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?
Intercorporate Investments
Some terms
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Mark-to-market
Realized
Recognized
Ready market
Trading security
Available for sale security
Under 20% - No ready market
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Account for at cost
No mark-to-market
Under 20% - 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 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
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10/1/98
12/21/98
02/20/99
Buy 10 shares @ $15 each
Market value rises to $18
Sell 10 shares @ @20 each
Accounting for Investments
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GAAP identifies three levels of influence/control:
 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. In certain circumstances, a company can exert
significant influence over, but not control, the activities of the investee
company. This level of influence may result from the percentage of voting
stock owned. It may also result from legal agreements, such as a license to
use technology, a formula, or a trade secret like production know-how. It also
may be that the investor company is the sole supplier or customer of the
investee. Generally, significant influence is presumed if the investor company
owns 20-50% of the voting stock of the investee company.
 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. Control can occur at less than 50%
stock ownership as well, by virtue of legal agreements, technology licensing,
and similar.
Once the level of influence/control is determined, the appropriate accounting
method is applied as outlined in the Investment Map
Accounting Treatment and
Financial Statement Effects
Passive Investments Market Method
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Initially record at purchase price (fair
market value on purchase date)
Gain (loss) on sale = Proceeds – Book value
of investment
During holding period, investment is
recorded at current market value (“markedto-market”)
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.
Investment Classifications
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GAAP allows for two possible classification is
equity investments:
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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.
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Trading. Investments in securities that
management intends to actively trade (buy and
sell) for trading profits as market prices fluctuate.
Financial Statement Effects
Bond Investment Classifications
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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.
 Held-to-maturity. Investments in debt securities
that management intends to hold until maturity.
Since debt securities yield their face value at
maturity, market fluctuations during intervening
years are less relevant for this investment strategy.
American Express
Stockholders’ Equity
Held To Maturity Investments
Equity Method Investments
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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.
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
• Investments are initially recorded at their purchase
cost
• Dividends received are treated as a recovery of the
investment and, thus, reduce the investment balance
(they are not recorded as income)
• The investor reports income equal to its percentage
share of the reported income of the investee; the
investment is increased (decreased) in the amount
of income (loss) recorded
• The investment is not reported at market value
Equity Method Accounting
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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
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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
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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.
Effects of Equity Method
Investments on ROE
• Net operating profit margin (NOPM=NOPAT/Sales). If equity
income is treated as operating (usually the case), NOPM is
overstated due to nonrecognition of investee sales and
recognition of investee income
• Net operating asset turnover (NOAT=Sales/Avg. NOA). If the
equity investment is treated NOPAT is treated as an operating
asset (usually the case), 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 indeterminate (overstated if NOA>Sales,
and understated otherwise.
• Financial leverage (FLEV=Avg. NFO/Avg. equity). Financial
leverage is understated doe to nonrecognition of investee
liabilities and recognition of investee equity.
Equity Method (20% – 50%)
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If holdings constitute significant influence, assumed at
20% or more.
Initially record investment at cost.
Increase (dr) to reflect proportionate share of net
income. Essentially treats their income as yours.
Dividends decrease investment. Treated as a return of
investment.
No mark-to-market
Income recognized rarely equals either cash flow or
actual change in market value.
Equity Method example
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Large Corp purchases 30% of Small Corp for $9
when equity balance of Small is $30
In year 1 Small has income of $20 and pays
dividends of $10
In year 2 Small has a loss of $10 and pays
dividends of $20
Equity method
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Why would a firm prefer using the equity
method over consolidation?
Investments with Control —
Consolidation Accounting
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H-P’s footnote on consolidated entities:
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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.
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Consolidation Accounting
Acquired Intangible Assets
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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.
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
GE’s
Consolidating
Balance Sheet
HP’s Acquired Intangible Assets
Impairment of Goodwill
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Goodwill recorded in the consolidation process has an
indefinite life and is not amortized. It is, however, subject
to annual review for impairment.
This review is a two-step process.
 First, the fair market value of the investee company is
compared with the book value of its associated
investment account on the investor’s books. The fair
market value of the investee company can be
determined using a number of alternative methods,
such as quoted market prices of comparable businesses
or a discounted free cash flow valuation method.
 Second, if the current market value is less than the
investment balance, goodwill is deemed to be impaired
and an impairment loss is computed and recorded in the
consolidated income statement.
Goodwill Impairment Example
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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. Further assume that
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:
Intel’s Goodwill Write-Off
Purchased In-Progress R&D
(IPR&D)
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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. The IPR&D value
is often computed as the present value of their
estimated (by the investor) prospective cash flows.
An investor company must value the IPR&D assets of
an investee company before writing them off.
However, there is no guidance on how to value
IPR&D.
Hewlett-Packard, in its $24.1 billion acquisition of
Compaq Computer, allocated $735 million to IPR&D,
which it immediately expensed in its 2002 income
statement.
Stock Sales by Subsidiaries
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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.
Stock Sales by Subsidiaries
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Reported as a gain”
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Reported as an increase in paid-in capital:
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
allocaiton of overhead
Pooling Accounting for Business
Combinations
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Prior to 2001, companies had a choice in their accounting for
business combinations. They could use the purchase method as
described in this module, or they could use the pooling-ofinterests (pooling) method.
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, as we showed, 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 is created. Further, since goodwill
amortization was required under previous GAAP, subsequent
income was larger under pooling because no amortization
arose.
 This feature spawned the widespread use of pooling,
especially for high tech companies.
Pooling Accounting for Business
Combinations
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Acquisitions previously accounted for under
pooling remain unaffected under current GAAP.
Accordingly, we must be aware of at least two
effects:
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Assets were 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 were nearly always
overstated due to the elimination of goodwill
amortization. This continues to create difficulties for
comparisons across companies that applied different
accounting methods.
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.