Inter-corporate investments

Market value accounting (minority passive
investments)
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Accounting
Met Life mini-case
Equity method accounting (significant
influence)
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
Accounting
Coca Cola mini-case
© 2005 by Robert F. Halsey, all rights reserved
The following is a general roadmap of the accounting for
marketable securities:
Securities available for
sale (Unrealized gains
and losses to
stockholder's equity)
Passive - market method
<20%
Minority
<50%
Trading securities
(Unrealized gains and
losses to Income
Statement)
Significant Influence Equity method
>20%
Degree of Ownership
>50%
Majority
© 2005 by Robert F. Halsey, all rights reserved
Consolidate
Purchase method
Ownership
percentage
Required
accounting
method
Balance sheet
Income statement
Held-toCost
maturity
bonds or
equities w/ no
public market
Report investments at
cost plus (less)
unamortized premium
(discount)
Income is interest
received minus (plus)
amortization of premium
(discount)
< 20% and Market
marketable
“Passive”
Investment reported at
FMV
Change in FMV is either
in
OCI (AFS)
Income (Trading)
Dividends are income
20 – 50 %
“Significant
Influence”
Equity
Report investments at
cost – dividends
received 
proportionate chare of
investee income
Dividends reported as
reduction of investment
Report income equal to
proportionate share of
investee profits
> 50%
“Control”
Consolidate
Report balance sheet of Report income
subsidiary together w/
statement of subsidiary
parent
together w/ parent
Minority Passive Investments –
Market Method


Investor owns < 20% of investee
Classify portfolio as “available-for-sale” or “trading.”
This classification dictates the accounting treatment
 Record dividends received as income
 Mark investments to market at each statement
date
 A
=L+ E
 ΔA  = L + ΔE 
 Q: Is ΔE income?
 A: AFS, no – record in OCI

Trading, yes – record in net income
 Equity increases either way. The issue is
whether profit is affected.
© 2005 by Robert F. Halsey, all rights reserved
Met Life mini-case
© 2005 by Robert F. Halsey, all rights reserved
Met Life
B/S
Met Life Income Statement
Met Life’s
Statement of Stockholders’ Equity
Met Life’s
Investment Footnote
Significant influence – Equity Method
Investor owns > 20% and less than 50%.
The key is the ability to exert “significant
influence.”
 Dividends treated as a return of
investment (reduce investment balance)
rather than income
 Report income equal to percentage
interest in investee profits
 Investment recorded at cost + profit
recognized – dividends received.

© 2005 by Robert F. Halsey, all rights reserved
Assume that HP acquires a 30% interest in Mitel Networks. On the date
of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP
purchases its 30% stake for $300 (at book value).
Transaction or event
Income Statement
Balance Sheet
Revenues
Cash
Asset
1. 30% investment
in Mitel
(300)
2. Mitel reports
$100 income
3. Mitel pays $20
dividends, $6 to HP
4. HP’s ending
balance of its
investment account
+
Other
Assets
Liabs +
Cont
. cap
Ret.
Earn
300
30
6
=
(6)
324
30
30
Exp
Investment balance parallels SE of Investee Co.
Investor – 30%
Investee
300
30 profit
1000
6 div
20 div
100 profit
1080
324
(1080 * .3 = 324)
Footnote Disclosures - SBC
$11,003
-
5,913 Notes / R
$ 5,090 Equity Inv.
$3,300 + $22,226 - $3,187 - $13,855 = $8,484 x 60% = $5,090
$1,022 x 60% = $613
Coca-Cola mini-case
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
Analysis Implications of Equity Method
Investments

Income does not equal Cash Flow
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Regulations. Regulatory authorities can sometimes
intervene in an investee company’s dividend policy.
International. An investee company may operate in a
country where restrictions exist on remittance of
earnings or where the value of currency can deteriorate
rapidly. Political risks can further inhibit access to
earnings.
Restrictions. Dividend restrictions in loan agreements
can limit the ability of the investee company to make
dividend payments from retained earnings.
Power. Presence of a stable or powerful minority
interest can reduce the investor company’s ability to set
dividend or other policies of the investee company.
© 2005 by Robert F. Halsey, all rights reserved
Analysis Implications of Equity Method
Investments
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Net operating profit margin (NOPM NOPAT/Sales). Most analysts
include equity income in NOPAT since it relates to operating investments.
The reported NOPM is, thus, overstated due to nonrecognition of investee
sales and the recognition of investee income.
Net operating asset turnover (NOAT Sales/Average NOA). The
equity investment balance is typically included in operating assets. This
means that NOAT is understated due to nonrecognition of investee sales
and overstated by nonrecognition of investee assets in excess of the
investment balance. The net effect is, therefore, indeterminate (NOAT is
overstated provided NOA exceeds sales, and understated otherwise.)
Financial leverage (FLEV Net financial obligations/Average
equity). Financial leverage is understated due to nonrecognition of
investee liabilities and the recognition of investee equity (the
proportionate share of investee earnings is included in SBC’s income).
Although ROE components are affected, ROE is unaffected since
income and equity are unaffected.
Book value does not equal market value. There can be significant
unrealized gains in the equity method investment.
© 2005 by Robert F. Halsey, all rights reserved
Summary: exclusion of debt from B/S

Operating leases


Equity method investments


Only record percentage of equity owned as an investment,
not full or proportionate assets and liabilities
SPEs


Leased asset/liability not recorded on B/S
A/R securitization / synthetic leases
Executory contracts (product financing agreements)

Transfer of manufacturing assets to a SPE or other party
with purchase agreement for output
© 2005 by Robert F. Halsey, all rights reserved
Consolidation Accounting Preview
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Equity accounting is used by the parent for any investment
with “significant influence,” usually > 20%
Consolidation is required is investor has “control,” usually >
50%
The consolidation process replaces the equity investment
with the balance sheet of the investee company.
Also, equity income is replaced with revenues and expenses
to which it relates.
Balance sheets and Income Statements are added together
Total stockholders’ equity remains the same as does net
income.
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved