Module 6
Reporting and Analyzing
Intercorporate Investments
Equity Securities

What is an equity investment?

Why would a firm invest in the equity of
another firm?
Accounting for Investments

GAAP identifies three levels of
influence/control:
Passive
 Significant influence
 Control

Passive

Passive. In this case the purchasing
company is merely an investor and cannot
exert any influence over the investee
company. Its goal for the investment is to
realize dividend and capital gain income.
Generally, passive investor status is
presumed if the investor company owns
less than 20% of the outstanding voting
stock of the investee company.
Significant influence

Significant influence. In certain
circumstances, a company can exert
significant influence over, but not control,
the activities of the investee company.
Generally, significant influence is
presumed if the investor company owns
20-50% of the voting stock of the investee
company.
Control

Control. When a company has control over
another, it has the ability to elect a majority
of the board of directors and, as a result, the
ability to affect its strategic direction and
hiring of executive management. Control is
generally presumed if the investor company
owns more than 50% of the outstanding
voting stock of the investee company.
Intercorporate Investments
Some terms






Mark-to-market
Realized
Recognized
Ready market
Trading security
Available for sale security
Accounting Treatment and
Financial Statement Effects
Passive - No ready market


Account for at cost
No mark-to-market
Investment Classifications

GAAP allows for two possible classification is
equity investments:

Available-for-sale. Investments in securities that
management intends to hold for capital gains and
dividend income; although it may sell them if the
price is right.

Trading. Investments in securities that
management intends to actively trade (buy and
sell) for trading profits as market prices fluctuate.
Passive - Ready market




Trading or Available for sale depending on
management’s intentions
Both are marked-to-market
For trading securities the gain/loss is recognized
prior to be realized (on income statement)
For available for sale securities recognition is at
realization. Until then the holding gain/loss is
kept in an the equity section of the balance
sheet (not on income statement)
Example of Trading and
Available for sale

10/1/98



Record at cost
12/21/98

Market value rises to $18
Mark-to-market
02/20/99

Buy 10 shares @ $15 each
Sell 10 shares @ @20 each
Gain (loss) = Sales price – Book Value
Are Changes in Asset Value Income?



Changes in the carrying amount of the
investment (asset) has a corresponding
effect on equity:
Assets  = Liabilities + Equity 
The central issue in the accounting for
investments is whether this change in equity
is income.
The answer depends on the investment
classification.
American Express
Stockholders’ Equity
Held To Maturity Investments
Equity Method Investments


Equity Method accounting is required for
investments in which the investor company
can exert “significant influence” over the
investee.
Significant influence is the ability of the
investor to affect the financial or operating
policies of the investee.
Equity Method Investments


Ownership levels of 20-50% of the outstanding
common stock of the investee company presume
significant influence.
Significant influence can also exist when
ownership is less than 20% if, for example,
the investor company is able to gain a seat on the
board of directors of the investee company by virtue
of its equity investment, or
 when the investor controls technical know-how or
patents that are used by the investee company, or
 when the investor company is able to exert control by
virtue of legal contracts between it and the investee
company.

Accounting for Equity
Method Investments





Initially record investment at cost.
Increase asset to reflect proportionate share of net
income. Essentially treats their income as yours.
Dividends decrease investment. Treated as a return of
investment. They are not considered income.
No mark-to-market
Income recognized rarely equals either cash flow or
actual change in market value.
Equity Method Accounting


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.
Assume that Mitel reports net income of
$100 and pays dividends of $20 (30% or $6 to
HP)
Equity Method Accounting
Following are the balance sheet and income
statement impacts for the preceding transactions:
Equity Method Accounting


Companies sometimes pay more than book value when
acquiring equity interest in other companies.
For example, if HP paid $400 for its 30% stake in Mitel, HP
would




Report its investment at its $400 purchase price
It would increase and decrease that investment by 30% of Mitel’s
increases and decreases in its stockholders’ equity.
If the $100 excess purchase cost ($400-$300) is treated as goodwill,
as is common, it remains on HP’s balance sheet without
adjustment unless it becomes impaired
Absent any goodwill impairment, the carrying amount of the
investment on HP’s balance sheet always equals $100 plus 30% of
Mitel’s stockholders’ equity.
Equity method

Why would a firm prefer using the equity
method over consolidation?
Business Combinations (Over 50%)




2 companies brought together as single
accounting entity.
Results in a combination of both the investor
and investment firm’s financial statements.
Purchase method must be used for acquisition
of another company.
Prior to 2002 and outside of U.S., under certain
conditions the pooling of interests method
was/is used.
Investments with Control —
Consolidation Accounting

H-P’s footnote on consolidated entities:

Accounting for business combinations (acquisitions)
involves one additional step to equity method
accounting.
Consolidation accounting replaces the investment
balance with the assets and liabilities to which it relates,
and it replaces the equity income reported by the
investor company with the sales and expenses of the
investee company to which it relates.

Consolidation Accounting
Acquired Assets - Tangible

Tangible assets and liabilities assumed
are valued at their fair market values on
the acquisition date. These amounts for
assets and liabilities are initially
recorded on the consolidated balance
sheet.
Acquired Assets - Intangible

The remaining purchase price is then 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
HP’s Allocation of Compaq
Purchase
Consolidation with Purchase Price
Above Book Value
Purchased In-Progress R&D
(IPR&D)


IPR&D refers to the value of those acquired
projects that have not reached technological
feasibility at the acquisition date and for
which no alternative uses exist. They might
be useful to the investor, but not in their
present stage of development.
An investor company must value the IPR&D
assets of an investee company before
writing them off.
Stock Sales by Subsidiaries


Stock sales by subsidiaries result in an
increase in the sub’s stockholders’ equity
and a corresponding increase in the parent
company’s investment account under equity
method accounting.
Under GAAP, the increase in the investment
as a result of subsidiary IPOs can be treated
either as a “gain” or as an increase in
additional paid-in-capital.
Pooling Accounting for Business
Combinations

The main difference between the pooling (no
longer allowed) and purchase methods is in the
amount recorded as the initial investment in the
acquired company.



Under the purchase method the investment account is
recorded at the fair market value of the acquired
company on the date of acquisition.
Under the pooling method, this account is recorded
using the book value amounts from the acquired
company.
As a result, no goodwill was created. Further, since
goodwill amortization was required under previous
GAAP, subsequent income was larger under pooling
because no amortization arose.
Pooling Accounting for Business
Combinations

Acquisitions previously accounted for under
pooling remain unaffected under current GAAP.
Accordingly, we must be aware of at least two
effects:


Assets are usually understated when using pooling since
investee companies were recorded at book rather than
market value. This means that such companies’ asset
turnover ratios are overstated.
Incomes of companies using pooling are nearly always
overstated due to the lower depreciation.
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
allocaiton of overhead