Fourth Edition
Peter D. Easton
Mary Lea McAnally
MODULE 9
Intercorporate
Entities
©Cambridge Business Publishers, 2015
Greg Sommers
Xiao-Jun Zhang
Learning Objective 1
Describe and illustrate accounting
for passive investments.
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Intercorporate Investments
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Accounting Treatment and
Financial Statement Effects
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Passive Investments – Market Method
 Initially record at purchase price (fair market
value on purchase date)
 Gain (loss) on sale:
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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.
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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.
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Fair Value Adjustments
During Holding Period
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Google’s Footnote
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Google’s Disclosure of
Fair Value Gains and Losses
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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):
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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:
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Cisco’s Disclosure of
Fair Value Gains and Losses
Investments are reported on Cisco’s balance sheet
at $38,917 million.
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Bond Investment Classifications
 Available-for-sale
 Trading
 Held-to-maturity
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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.
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Learning Objective 2
Explain and illustrate accounting
for equity method investments.
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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.
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Equity Method Accounting Mechanics
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Equity Method Accounting Mechanics
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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.
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Learning Objective 3
Describe and illustrate accounting
for consolidations.
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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.
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Consolidation – 100% owned,
purchased at book value
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Consolidation - Less than wholly-Owned
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Consolidation – 100% owned,
purchased at more than book value
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CAT’s Consolidating Balance Sheet
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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
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Kellogg’s Allocation of
Pringles Purchase
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Oracle’s Acquisition of
Siebel Systems, Inc.
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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.
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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:
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Hewlett-Packard’s Goodwill Write-Off
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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.
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Sales of Subsidiaries –
Discontinued Operations
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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.
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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).
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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.
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Global Accounting:
Passive Investments
 Under both U.S. GAAP and IFRS, companies classify
financial (passive) instruments as trading, availablefor-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.
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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).
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The End