ $210,000 ÷ 1.20] = $35,000 Unconfirmed gross profit on $100,000 downstream sales: $100,000 – [$100,000 ÷ 1.25] = $20,000

Recognition of Adjusted Equity in Net Income for 2013 $300,000 ÷ 10 Coca-Cola's share of Rocky Mountain's reported 2013 income (30% x $2,000,000) $600,000 Adjustments for revaluation write-offs:   Plant and equipment (30,000) Previously unreported technology (300,000) Adjustments for unconfirmed inventory profits: Upstream sales (10,500) Downstream sales (6,000) Equity in net income of Rocky Mountain $253,500 $1,500,000 ÷ 5 30% × $20,000 30% × $35,000 2013   Dec. 31 Investment in Rocky Mountain Bottlers 253,500 Equity in income of Rocky Mountain Bottlers

Impairment Testing: Equity Method Investments Impairment testing required for equity method investments (ASC Topic 323) Criteria Fair value of the investment declines below its carrying value, and The decline is other than temporary Accounting requirements Investment is written down and a loss is recognized on the investor’s income statement Subsequent increases are ignored

U.S. companies use the equity method for joint ventures. An entity formed by a group of individuals or firms that contribute resources and jointly share in managing and controlling the venture Often established for a short-term, single business transaction or activity Enables expertise, special technology, capital, market access to be combined U.S. companies use the equity method for joint ventures.

Describe the reporting for controlling interests in other companies. Learning Objective 3 Describe the reporting for controlling interests in other companies.

Controlling Investments The investor has control over the operating and financial decisions of the investee Three forms Statutory merger, statutory consolidation, or asset acquisition Stock acquisition Variable interest entity Assets, liabilities, revenues, and expenses are combined with those of the investor for financial statement reporting

Statutory Mergers, Statutory Consolidations, and Asset Acquisitions Investor directly acquires the assets and liabilities of the investee Assets and liabilities recorded directly on investor’s balance sheet at fair value Statutory merger Occurs when the investor acquires the investee and becomes the remaining legal entity Statutory consolidation Occurs when a new entity is formed to acquire both the investor and the investee Asset acquisition Occurs when an investor acquires a subset of the investee’s assets

Statutory Merger Example Coca-Cola acquires all of Rocky Mountain’s assets and liabilities in a statutory merger by paying $40 million in cash on Jan. 2, 2013. Fair values in millions are: Current assets, $20; plant and equipment, $61; current liabilities, $15; and long-term liabilities, $35. Coca-Cola identified and valued Rocky Mountain’s previously unreported intangibles asset, technology, at $5 million. Price paid   $40,000,000 Fair value of identifiable net assets acquired: Current assets $20,000,000 Plant and equipment 61,000,000 Technology 5,000,000 Current liabilities (15,000,000) Long-term debt (35,000,000) 36,000,000 Goodwill $4,000,000

Statutory Merger Example continued To record the acquisition of Rocky Mountain Bottlers: Current assets 20,000,000   Plant and equipment 61,000,000 Technology 5,000,000 Goodwill 4,000,000 Current liabilities 15,000,000 Long-term debt 35,000,000 Cash 40,000,000

Stock Acquisitions Occurs when an investor obtains control over another company by investing in its voting stock Investee remains a separate legal entity Parent the investor Subsidiary the acquired company The separate financial records are consolidated at the end of each reporting period.

Stock Acquisition Example Assume Coca-Cola acquires and holds all of the voting stock of Rocky Mountain Bottlers, paying the former stockholders of Rocky Mountain $40 million cash. Investment in Rocky Mountain Bottlers 40,000,000   Cash This is the entry Coca-Cola makes on its own books, but its annual report shows Coca-Cola and Rocky Mountain’s combined accounts as if Coca-Cola recorded the acquisition as a statutory merger.

Variable Interest Entities (VIEs) Investee is a separate legal entity controlled by another company Control occurs through legal relationships rather than stock ownership Entity is considered to be a VIE if: The entity must obtain guarantees from other parties in order to obtain financing, or The equity holders do not have the usual rights and responsibilities of equity ownership, such as voting and residual return rights

Issue of Control with VIEs Consequences of control Must have the power to direct the VIE’s activities Must absorb the majority of the VIE’s risks and rewards Reporting is the same as for stock investments Voting rights are not an indicator of controlling a VIE

Learning Objective 4 Discuss International Financial Reporting Standards (IFRS) for intercorporate investments.

IFRS for Marketable Debt and Equity Investments Currently accounted for the same as U.S. GAAP (IAS 39) IFRS 9 (effective 2015): Default: FV-NI Option for equity investments not held for trading: FV-OCI, never reclassified to income Option for debt securities held for principal and interest payments: amortized cost

IFRS for Marketable Debt and Equity Investments continued Impairment losses Focus on observance of ‘loss events’ related to the decline in value Such as decline in credit rating, or Investee misses scheduled debt payments New standards for impairment testing under consideration

IFRS for Significant Influence Investments Investee is defined as an associate Principles-oriented view to significant influence Representation on the investee’s board Participation in policy-making process Material transactions between the investor and the investee Interchange of managerial personnel Provision of essential technical information

IFRS for Significant Influence Investments continued Equity method required Similar to U.S. GAAP procedures Impairment testing Compare the investment carrying value with the higher of its market value or value-in-use Value-in-use is the present value of the investment’s future expected cash flows Possible differences in impairment loss recognition between IFRS and U.S. GAAP

IFRS and Joint Ventures IFRS 11, effective 2013 Two kinds of joint arrangements: Joint operations (rights to entity’s assets and liabilities) Joint ventures (rights to entity’s returns and disposal value) Joint ventures are most common Reported using the equity method

IFRS and Joint Ventures continued Until 2013, joint ventures may be reported using proportionate consolidation Investor includes proportionate share of JV’s assets and liabilities on its balance sheet Affects investor’s leverage No effect on investor’s equity or income

IFRS and Controlling Investments IFRS 10: When should an entity be consolidated: all of the following Power to direct the activities that significantly affect the investee’s returns Exposure to variable returns from investee Ability to use power to affect the amount of investor’s returns

IFRS and Controlling Investments continued IFRS 10 applies to all control relationships Investments in stock of a company Control achieved through financial relationships Variable interest entities Should an entity controlled through a financial relationship be consolidated? Possible differences between IFRS and U.S. GAAP

End of Chapter 1