Intercorporate Equity Investments Revsine/Collins/Johnson: Chapter 16

Learning objectives How a company benefits from owning another company’s common stock. How and why an investor’s ownership share determines the accounting treatment for equity investments. How the accounting for short-term speculative investments differs from the accounting for long-term investments. The equity accounting method and when to use it. What consolidated financial statements are, and how they are compiled.

Learning objectives: Concluded What goodwill is, and when it is shown on the financial statements. How business acquisitions and mergers are recorded and why the recording method matters to statement readers. How foreign subsidiaries are treated when financial statements in U.S. dollars are prepared.

Financial Reporting Alternatives for Intercorporate Equity Overview Financial Reporting Alternatives for Intercorporate Equity

Minority passive investment: Trading securities The entry to record the share purchases on 1/1/2005: DR Trading securities –A Company common $10,000 DR Trading securities –B Company preferred 20,000 CR Cash $30,000 The entry to record dividends declared: DR Dividend receivable $1,000 CR Dividend income $1,000

Minority passive investment: Trading securities—mark-to-market accounting Step 1: The total market value of all trading securities is compared to the total cost of the securities. Any difference becomes the target balance for the market adjustment account. Step 2: Increase or decrease the market adjustment account so that it equals the target balance.

Minority passive investment: Trading securities—mark-to-market accounting Once this entry is recorded, the balance sheet shows:

Minority passive investment: Trading securities—mark-to-market accounting To record the purchases in 2006: DR Trading securities –Company C common stock $30,000 DR Trading securities –Company D stock options 40,000 CR Cash $70,000 Mark-to-market adjustment at year end:

Minority passive investment: Trading securities—mark-to-market accounting The mark-to-market adjustment for 2007:

Minority passive investment: Trading securities—mark-to-market accounting When trading securities are sold, a realized gain or loss is recorded. Realized gain or loss Selling price Most recent mark-to-market price = - Here’s what happens when Company B preferred stock is sold:

Minority passive investment: Trading securities—mark-to-market accounting After the sale is recorded, the balance sheet shows: The mark-to-market adjustment at the end of 2008 is:

Minority passive investment: Available-for-sale securities Mark-to-market accounting is used, but the adjustment is not included in income. Instead, the upward or downward adjustment to reflect fair value is a direct (net of tax) credit or debit to a special owners’ equity account. This special owners’ equity account is one of the “Other comprehensive income” components described in Chapter 2.

Minority passive investment: Available-for-sale securities illustration The 2005 year-end mark-to-market adjustment entry: DR Unrealized change in value of available-for -sale securities (owners’ equity) $650 DR Deferred income taxes (assumed 35% tax rate x $1,000) 350 CR Market adjustment –available-for-sale securities $1,000 DR Market adjustment –available-for-sale securities $5,000 CR Unrealized change in value of available-for -sale securities (owners’ equity) $3,250 CR Deferred income taxes (assumed 35% tax rate x $1,000) 1,750 The 2007 year-end mark-to-market adjustment entry:

Minority active investments: Equity method When the ownership percentage equals or exceeds 20%, GAAP presumes two elements: The investor can exert influence over the company. The investment represents a continuing relationship between the two companies. The accounting approach used for minority passive investments is no longer suitable.

Minority active investments: GM’s investment in Fuji Industries

Minority active investments: Equity method illustration

Minority active investments: Equity method illustration (concluded) Balance sheet amount at the end of 2005

Minority active investments: Equity method when cost and book value differ $24,000,000 There are two reasons why Willis willingly paid more than book value for a 30% stake in Planet Burbank: The books show balance sheet items at GAAP historical cost rather than current fair value. The business is worth more than the sum of its individual parts (i.e., more than the current fair value of all balance sheet items). This is goodwill.

Minority active investments: Equity method—purchase price allocation

Minority active investments: Equity method—purchase price allocation

Minority active investments: Equity method journal entries

Majority ownership When the ownership percentage exceeds 50% of the voting shares, GAAP presumes the parent controls the subsidiary. The financial statements of the subsidiary are then combined—line by line—with those of the parent using a process called consolidation. This consolidation process occurs each reporting period. If the ownership percentage is exactly 50% of the voting shares, the equity method is used and no line-by-line consolidation is necessary.

Majority ownership: Presumptive control According to the FASB, control is “the ability of one entity to direct the policies and management that guide the ongoing activities of another entity.” [FASB Exposure Draft, February 1999]. The Exposure Draft presumes that control exists if any of the following conditions are met: Majority voting interest in the election of the board, or the right to appoint the majority of the board. Large minority voting interest (e.g., more than 50% of the votes typically cast) and no other significant minority interest exists. Convertible securities are owned which (if converted) would give it the right to obtain or appoint a majority of the board. Consolidation would then be required unless presumptive control is temporary.

Majority ownership: Consolidation example Step 1: Identify all components of the “investment” account, and remove the book value amount. Step 2: Eliminate and reclassify the remaining “investment” account components. Step 3: Eliminate the “common stock” book value amount.

Majority ownership: Consolidation example (continued) Increased to FMV Excess of purchase price over FMV Eliminates book value These are the surviving outside shareholders

Majority ownership: Consolidation example (concluded) Journal entry to eliminate Gaston’s common stock account: Journal entry to eliminate the remaining “investment” account balance:

Majority ownership: Intercompany transactions—loans Suppose that, prior to the acquisition, Gaston had borrowed $300,000 from Alphonse. The adjusting entry made to eliminate this “internal” transaction is: $300,000 cash loan Alphonse’s receivable Gaston’s payable DR Loan payable –Gaston (on Alphonse’s books) $300,000 CR Loan receivable –Alphonse (on Gaston’s books) $300,000

Majority ownership: Intercompany transactions—sales Suppose that Alphonse sold goods to Gaston as follows: Two things must happen to eliminate this intercompany sale: Alphonse’s revenue Gaston’s COGS No change to gross margin

Majority ownership: Minority interest Suppose Alphonse only bought 80% of Gaston: Owned by other “minority” investors 20% 80% Owned by Alphonse Consolidation is still required, but the financial statements will also reflect a minority interest in Gaston. Assets Liabilities Profit Or loss Minority interest = Minority interest = Available to Shareholders Shareholders’ equity Consolidated Balance sheet Consolidated Income statement

Majority ownership: Minority interest example Minority investors who retain a stake in Gaston

Majority ownership: Minority interest adjusting entries Excess of net asset FMV over BV

Accounting goodwill Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business. $10 million $0.5 million Goodwill $1.5 million Excess of net asset FMV over BV $8 million Net asset BV Purchase price Allocation Prior to 2002, acquired goodwill in the U.S. was amortized to income over a period not exceeding 40 years. SFAS No. 142 no longer permits amortization but instead requires periodic impairment tests.

Accounting goodwill: Impairment SFAS No. 142 Goodwill Impairment Test

Accounting goodwill: Implementing the impairment test

Accounting goodwill: When to test for impairment SFAS No. 142 says impairment must be tested at least annually or when there is reason to suspect that the value of goodwill has been diminished. Circumstances that might prompt an impairment test include: Significant adverse change in business climate. Adverse regulatory action or assessment. Unanticipated competition. Loss of key personnel. The reporting unit (to which the goodwill is attached) is likely to be sold.

Accounting goodwill: Goodwill impairment charges

Purchase vs. pooling: Purchase method intuition Purchase: A buys B There has been a change in ownership. Various assets are written up to their fair market value. The excess (if any) of purchase price over FMV of net identifiable assets is assigned to goodwill. Goodwill is not amortized, but is subject to impairment testing. Cash A’s owners B’s Owner’s B shares Surviving shareholders are those of A.

Purchase vs. pooling: Pooling-of-interests method intuiton There has NOT been a change in ownership. Net assets remain at book value. The purchase price does not appear on the consolidated books. No goodwill is recorded. This approach is no longer permitted (SFAS No. 141) Pooling: A and B merge A shares A’s owners B’s Owner’s B shares Surviving shareholders include those of A and those of B.

Purchase accounting: How it complicates financial analysis Amounts reported before the Sema acquisition in April 2002.

Purchase accounting: Understanding revenue growth As reported Pro forma footnote

Variable Interest Entities A corporation, partnership, trust or other legal structure. Does not have equity investors with voting rights, or Has equity investors that do not provide sufficient financial resources for the entity to support its activities. Major uses include selling receivables, securitizing loans and mortgages, synthetic leases, take-or-pay contracts. FAS Interpretation 46 requires the VIE to be consolidated on the books of the primary beneficiary when: The company is subject to the majority of the risk of loss from the VIE’s activities. Or The company is entitled to receive a majority of the VIE’s residual returns.

Accounting for foreign subsidiaries: Overview All majority-owned subsidiaries—foreign and domestic—must be consolidated. An additional complication arises when consolidating a foreign subsidiary because the financial records are expressed in the foreign currency. One of two procedures is used, depending on the operating characteristics of the foreign subsidiary: Temporal method (remeasured) Foreign sub is not self-sufficient Functional currency choice Current rate method (translated) Foreign sub has self-contained foreign operations

Accounting for foreign subsidiaries: Foreign currency transactions On January 1, 2005 Yankee Corporation sells 100 units of its product to a U.K customer. The selling price is £10 per unit or £1,000 total. Payment is due on April 1, 2005. One British pound is worth $2 U.S., and the per-unit cost of production incurred by Yankee is $8.00 DR Accounts receivable $2,000 CR Sales revenue $2,000 (To record the receivable of £1,000 at it 1/1/05 U.S. dollar equivalence of $2,000) DR Cost of goods sold $800 CR Inventory $800 (100 units@$8.00)

Accounting for foreign subsidiaries: Foreign currency transactions—monetary assets On January 1, 2005 Yankee Corporation sells 100 units of its product to a U.K customer. The selling price is £10 per unit or £1,000 total. Payment is due on April 1, 2005. One British pound is worth $2 U.S., and the per-unit cost of production incurred by Yankee is $8.00. By the end of the quarter, the value of a pound has fallen to only $1.80 U.S. DR Foreign currency transaction loss $200 CR Accounts receivable $200 (To reflect the £1,000 receivable at its end-of-quarter dollar equivalent of $1,800.) DR Cash $1,800 CR Accounts receivable $1,800 (To remove the receivable from the books. The initial $2,000 minus the 3/31/05 write-down of $200 equals the carrying amount of $1,800.)

Accounting for foreign subsidiaries: Foreign currency transactions—nonmonetary assets Suppose Yankee decides to purchase a warehouse in London for £300,000 when the exchange rate is $1.75 U.S. per British pound. DR Warehouse building $525,800 CR Cash $525,000 (To record the acquisition of the London warehouse at the U.S. dollar equivalent of the foreign currency transaction price: £300,000 x 1.75 = $525,000.)

Accounting for foreign subsidiaries: Non-freestanding subsidiaries Doodle Corp Inventories Dandy Ltd Cash Unshipped customer inventory Warehouse Customers receipts U.S. parent Foreign sub Foreign subsidiary is merely an extension of the parent. SFAS No. 52 says subsidiaries like this one are treated as if they were created for the sole purpose of facilitating foreign currency transactions. The numbers included when consolidating the subsidiary are identical to the numbers that would have been included if the parent had engaged in the foreign transaction (temporal method).

Accounting for foreign subsidiaries: Non-freestanding subsidiaries

Accounting for foreign subsidiaries: Non-freestanding subsidiaries example Dandy Ltd. received inventory cost $800 (£1 = $2) and sold the goods on credit for £1,000. The pound then falls to $1.80 when the receivables are collected. The company also purchased a building in London for £300,000 when the pound was worth $1.75.

Accounting for foreign subsidiaries: Self-contained subsidiaries Ship inventories U.S. Food Swiss company Foreign customers Customer receipts Parent Foreign sub Foreign subsidiary is self-contained—no transactions with the parent. In this case, the effect of changes in exchange rates on future dollar cash flows to the parent is uncertain. SFAS No. 52 requires the use of the current rate method, with translation “gains” or “losses” flowing directly into an owners’ equity account.

Accounting for foreign subsidiaries: Summary Translation Approach Used in SFAS NO.52

Accounting for foreign subsidiaries: Illustrative disclosure

Accounting for foreign subsidiaries: Illustrative disclosure (continued)

Summary Financial reporting for intercorporate equity investments depends on the size of the parent company’s ownership shares. When the ownership share is less than 20% (minority passive investment), mark-to-market accounting is used. When the ownership share is from 20% to 50% (minority active investment), the equity method is used. When the ownership share exceeds 50% (majority investment), full consolidation is required. Consolidation is also required when the ownership share is less than 50% but “presumptive control” exists, and for certain variable interest entities (VIEs).

Summary concluded Accounting goodwill arises when the purchase price for another company exceeds the fair value of identifiable net assets. Goodwill is no longer amortized to income, but it is subject to impairment tests. The pooling-of-interests method for business combinations can no longer be used. When freestanding foreign subsidiaries are consolidated with at U.S. company, the current rate method for foreign currency translation is used. When the foreign subsidiary is not freestanding, the temporal method is used.