Intercorporate Entities Module 9 Intercorporate Entities

Describe and illustrate accounting for passive investments. Learning Objective 1 Describe and illustrate accounting for passive investments. ©Cambridge Business Publishers, 2015

Intercorporate Investments ©Cambridge Business Publishers, 2015

Accounting Treatment and Financial Statement Effects ©Cambridge Business Publishers, 2015

Passive Investments – Market Method Initially record at purchase price (fair market value on purchase date) Gain (loss) on sale: ©Cambridge Business Publishers, 2015

Are Changes in Asset Value During the Holding Period Income? During holding period, investment is recorded at current market value (“marked-to-market”). Changes in the carrying amount of the investment (asset) has a corresponding effect on equity: Is the change in equity is income? The answer depends on the investment classification. ©Cambridge Business Publishers, 2015

Financial Statement Effects Available-for-sale (AFS). These are securities that management intends to hold for capital gains and dividend revenue; although, they might be sold if the price is right. Trading (T). These are investments that management intends to actively buy and sell for trading profits as market prices fluctuate. ©Cambridge Business Publishers, 2015

Fair Value Adjustments During Holding Period ©Cambridge Business Publishers, 2015

Google’s Footnote ©Cambridge Business Publishers, 2015

Google’s Disclosure of Fair Value Gains and Losses ©Cambridge Business Publishers, 2015

Google’s Disclosure of Fair Value Gains and Losses Google’s net unrealized gain of $810 million ($840 million - $30 million) is reported net of tax in the accumulated other comprehensive income (AOCI) section of its stockholders’ equity as follows ($ millions): ©Cambridge Business Publishers, 2015

Google’s Disclosure of Fair Value Gains and Losses Google identifies the components of its 2012 accumulated other comprehensive income of $538 million in the following footnote disclosure: ©Cambridge Business Publishers, 2015

Cisco’s Disclosure of Fair Value Gains and Losses Investments are reported on Cisco’s balance sheet at $38,917 million. ©Cambridge Business Publishers, 2015

Bond Investment Classifications Available-for-sale Trading Held-to-maturity ©Cambridge Business Publishers, 2015

Google’s Investments Reported at Cost Google uses historical cost to account for investments in non-marketable securities. Google monitors the value of these investments and writes them down to market value if they suffer a permanent decline in value. If such an investee company ever goes public, Google will change its accounting method. ©Cambridge Business Publishers, 2015

Explain and illustrate accounting for equity method investments. Learning Objective 2 Explain and illustrate accounting for equity method investments. ©Cambridge Business Publishers, 2015

Equity Method Investments Investments are recorded at their purchase cost. Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (dividends are not reported as income). The investor reports income equal to its percentage share of the investee’s reported net income; the investment account is increased by the percentage share of the investee’s income or is decreased by the percentage share of any loss. Changes in fair value do not affect the investment’s carrying value. ©Cambridge Business Publishers, 2015

Equity Method Accounting Mechanics ©Cambridge Business Publishers, 2015

Equity Method Accounting Mechanics ©Cambridge Business Publishers, 2015

Effects of Equity Method Investments on ROE Net operating profit margin (NOPM = NOPAT/Sales). Most analysts include equity income (sales less expenses) in NOPAT since it relates to operating investments. However, investee’s sales are not included in the NOPM denominator. The reported NOPM is, thus, overstated. Net operating asset turnover (NOAT = Sales/Average NOA). Investee’s sales are excluded from the NOAT numerator, and net operating assets in excess of the investment balance are excluded from the denominator. This means the impact on NOAT is indeterminate. Financial leverage (FLEV = Net nonoperating obligations / Average equity). Financial leverage is understated due to the absence of investee liabilities in the numerator. ©Cambridge Business Publishers, 2015

Describe and illustrate accounting for consolidations. Learning Objective 3 Describe and illustrate accounting for consolidations. ©Cambridge Business Publishers, 2015

Investments with Control: Consolidation Google’s footnote on consolidated entities: Consolidation replaces… the equity investment balance with the assets and liabilities to which it relates, and the equity income reported by the investor company with the sales and expenses of the investee company to which it relates. ©Cambridge Business Publishers, 2015

Consolidation – 100% owned, purchased at book value ©Cambridge Business Publishers, 2015

Consolidation - Less than wholly-Owned ©Cambridge Business Publishers, 2015

Consolidation – 100% owned, purchased at more than book value ©Cambridge Business Publishers, 2015

CAT’s Consolidating Balance Sheet ©Cambridge Business Publishers, 2015

Acquired Intangible Assets The purchase price is allocated to acquired identifiable intangible assets, which include the following: Marketing-related assets like trademarks and internet domain names Customer-related assets like customer lists, production backlog, and customer contracts Artistic-related assets like plays, books, and video 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 ©Cambridge Business Publishers, 2015

Kellogg’s Allocation of Pringles Purchase ©Cambridge Business Publishers, 2015

Oracle’s Acquisition of Siebel Systems, Inc. ©Cambridge Business Publishers, 2015

Impairment of Goodwill The impairment test is a two-step process. First, if the market value of the investee company is less than the investment balance, the investment is deemed impaired. Second, the investor estimates the goodwill value as if the subsidiary were acquired at current market value, and the imputed balance for goodwill becomes the balance in the goodwill account. ©Cambridge Business Publishers, 2015

Goodwill Impairment Example Assume that an investment currently reported on the investor's balance sheet in the amount of $1 million has a current fair market value of $900,000. the fair market value of the net assets of the investee company is $700,000 and the current value of goodwill on the consolidated balance sheet is 300,000. This indicates an impairment loss of $100,000, which is computed as follows: ©Cambridge Business Publishers, 2015

Hewlett-Packard’s Goodwill Write-Off ©Cambridge Business Publishers, 2015

Zoetis’ IPO Pfizer’s equity method investment account increased by $2.3 billion. Pfizer recognized a corresponding $2.3 billion increase in the additional paid-in capital account of stockholders’ equity. ©Cambridge Business Publishers, 2015

Sales of Subsidiaries – Discontinued Operations ©Cambridge Business Publishers, 2015

P&G’s Divestiture of Pringles Once P&G decided to sell its snacks business, it accounted for the business unit as a discontinued operation with the following financial statement effects: It removed from the consolidated income statement, the revenues and expense relating to the snacks business and reported only the net profit after tax of the snacks business unit in a separate section below income from continuing operations. ©Cambridge Business Publishers, 2015

P&G’s Divestiture of Pringles (continued) In the year of sale, P&G reported a $1.4 billion gain on the sale of the snacks business unit (sales proceeds of $2.7 billion less book value of the snacks business unit of $1.3 on the date of sale). ©Cambridge Business Publishers, 2015

Limitations of Consolidated Financial Statements 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. Segment profitability can be affected by intercorporate transfer pricing and allocation of overhead. ©Cambridge Business Publishers, 2015

Global Accounting: Passive Investments Under both U.S. GAAP and IFRS, companies classify financial (passive) instruments as trading, available-for-sale, or held-to-maturity. Under IFRS the definition of financial instrument is much broader. Under IFRS, unlisted securities can be valued at fair value, if it can be reliably measured. Under IFRS, reclassifications to and from the trading portfolio is prohibited. ©Cambridge Business Publishers, 2015

Global Accounting: Consolidation Consolidation accounting standards were developed jointly by the FASB and the IASB. Yes, a few differences remain: Under IFRS, companies can measure noncontrolling interests either at fair value (full goodwill approach) or at the proportionate share of the identifiable net assets acquired (purchased goodwill approach). U.S. GAAP permits fair value only. Contrary to US GAAP, under IFRS, parent and subsidiaries’ accounting policies must conform. Contrary to US GAAP, under IFRS, fair-value impairments for intangible assets, excluding goodwill, can be later reversed (that is, written back up after being written down). ©Cambridge Business Publishers, 2015