©Cambridge Business Publishing, 2010 Motivations for Intercorporate Investments  As a temporary investment of excess cash  As part of a long-term risk-adjusted portfolio  Expectations of dividends and gains  As a strategic investment  To develop relationships with suppliers and customers  To gain access to new product or geographic markets  To facilitate activity along a supply chain 1

©Cambridge Business Publishing, 2010 Investments on the Balance Sheet Coca-Cola Company reported the following investments at December 31, 2007 and 2008 (in millions): 2 Assets Current Assets Cash and cash equivalents$4,701$4,093 Marketable securities Trade accounts receivable, less allowances of $51 and $56, respectively3,0903,317 Inventories2,1872,220 Prepaid expenses and other assets 1,9202,260 Total Current Assets$12,176$12,105 Investments Equity method investments: Coca-Cola Hellenic Bottling Company, S.A.$1,487$1,549 Coca-Cola FEMSA, S.A.B. de C.V Coca-Cola Amatil Limited Coca-Cola Enterprises, Inc. -1,637 Other, principally bottling companies and joint ventures2,3142,301 Other investments,,principally bottling companies Total Investments$5,779$7,777

©Cambridge Business Publishing, 2010 Note Disclosure of Investments Coca-Cola Company reported the following in Footnote 10 of its 2008 annual report: 3 The Coca-Cola Company, Footnote 10, 2008 Annual Report Gross Unrealized Estimated 2008 (in millions)CostGainsLosses Fair Value Trading securities Equity Securities$74 $ -($30)$ 44 Other securities 7 - (2) 5 $81$ -($32)$ 49 Available-for-sale securities: Equity securities$329$193($7)$515 Other securities 12 - (5) 7 $341$193($12)$522 Held-to-maturity securities: Bank and corporate debt$74$ - $74

©Cambridge Business Publishing, 2010 Coca-Cola’s Investments  Marketable securities  Includes trading, available-for-sale, and cost method investments  Equity method investments  Investments for which Coca-Cola intends to exert significant influence over operations  Coca-Cola’s equity method investments  35% interest in Coca-Cola Enterprises Inc.  23% interest in Coca-Cola Hellenic  32% interest in Coca-Cola FEMSA  30% interest in Coca-Cola Amatil 4

©Cambridge Business Publishing, 2010 Coca-Cola’s Investments  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 for strategic reasons  acquisitions by Coca-Cola  18 German bottling and distribution operations  Energy Brands Inc. 5

©Cambridge Business Publishing, 2010 Types of Investments for Reporting Purposes Trading Held-to- Maturity Available- for-Sale Equity method Hedges Statutory Mergers Controlling Interest 6

©Cambridge Business Publishing, 2010 Fair Value Option  SFAS 159 allows companies to elect ‘fair value option’ for eligible intercorporate investments  Investments reported at fair value  Value changes reported as part of income  Excludes controlling equity investments 7 The discussion on marketable investments and equity method investments in this chapter assumes the company did NOT elect the fair value option for these investments.

©Cambridge Business Publishing, 2010 Investments Under SFAS 115  Must have readily determinable market value  Must have no significant influence over the investee  Three categories 8 Held-to-Maturity Securities Trading Investments Available-for-Sale Investments

©Cambridge Business Publishing, 2010 Trading Investments  Debt or equity securities  Reported as current assets at fair value  Income statement reporting 9 Income Statement Other Income/losses: Unrealized gains/losses on trading investments…………$ xx Realized gains/losses on trading investments……………..xx Investment income…………………………………………… xx

©Cambridge Business Publishing, 2010 Accounting for Trading Investments Securities owned by Zinc, Inc. are: 10 Security Date AcquiredCost December 31, 2010 ValueDate Sold Selling Price A10/15/10$100,000$125,0001/15/11$120,000 B10/15/10500, ,0001/15/11496,000 C10/15/10200,000N/A12/5/10214,000 $800, Oct. 15Investment in trading securities800,000 Cash 800,000 To record purchase of investments costing $800,000: Exhibit 1.2

©Cambridge Business Publishing, 2010 Accounting for Trading Investments 2010 Dec. 5Cash 214,000 Investment in trading securities 200,000 Realized gain on sale of trading securities14, Dec. 31Investment in trading securities10,000 Unrealized gain on trading securities 10,000 To record the sale of trading security C for $214,000: To record the unrealized value change for securities A and B: SecurityCostYear-end ValueUnrealized Gain(loss) A$100,000$125,000$25,000 Gain B500, ,000$15,000 Loss Net unrealized gain = $10,000 11

©Cambridge Business Publishing, 2010 Accounting for Trading Investments 2011 Jan. 15Cash 616,000 Investment in trading securities 610,000 Realized gain on sale of trading securities6,000 To record the sale of trading securities A and B: Net realized gain = $6, SecurityCostYear-end ValueDate SoldSelling Price Realized Gain (Loss) A$100,000$125,0001/15/11$120,000($5,000) B500, ,0001/15/11496,000$11,000 $610,000 $616,000 Exhibit 1.2

©Cambridge Business Publishing, 2010 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 13

©Cambridge Business Publishing, 2010 Journal Entries for Available-for-Sale Investments 14 Security Date AcquiredCostDecember 31, 2010 ValueDate Sold Selling Price A10/15/10$100,000$125,0001/15/11$120,000 B10/15/10500, ,0001/15/11496,000 C10/15/10200,000N/A12/5/10214,000 $800, Oct. 15Investment in AFS securities800,000 Cash 800,000 To record the purchase of investments costing $800,000: Securities owned by Zinc, Inc. are: Exhibit 1.2

©Cambridge Business Publishing, 2010 Journal Entries for Available-for-Sale Investments continued Dec. 5Cash 214,000 Investment in AFS securities 200,000 Realized gain on sale of AFS securities (income) 14, Dec. 31Investment in AFS securities10,000 Unrealized gains on AFS securities (OCI) 10,000 To record the sale of AFS security C for $214,000: To record the unrealized value change for securities A and B: SecurityCostYear-end ValueUnrealized Gain(loss) A$100,000$125,000$25,000 Gain B500, ,000$15,000 Loss Net unrealized gain = $10,000

©Cambridge Business Publishing, 2010 Journal Entries for Available-for-Sale Investments continued Jan. 15Cash 616,000 Investment in AFS securities 610,000 Realized gains on sale of AFS securities6,000 To record the sale of AFS securities A and B: Net unrealized gain = $6,000 SecurityCostYear-end ValueDate SoldSelling Price Realized Gain (Loss) A$100,000$125,0001/15/11$120,000($5,000) B500, ,0001/15/11496,000$11,000 $610,000 $616,000 Jan. 15 Unrealized gains on AFS securities10,000 Realized gains on sale of AFS securities10,000 To reclassify unrealized gains of AFS securities from AOCI to income:

©Cambridge Business Publishing, 2010 Held-to-Maturity Investments  Debt securities only  Reported as noncurrent assets at amortized cost  Discount or premium amortized over time  Moved to current assets during year of maturity  No gains or losses unless sold prior to maturity  Early sale requires extreme circumstances 17 Income Statement Other Income/losses: Interest income…………………………………………………… $xx

©Cambridge Business Publishing, 2010 Journal Entries for HTM Investments A company invested in a $1 million, 5% face value corporate bond on January 1, 2010 for $965,349, yielding 6%. Interest is paid annually on December 31. Maturity is December 31, Jan. 1Investment in HTM securities965,349 Cash 965, Dec. 31Cash50,000 Investment in HTM securities 7,921 Interest income 57,921 To record the purchase of HTM securities: To record the receipt of interest income for 2010: $1,000,000 × 5% $965,349 × 6%$50,000 – $57,921

©Cambridge Business Publishing, 2010 Journal Entries for HTM Investments $1 million, 5% face value corporate bond for $965,349, yielding 6%. Carrying value at December 31, 2010: $965,349 + $7,921 = $973, Dec. 31Cash50,000 Investment in HTM securities 8,396 Interest income 58,396 To record the receipt of interest income for 2011: $1,000,000 × 5% $973,270 × 6% 2012 Dec. 31Cash50,000 Investment in HTM securities 8,900 Interest income 58,900 To record the receipt of interest income for 2012: $1,000,000 × 5% $981,666 × 6% $50,000 – $58,396 $50,000 – $58,900 Carrying value at December 31, 2011: $973,270 + $8,396 = $981,666

©Cambridge Business Publishing, 2010 Journal Entries for HTM Investments $1 million, 5% face value corporate bond for $965,349, yielding 6% Dec. 31Cash1,000,000 Investment in HTM securities 1,000,000 To record receipt of face value of bonds at maturity: Carrying value at December 31, 2013: $990,566 + $9,434 = $1,000, Dec. 31Cash50,000 Investment in HTM securities 9,434 Interest income 59,434 To record the receipt of interest income for 2013: $1,000,000 × 5% $990,566 × 6% $50,000 – $59,434 Carrying value at December 31, 2012: $981,666 + $8,900 = $990,566

©Cambridge Business Publishing, 2010 Impairment Test for HTM Investments  HTM investments must be evaluated for impairment  Two criteria  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 21

©Cambridge Business Publishing, 2010 Recording an Impairment Loss Example: An investor owns an HTM security with a current amortized cost of $981,666. During 2011, the investor has determined 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 $200, Dec. 31Impairment loss on HTM securities781,666 Investment in HTM securities 781,666 To record the impairment:

©Cambridge Business Publishing, 2010 Investments with Significant Influence  Two accounting options exist  Elect to use the SFAS 159 fair value option, or  Apply the equity method  Investor must exert significant influence over operating and financing decisions of the investee 23

©Cambridge Business Publishing, 2010 When is Significant Influence Present?  Assumed to be present if the investment allows the investor to exercise significant influence over the financial and operating decisions of the investee  Generally 20 to 50% ownership required  Less than 20% ownership exceptions  Representation on the investee’s board  Involvement in investee operating and financial policies  Significant transactions between investor and investee 24

©Cambridge Business Publishing, 2010 Accounting Under the Equity Method Investment performance should parallel the investee’s performance 25 Investment in Stock Cost of investment Investor's share of investee's income Investor's share of investee's loss Dividends received from investee Ending cost basis IncreasesDecreases Changes in proportion to the investee’s retained earnings account

©Cambridge Business Publishing, 2010 Equity Method Example Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December Jan. 2Investment in Rocky Mountain Bot.12,000,000 Cash 12,000, Nov. 1Dividends receivable 150,000 Investment in Rocky Mountain Bottlers150,000 To record the purchase of equity investment: To record dividends declared: $0.50 × 300,000

©Cambridge Business Publishing, Dec. 31Investment in Rocky Mountain Bottlers600,000 Equity in income of Rocky Mountain Bottlers600,000 Equity Method Example continued Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December To record dividends received: To accrue earnings of the investee: 30% × $2,000, Dec. 2Cash 150,000 Dividends receivable 150,000

©Cambridge Business Publishing, 2010 Equity Method Example continued Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December Investment in Rocky Mountain Bottlers 12,000, , ,000 12,450,000 Equity in income of Rocky Mountain 600,000 Income Statement Balance Sheet as long-term asset

©Cambridge Business Publishing, 2010 Equity in Net Income  Adjustments to reported net income may be required  If investment cost differs from investee’s book value  Adjustment required: Must amortize investment cost in excess of book value acquired  If investor and investee transact business with each other  Adjustment required: Remove gross margin that is not yet earned 29

©Cambridge Business Publishing, 2010 Adjustments to Equity in Net Income Adjustments should be made for  Depreciation and amortization on revaluations of  Tangible assets, and  Limited life intangible assets 30 Exceptions No adjustments for goodwill impairment (SFAS 142) and other indefinite life intangibles (EITF Issue 08-06)

©Cambridge Business Publishing, 2010 Additional Investment Cost Valuation Rocky Mountain reports total assets of $80 million and total liabilities of $50 million, for a net book value of $30 million. The original cost paid by Coca-Cola was $12 million. 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, 2011 and uses straight-line depreciation. The previously unreported technology is a limited life intangible asset with a 5-year life. 31 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)1,500,00010,800,000 Additional investment cost (goodwill) $1,200,000

©Cambridge Business Publishing, 2010 Inventory Sales Between Investee and Investor Downstream Sales Investor sells inventory to investee 32 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

©Cambridge Business Publishing, 2010 Adjustments for Unconfirmed Inventory Profits Example 33 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

©Cambridge Business Publishing, 2010 Recognition of Adjusted Equity Income Coca-Cola's share of Rocky Mountain's reported 2011 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, % × $35,000 30% × $20, Dec. 31Investment in Rocky Mountain Bottlers253,500 Equity in income of Rocky Mountain Bottlers253,500 $300,000 ÷ 10 $300,000 ÷ 10 $1,500,000 ÷ 5 $1,500,000 ÷ 5

©Cambridge Business Publishing, 2010 Other Comprehensive Income and the Equity Method  Investor must adjust its investment and other comprehensive income for its share of the investee’s yearly OCI  Such as investor’s recognition of unrealized gain on AFS securities 35 Suppose Rocky Mountain reported $200,000 in unrealized gains on AFS securities. 30% × $200,000 = $60, Dec. 31Investment in Rocky Mountain Bottlers60,000 Unrealized gains on equity method investments (OCI)60,000

©Cambridge Business Publishing, 2010 Impairment Testing  Impairment testing required under APBO 18 for equity method investments  Criteria  If fair value of the investment declines below its carrying value, and  The decline is judged to be other than temporary  Accounting requirements  Investment is written down and a loss is recognized on the investor’s income statement  Subsequent increases ignored 36

©Cambridge Business Publishing, 2010 Joint Venture  An entity formed by a small 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  Corporate joint venture  Exists when the venture is organized as a corporation 37 U.S. companies use the equity method for joint ventures.

©Cambridge Business Publishing, 2010 Controlling Investments  Give the investor control over the operating and financial decisions of the investee  Three forms  Statutory merger, statutory consolidation, or asset acquisition  Stock acquisition  Variable interest entity  General rule: assets, liabilities, revenues, and expenses are combined with those of the investor for financial statement reporting 38

©Cambridge Business Publishing, 2010 Statutory Mergers, Statutory Consolidations, and Asset Acquisitions  An investor directly acquires the assets and liabilities of the investee  Assets and liabilities recorded directly on investor’s balance sheet at fair value 39 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

©Cambridge Business Publishing, 2010 Stock Acquisitions  Occurs when an investor obtains control over another company by investing in its voting stock  Investee remains a separate legal entity 40 Parent the investor Subsidiary the acquired company The separate financial records are consolidated at the end of each reporting period.

©Cambridge Business Publishing, 2010 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. 41 Investment in Rocky Mountain Bottlers40,000,000 Cash 40,000,000 This is the entry Coke makes on its own books, but its annual report shows Coke and Rocky Mountain’s combined accounts as if Coke recorded the acquisition as a statutory merger.