Intercorporate Equity Investments Revsine/Collins/Johnson/Mittelstaedt: Chapter 16 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives 1.How and why an investor’s percentage ownership share determines the accounting treatment for equity investments. 2.How fair value accounting is applied to securities held in trading and available-for-sale portfolios and how impairments are recorded. 3.How to apply the equity method and the fair value option. 4.What consolidated financial statements are, how they are prepared under the acquisition and purchase methods, and how noncontrolling interests are measured and reported. 5.What goodwill is and when it is shown on financial statements. 16-2

Learning objectives: Concluded 6.How the acquisition and purchase methods of reporting business combinations complicate financial analysis. 7.What variable interest entities (VIEs) are and when they must be consolidated. 8.How operations reported in foreign currencies affect the preparation of financial statements in U.S. dollars. 9.The major differences between IFRS and U.S. GAAP related to accounting for financial assets, consolidations, special purpose entities (SPEs) or VIEs, and joint ventures. 10.How business combinations were previously accounted for under the pooling of interests method. 16-3

Overview Figure 16.1 Financial reporting alternatives for intercorporate equity investments 16-4

Minority passive investment: Trading securities—fair value accounting  When trading securities are sold, a realized gain or loss is recorded.  Here’s what happens when Company B preferred stock is sold: Selling price Realized gain or loss Most recent mark-to-market price =- 16-5

 Fair value 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 16-6

Minority active investments: Equity method When the ownership percentage equals or exceeds 20%, GAAP presumes two elements: 1.The investor can exert influence over the company. 2.The investment represents a continuing relationship between the two companies. The accounting approach used for minority passive investments is no longer suitable. This 20% is a guideline – could be less than 20% - the key is the ability to influence management 16-7

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. 16-8

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 $8 million $1.5 million $0.5 million Goodwill Excess of net asset FMV over BV Net asset BV  Prior to 2002, acquired goodwill in the U.S. was amortized to income over a period not exceeding 40 years.  GAAP no longer permits amortization but instead requires periodic impairment tests. Purchase priceAllocation 16-9

Accounting goodwill: Impairment Figure 16.2 Goodwill Impairment Test 16-10

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.  GAAP requires the VIE to be consolidated if that company has a controlling financial interest in the VIE and is the VIE’s primary beneficiary if it has both of the following characteristics: The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance The obligation to absorb losses of the VIE that could be potentially be significant to the VIE 16-11

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) Current rate method (translated) Foreign sub is not self-sufficient Foreign sub has self-contained foreign operations Functional currency choice 16-12

Accounting for foreign subsidiaries: Summary Figure 16.3 Translation approach used in U.S. GAAP 16-13

Global Vantage Point There are many key differences between IFRS and U.S. GAAP in the following four areas. 1. Accounting for financial assets (marketable securities and investments) 2. Consolidated financial statements and accounting for business combinations 3. Accounting for special purpose entities (SPEs) or variable interest entities (VIEs) 4. Accounting for joint ventures 16-14

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), fair value accounting is used.  When the ownership share is from 20% to 50% (minority active investment), the equity method is used.  GAAP allows firms to elect the fair value option for equity investments. Unrealized gains and losses resulting from fair value changes are reported on the investor’s income statement.  Consolidated financial statements are required when one entity acquires more than 50% of another entity

Summary concluded  Goodwill is typically recorded in business combinations using the acquisitions or purchase method, and is not amortized, but is subject to annual impairment tests.  Acquisition and purchase methods of accounting complicate financial analysis because of the differing treatment of subsidiary’s net income.  When freestanding foreign subsidiaries are consolidated with a 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.  There are a number of important differences between IFRS and U.S. GAAP and a recent FASB Exposure Draft on financial instruments would, if adopted, substantially change the classification, measurements, and impairment account for several categories of financial assets