Chap016 Financial Reporting Analysis

8/2/2019 Chap016 Financial Reporting Analysis

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Intercorporate EquityInvestments

Revsine/Collins/Johnson/Mittelstaedt: Chapter 16

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.McGraw-Hill/Irwin


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RCJM: Chapter 16 2009 2

Learning objectives

1. How a company benefits from owning another companys common stock.

2. How and why an investors ownership share determines the accountingtreatment for equity investments.

3. How the accounting for short-term speculative investments differs fromthe accounting for long-term investments.

4. The equity accounting method and when to use it.

5. Fair Value election for equity method investments.

6. What consolidated financial statements are, and how they are compiled.


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Learning objectives:Concluded

7. What goodwill is and when it is shown on financial statements.

8. How the purchase and acquisition methods of reporting mergersand acquisitions complicates financial analysis.

9. What special purpose entities are and when they must beconsolidated.

10.How foreign subsidiaries are treated when financial statements in

U.S. dollars are prepared.

11.How businesses combined in prior years have been accountedfor under the pooling of interests method.


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Overview

Financial Reporting Alternatives for Intercorporate Equity


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Minority passive investment:Trading securitiesmark-to-market accounting

When trading securities are sold,a realized gain or loss isrecorded.

Heres what happens when Company B preferred stock is sold:

Selling priceRealized

gain or loss

Most recentmark-to-market

price= -


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Mark-to-market accounting is used, but the adjustment is not included inincome.

Instead, the upward or downward adjustment to reflect fair value is adirect (net of tax) credit or debit to a special owners equity account.

This special owners equity account is one of the Other comprehensiveincome components described in Chapter 2.

Minority passive investment:Available-for-sale securities


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Minority active investments:Equity method

When the ownership percentage equals

or exceeds 20%, GAAP presumes two

elements:

1. The investor can exert influence over thecompany.

2. The investment represents a continuingrelationship between the two companies.

The accounting approach used for

minority passive investments is no

longer suitable.



Majority ownership

When the ownership percentage exceeds 50%of the voting shares, GAAP presumes theparent controls the subsidiary.

The financial statements of the subsidiary are

then combinedline by linewith those of theparent using a process called consolidation.

This consolidation process occurs eachreporting period.

If the ownership percentage is exactly 50% ofthe voting shares, the equity method is usedand no line-by-line consolidation is necessary.



Accounting goodwill

Goodwill arises when the purchase price paid for anotherbusiness exceeds the fair market value of the acquired net assetsof that business.

$10 million

$8 million

$1.5 million

$0.5 million GoodwillExcess of net assetFMV over BV

Net asset BV

Prior to 2002, acquired goodwill in the U.S. was amortized toincome over a period not exceeding 40 years.

SFAS No. 142no longer permits amortization but instead requiresperiodic impairment tests.

Purchase price Allocation


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Accounting goodwill:Impairment

SFAS No. 142GoodwillImpairment Test


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Variable Interest Entities

A corporation, partnership, trustor other legal structure.

Does not have equity investorswith voting rights, or

Has equity investors that do notprovide sufficient financialresources for the entity tosupport its activities.

Major uses include sellingreceivables, securitizing loansand mortgages, synthetic leases,take-or-pay contracts.

FAS Interpretation 46requiresthe VIE to be consolidated on thebooks of the primary beneficiarywhen:

The company is subject to themajority of the risk of loss fromthe VIEs activities.

Or

The company is entitled to

receive a majority of the VIEsresidual returns.


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Accounting for foreign subsidiaries:Overview

All majority-owned subsidiariesforeign and domesticmust beconsolidated.

An additional complication arises when consolidating a foreignsubsidiary because the financial records are expressed in the

foreign currency.

One of two procedures is used, depending on the operatingcharacteristics of the foreign subsidiary:

Temporal method(remeasured)

Current rate method(translated)

Foreign sub is not self-sufficient

Foreign sub has self-containedforeign operations

Functionalcurrency choice


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Accounting for foreign subsidiaries:Summary

Translation Approach Used in SFAS NO.52


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Summary

Financial reporting for intercorporate equity investments dependson the size of the parent companys ownership shares.

When the ownership share is less than 20% (minority passive

investment), mark-to-market accounting is used.

When the ownership share is from 20% to 50% (minority activeinvestment), the equity method is used.

SFAS No. 159 allows firms to elect the fair value option for equityinvestments. Unrealized gains and losses resulting from marketvalue changes are reported on the investors income statement.


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Summary concluded

Consolidated financial statements are required when one entity acquiresmore than 50% of another entity.

Goodwill is typically recorded in business combinations using thepurchase method, and is not amortized, but is subject to annualimpairment tests.

Purchase and acquisition methods of accounting complicate financialanalysis because of the differing treatment of subsidiarys net income.

When freestanding foreign subsidiaries are consolidated with at U.S.company, the current rate method for foreign currency translation is used.When the foreign subsidiary is not freestanding, the temporal method isused.

Chap016 Financial Reporting Analysis

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