Chapter 17:
Intercorporate Equity Investments
Relevant circumstances
Consolidation
Pooling of interests
Purchase method
New entity approach
Pro rata
Equity method
Fair value method
Special Purpose Entity
Reporting on
Intercorporate Equity Investments
1. Consolidated reporting as if the two
separate legal entities are one accounting
entity using either the purchase or pooling
method (as appropriate)
2. Nonconsolidation using the equity method
of accounting
3. Nonconsolidation using the fair (market)
value approaches
Finite Uniformity for Intercorporate Investments
Ownership of
Voting Stock
Accounting Method
>50%
Consolidate per ARB 51 (SFAS No. 94)
SFAS No. 141 and 142
20% to 50%
Equity Accounting per APB Opinion No. 18
>20%
Fair (market) value for both trading
securities and available-for-sale securities...
Relevant Circumstances
The relevant
circumstances that
justify differential
accounting for
intercorporate
equity investments
depend on the level
of influence held by
the investor
Three Levels of Control
Majority owned company: owner has effective
control
Majority owned company: control is only temporary
or the majority owner does not have effective
control
Less-than-majority-owned companies: relevant
circumstance is whether the investor can exercise
significant influence over operating and financial
policies
Consolidation
A technique in which
two or more entities
are reported as if they
are one common
accounting entity
Also called a business
combination
Consolidation Terms
Combined enterprise
Constituent companies
Combinor
Combinee
Consolidation
Central accounting issue is the valuation of the
assets and liabilities of the separate entities being
combined for reporting purposes
FASB (1976) outlined three possible methods of
accounting
1.
2.
3.
pooling of interests accounting
purchase accounting
new entity approach
Divestitures
Sell-off
Spin-off
Split-off
Split-up
Pooling of Interests
Based on the premise that no substantive
transaction occurs between the constituent
companies
Is argued to be simply the formal
unification of two previously separate
ownership groups
Desirability of pooling is to avoid certain
ramifications of purchase accounting
Purchase Method
Assumption is that the combinor is a parent
company that purchases the combinee (subsidiary)
and must account for the purchase as it would for
the acquisition of any asset
The asset, investment in the combinee company, is
recorded by the combinor at the latter’s cost
determined as of the date the combination is
consummated
New Entity Approach
Regard the combined
enterprise as an
entirely new entity
Results in the use of
current values for the
assets and liabilities of
all the separate entities
as of the date the
combination is
consummated
Pro Rata Consolidation ( 4th method)
Consolidation of
assets and liabilities
occurs only to the
extent of the stock
acquired by the parent
An arbitrary
distinction at the 50 %
point where control is
assumed does not exist
Equity Method
Used whenever the
investor has the ability to
exercise significant
influence over the investee
A one-line consolidation
takes place
The investment account
simply mirrors the net
change in investee book
value
Fair Value Method
Market value applies where no significant
influence exists and market values are
readily determinable for investments of
approximately 20 percent or less
Increases or decreases in market value may
or may not go through income depending
upon management’s intention to sell them in
the near term
SFAS No. 94
Asserts, rather than demonstrates, that
consolidated reporting (and the
fictional accounting entity thus
created) is more relevant to investors
than are separate entity statements in
which the reporting entity is the legal
entity
SFAS No. 142
Goodwill is converted into an intangible asset
with an indefinite life
but it is subject to write-off as an expense if it becomes “impaired.”
Tests of impairment must be made on an annual basis.
Impairment test after acquisition compares
(1) the fair market value of the acquisition against
(2) the historical cost of the net assets plus goodwill at an annual
measurement date after acquisition. If (1) is greater than (2), no
impairment has occurred. However, if (2) is greater than (1),
goodwill is impaired and the impaired amount is written off as a
loss appearing above income from continuing operations.
Impairment rules are generally going to generate soft
numbers (low verifiability)
Special Purpose Entity (SPE)
A joint venture between a sponsoring company
and a group of outside investors
SPE is limited by its charter to certain permitted
activities. Hence, the term “special purpose”
comes from the limited scope of the SPE.
Most common uses an SPE are
financing arrangements,
leasing arrangements,
and sales/transfers of illiquid or poor performing assets
Special Purpose Entity (SPE)
Hundreds of respected U.S. companies have an estimated
$2 trillion of debt hidden in off-balance sheet subsidiaries
such as SPEs.
In a recent survey, 29 percent of the 141 CFOs responding
indicated that some of their company’s debt was not
reflected on the balance sheet. 3% reported that more than
50% of the corporate debt was off balance sheet.
42% of the companies that reported off balance sheet debt
indicated that they guarantee or otherwise protect the
investment of third parties in the SPEs, precisely the
practice that led to Enron’s downfall and a practice that
should lead to consolidation even though these companies
report not consolidating the SPEs in question.
Enron
Enron’s sold poorly performing assets to LJMs
enabled Enron to move debt off its books and
to show inflated earnings and cash flow from the
sale of assets to the SPEs which were controlled and
run by Enron employees.
Enron’s “aggressive” accounting and the use of
SPEs broke new ground to the extent in which
structured finance arrangements can be used to
manipulate reported financial
Chapter 17:
Intercorporate Equity Investments
Relevant circumstances
Consolidation
Pooling of interests
Purchase method
New entity approach
Pro rata
Equity method
Fair value method
SPE