Module 6
Reporting and
Analyzing
Intercorporate
Investments
Equity Securities
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What is an equity investment?
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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

Accounting Treatment and
Financial Statement Effects
Intercorporate Investments
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.
Some terms
Mark-to-market
 Realized
 Recognized
 Ready market
 Trading security
 Available for sale security

Passive - No ready market
Account for at cost
 No mark-to-market

Investment Classifications


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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
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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 being 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 Buy 10 shares @ $15 each
• Record at cost

12/21/98 Market value rises to $18
• Mark-to-market

02/20/99 Sell 10 shares @20 each
• Gain (loss) = Sales price – Book Value
Are Changes in Asset Value
Income?

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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, 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

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
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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:
Your turn

1.
2.

Initially L purchases 30% of S for
$9 when the book value of S = $30
S has income of $20 and pays total
dividends of $10
S has a loss of $10 and pays total
dividends of $20
Record L’s yearly income from S
and investment in S
Equity method

Why would a firm prefer using the
equity method over consolidation?

Blue and Yellow = Green example
Equity method cautions!
Income shown on income statement
is not really income.
 The asset shown is not at market
value.
 Potentially liabilities are “hidden” off
balance sheet.

Business Combinations (Over
50%)

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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


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:

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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
Pooling Accounting for
Business Combinations

The main difference between the pooling 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.
Limitations of Consolidated
Financial Statements


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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