Chapter 1: Intercorporate Investments: An Overview Susan S.Ronald J.James A. Hamlen Huefner Largay...

Chapter 1:Chapter 1:Intercorporate Investments:

An Overview

Susan S. Ronald J. James A. Hamlen Huefner Largay

1

©Cambridge Business Publishing, 2013©Cambridge Business Publishing, 2013

Motivations for Intercorporate Investments

As a temporary investment of excess cash or part of a long-term risk-adjusted portfolio Expectations of dividends and gains

As a strategic investment Develop relationships with suppliers and

customers Gain access to new product or geographic

markets

To facilitate activity along its supply chain

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Investments on the Balance Sheet

Coca-Cola Company reported the following investments at December 31, 2010 and 2009 (in millions):

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2010 2009

Investments

Trading securities $ 209 $ 61

Available-for-sale securities 485 398

Held-to-maturity securities 111 199

Equity method investments 6,954 6,217

Other investments, principally bottling companies 631 538


Coca-Cola’s Investments

Marketable securities Includes trading, available-for-sale, and held-

to-maturity investments Equity method investments

Investments for which Coca-Cola exerts significant influence over operations

Coca-Cola’s equity method investments 23% interest in Coca-Cola Hellenic 32% interest in Coca-Cola FEMSA 30% interest in Coca-Cola Amatil

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Coca-Cola’s Investments continued

Joint ventures Investments for which Coca-Cola and at least

one other company share ownership interest and jointly control a separate entity

Controlling interest Investments for which Coca-Cola has a

controlling interest in another company 2010 acquisition: Coca-Cola Enterprises (CCE)

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Types of Investments for Reporting Purposes

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Fair Value Option

ASC Topic 825 allows companies to elect the fair value option for eligible intercorporate investments

Investments reported at fair value Value changes reported as part of income Option available only for noncontrolling

investments

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This chapter assumes the company did NOT elect the fair value option.


Learning Objective 1

Describe the reporting for trading, available-for-sale, and held-to-maturity

investments in other companies.

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Examples of Marketable Debt and Equity Investments

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Investments Under ASC Topic 320

Readily determinable market values No significant influence over the investee Three categories:

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Held-to-maturity investments

Trading investments

Available-for-sale investments


Trading Investments

Debt or equity securities Reported as current assets at fair value Income statement reporting

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Income statementOther Income/losses: Unrealized gains/losses on trading investments…………$ xx Realized gains/losses on trading investments……………..xx Investment income…………………………………………… xx


Accounting for Trading Investments

Securities owned:

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SecurityDate

Acquired CostDecember 31, 2012

Value Date SoldSelling

PriceA 10/15/12 $100,000 $125,000 1/15/13 $120,000B 10/15/12 500,000 485,000 1/15/13 496,000C 10/15/12 200,000 N/A 12/5/12 214,000

$800,000

2012 Oct. 15 Investment in trading securities 800,000 Cash 800,000

To record purchase of trading investments costing $800,000:

Exhibit 1.1


Accounting for Trading Investments continued

2012 Dec. 5 Cash 214,000 Investment in trading securities 200,000 Realized gain on sale of trading securities (income) 14,000

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2012 Dec. 31 Investment in trading securities 25,000

Unrealized gain on trading securities (income) 25,000

To record the sale of trading security C for $214,000:

To record the unrealized value change for securities A and B: Security Cost Year-end Value Unrealized Gain(loss)

A $100,000 $125,000 $25,000 GainB 500,000 485,000 $15,000 Loss

2012

Dec. 31Unrealized loss on trading securities (income) 15,000

Investment in trading securities 15,000



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2013 Jan. 15 Cash 120,000

Realized loss on sale of trading securities (income) 5,000

Investment in trading securities 125,000

To record the sale of trading securities A and B:

Security Cost Year-end Value Date Sold Selling PriceRealized

Gain (Loss)

A $100,000 $125,000 1/15/13 $120,000 ($5,000)B 500,000 485,000 1/15/13 496,000 $11,000

Exhibit 1.1

2013 Jan. 15 Cash 496,000 Investment in trading securities 485,000

Realized gain on sale of trading securities (income) 11,000



Gains and losses are reported in income as the value of the securities changes

No impairment testing is necessary since all changes in value flow through income No difference in accounting between a

“normal” decline in value and a decline characterized as “impairment.”

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Available-for-Sale Investments Debt or equity securities Balance sheet

Reported as current or noncurrent assets at fair value Unrealized gains/losses reported in accumulated

other comprehensive income Income statement reporting

Realized gains/losses on available-for-sale investments

Investment income Other comprehensive income

Unrealized gains/losses on available-for-sale investments

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Journal Entries for Available-for-Sale Investments

AFS investments:

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SecurityDate

Acquired Cost December 31, 2012 Value Date SoldSelling

Price

A 10/15/12 $100,000 $125,000 1/15/13 $120,000B 10/15/12 500,000 485,000 1/15/13 496,000C 10/15/12 200,000 N/A 12/5/12 214,000

$800,000

2012 Oct. 15 Investment in AFS securities 800,000 Cash 800,000

To record the purchase of investments costing $800,000:

Exhibit 1.1


Journal Entries for Available-for-Sale Investments continued

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2012 Dec. 5 Cash 214,000 Investment in AFS securities 200,000

Realized gain on sale of AFS securities (income) 14,000

2012 Dec. 31 Investment in AFS securities 25,000 Unrealized gain on AFS securities (OCI) 25,000

To record the sale of AFS security C for $214,000:

To record the unrealized value change for securities A and B: Security Cost Year-end Value Unrealized Gain(loss)

A $100,000 $125,000 $25,000 GainB 500,000 485,000 $15,000 Loss

2012 Dec. 31 Unrealized loss on AFS securities (OCI) 15,000 Investment in AFS securities 15,000


Journal Entries for Available-for-Sale Investments continued

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2013 Jan. 15 Cash 120,000

Other comprehensive income 25,000 Investment in AFS securities 125,000 Realized gain on sale (income) 20,000

To record the sale of AFS security A:

Security Cost2013 Year-end

Value Date Sold Selling PriceRealized

Gain (Loss)

A $100,000 $125,000 1/15/13 $120,000 $20,000B 500,000 485,000 1/15/13 496,000 $(4,000)

2013 Jan. 15 Cash 496,000

Realized loss on sale (income) 4,000 Investment in AFS securities 485,000 Other comprehensive income 15,000

To record the sale of AFS security B:


Impairment Testing for AFS Securities

Required because impairment losses go through income but “normal” declines are reported in OCI

Is the security’s fair value below its cost? If so, is the decline other than temporary?

Common indicator: security will be sold before value can be recovered

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To record the $15,000 decline in value of AFS security B at December 31, 2012 as impairment:

2012 Dec. 31 Loss on security B (income) 15,000 Investment in AFS securities 15,000


Impairment Testing of AFS Securities continued

After recognition of impairment, Security B’s “cost” is $485,000. Subsequent value increases are not reported

Example of loss recognition when unrealized gains/losses previously reported: AFS security, book value $200,000, original

cost $160,000, fair value $90,000

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Impairment Testing of AFS Securities continued

Fair value ($90,000) < cost ($160,000) If the decline in value is other than

temporary:

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Record the decline in value of the AFS security from cost to fair value as impairment loss, in income, reclassify the unrealized gain out of AOCI, and write the investment down from book value to fair value:

Unrealized loss on AFS securities (OCI) 40,000 Impairment loss on AFS securities (income) 70,000

Investment in AFS securities 110,000


Held-to-Maturity Investments

Debt securities only Reported at amortized cost

Discount or premium amortized over time No gains or losses unless sold prior to

maturity Early sale requires extreme circumstances

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Income StatementOther income/losses: Interest income…………………………………………………… $xx


Journal Entries for HTM Investments

A company invested in a $1 million face value, 5% corporate bond on January 1, 2012 for $965,349, yielding 6%. Interest is paid annually on December 31. Maturity is December 31, 2015.

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2012 Jan. 1 Investment in HTM securities 965,349 Cash 965,349

2012 Dec. 31 Cash 50,000 Investment in HTM securities 7,921 Interest income 57,921

To record the purchase of HTM securities:

To record the receipt of interest income for 2012: $1,000,000 × 5%

$965,349 × 6%$57,921 – $50,000


Journal Entries for HTM Investments continued

$1 million, 5% face value corporate bond for $965,349, yielding 6%.

Carrying value at December 31, 2012: $965,349 + $7,921 = $973,270

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$973,270 × 6%



$981,666 × 6%

$58,396 – $50,000

$58,900 – $50,000



Journal Entries for HTM Investments continued

$1 million, 5% face value corporate bond for $965,349, yielding 6%.

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2015 Dec. 31 Cash 1,000,000 Investment in HTM securities 1,000,000

To record receipt of face value of bonds at maturity:

Carrying value at December 31, 2015: $990,566 + $9,434 = $1,000,000



$990,566 × 6%$59,434 – $50,000



Impairment Testing for HTM Investments

Required because normally HTM investments are carried at amortized cost

Two criteria, same as for AFS securities Fair value declines below amortized cost, and Decline is judged to be other than temporary

If judged to be impaired Write down the security to fair value Report the decline as an impairment loss on the

income statement Ignore subsequent increases in fair value

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Recording an Impairment Loss

Example: An investor owns an HTM security with a current amortized cost

of $981,666. At the end of 2013, the investor determines that it is probable that all amounts due according to the contractual terms of a debt security will not be collected. The current market value is $500,000.

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2013

Dec. 31Impairment loss on HTM securities (income) 481,666

Investment in HTM securities 481,666

To record the impairment:



Explain the reporting for equity method intercorporate investments.

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Investments with Significant Influence

Two accounting options exist Elect to use the ASC Topic 825 fair value

option, or Apply the equity method (ASC Topic 323)

Investor must exert significant influence over operating and financing decisions of the investee

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When is Significant Influence Present?

Representation on the investee’s board Involvement in investee operating and

financial policies Significant transactions between investor

and investee Guideline: 20% to 50% ownership

BUT significant influence can exist with less than 20% ownership

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Accounting Using the Equity Method

Investment performance reflects the investee’s performance

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Equity method investment

Cost of investment

Investor's share of investee's income and

OCI gains

Investor's share of investee's losses and

OCI losses

Dividends declared by

investeeEnding balance

Increases

Decreases

Investment changes in proportion to the investee’s retained earnings and

AOCI accounts


Equity Method Example

Investment cost = $2,000,000 for 30% of the investee’s stock. During the first year, the investee reports net income of $800,000, declares and pays dividends of $300,000, and has $50,000 in unrealized losses on AFS securities.

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Equity method investment 2,000,000 Cash 2,000,000

Cash 90,000 Equity method investment 90,000

To record the purchase of equity investment:

To record dividends declared and paid:

To accrue earnings of investee: Equity method investment 240,000

Equity in income of investee 240,000


Equity method example continued


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To record investee’s OCI:Other comprehensive income 15,000

Equity method investment 15,000

Change in investee’s equity = $800,000 - $300,000 - $50,000 = $450,000

Change in equity method investment = $240,000 - $90,000 - $15,000 = $135,000, or 30% of the change in the investee’s equity


Equity Method Example continued


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Equity method investment2,000,000

240,00090,000 15,000

2,135,000

Equity in income of investee

240,000

240,000

Income Statement

Balance Sheet as long-term asset


Equity in Net Income

Adjustments to reported net income may be required If investment cost differs from investee’s book

value Adjustment required: Amortize investment cost in

excess of book value acquired

If investor and investee transact business with each other Adjustment required: Remove intercompany profit

that is not yet earned

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Adjustments to Equity in Net Income

Adjustments should be made for depreciation and amortization on revaluations of Tangible assets, and Limited life intangible assets

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ExceptionsNo adjustments for goodwill impairment or impairment

of other indefinite life intangibles


Inventory Sales Between Investee and Investor

Downstream sales

Investor sells inventory to investee

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Upstream sales

Investee sells inventory to investor

Both companies Both companies record sales as if record sales as if selling to outside selling to outside

customerscustomers

Both report gross Both report gross margin as part of margin as part of

incomeincomeResults in

If inventory not sold to If inventory not sold to unrelated outside party at unrelated outside party at year-end, gross margin is year-end, gross margin is

not yet earnednot yet earned

Investor must remove Investor must remove when calculating equity in when calculating equity in

net income of investeenet income of investee


Example: RevaluationsOn January 1, 2013, Rocky Mountain reports total assets of $80 million and total liabilities of $50 million, for a net book value of $30 million. Coca-Cola paid $12 million for 30% of Rocky Mountain’s shares. Analysis indicates that Rocky Mountain has unreported technology valued at $5 million and its plant and equipment is undervalued by $1 million. Plant and equipment has a remaining life of 10 years as of January 2, 2013 and uses straight-line depreciation. The previously unreported technology is a limited life intangible asset with a 5-year life.

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Price paid $12,000,000Share of Rocky Mountain's net assets acquired:

Book value (30% x $30,000,000) $9,000,000 Revaluation of plant and equipment (30% x $1,000,000) 300,000 Unreported technology (30% x $5,000,000) 1,500,000 10,800,000

Additional investment cost (goodwill) $1,200,000


Example: Unconfirmed Inventory Profits

Suppose Rocky Mountain sells canned beverages to Coca-Cola upstream for $800,000 at a 20% markup on cost. Coca-Cola holds $210,000 of this inventory at year-end. Coca-Cola sells finished products to Rocky Mountain downstream for $500,000 at a 25% markup on cost. Rocky Mountain holds $100,000 of this inventory at year-end. How much is unconfirmed profit?

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Unconfirmed gross profit on $210,000 upstream sales:$210,000 –[ $210,000 ÷ 1.20] = $35,000

Unconfirmed gross profit on $100,000 downstream sales:$100,000 – [$100,000 ÷ 1.25] = $20,000


Recognition of Adjusted Equity in Net Income for 2013

Coca-Cola's share of Rocky Mountain's reported 2013 income (30% x $2,000,000) $600,000Adjustments for revaluation write-offs:

Plant and equipment (30,000)Previously unreported technology (300,000)

Adjustments for unconfirmed inventory profits: Upstream sales (10,500)Downstream sales (6,000)

Equity in net income of Rocky Mountain $253,500

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30% × $35,000

30% × $20,000

2013 Dec. 31 Investment in Rocky Mountain Bottlers 253,500 Equity in income of Rocky Mountain Bottlers 253,500

$300,000÷ 10

$1,500,000÷ 5


Impairment Testing: Equity Method Investments

Impairment testing required for equity method investments (ASC Topic 323)

Criteria Fair value of the investment declines below its

carrying value, and The decline is other than temporary

Accounting requirements Investment is written down and a loss is

recognized on the investor’s income statement Subsequent increases are ignored

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Joint Ventures

An entity formed by a group of individuals or firms that contribute resources and jointly share in managing and controlling the venture Often established for a short-term, single business

transaction or activity Enables expertise, special technology, capital,

market access to be combined

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U.S. companies use the equity method for joint ventures.



Describe the reporting for controlling interests in other companies.

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Controlling Investments

The investor has control over the operating and financial decisions of the investee

Three forms Statutory merger, statutory consolidation, or

asset acquisition Stock acquisition Variable interest entity

Assets, liabilities, revenues, and expenses are combined with those of the investor for financial statement reporting

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Statutory Mergers, Statutory Consolidations, and Asset Acquisitions

Investor directly acquires the assets and liabilities of the investee

Assets and liabilities recorded directly on investor’s balance sheet at fair value

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Statutory mergerOccurs when the investor acquires

the investee and becomes the remaining legal entity

Statutory consolidationOccurs when a new entity is formed to acquire both the investor and the investee

Asset acquisitionOccurs when an investor acquires a subset of the

investee’s assets


Statutory Merger Example

Coca-Cola acquires all of Rocky Mountain’s assets and liabilities in a statutory merger by paying $40 million in cash on Jan. 2, 2013. Fair values in millions are: Current assets, $20; plant and equipment, $61; current liabilities, $15; and long-term liabilities, $35. Coca-Cola identified and valued Rocky Mountain’s previously unreported intangibles asset, technology, at $5 million.

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Price paid $40,000,000Fair value of identifiable net assets acquired:

Current assets $20,000,000 Plant and equipment 61,000,000 Technology 5,000,000 Current liabilities (15,000,000) Long-term debt (35,000,000) 36,000,000

Goodwill $4,000,000


Statutory Merger Example continued

To record the acquisition of Rocky Mountain Bottlers:

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Current assets 20,000,000 Plant and equipment 61,000,000 Technology 5,000,000 Goodwill 4,000,000

Current liabilities 15,000,000Long-term debt 35,000,000Cash 40,000,000


Stock Acquisitions

Occurs when an investor obtains control over another company by investing in its voting stock Investee remains a separate legal entity

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The separate financial records are consolidated

at the end of each reporting

period.


Stock Acquisition Example

Assume Coca-Cola acquires and holds all of the voting stock of Rocky Mountain Bottlers, paying the former stockholders of Rocky Mountain $40 million cash.

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Investment in Rocky Mountain Bottlers 40,000,000 Cash 40,000,000

This is the entry Coca-Cola makes on its own books, but its annual report shows Coca-Cola and Rocky Mountain’s combined accounts as if Coca-Cola recorded the acquisition as a statutory merger.


Variable Interest Entities (VIEs)

Investee is a separate legal entity controlled by another company

Control occurs through legal relationships rather than stock ownership

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Entity is considered to be a VIE if:•The entity must obtain guarantees from other parties in order to obtain financing, or•The equity holders do not have the usual rights and responsibilities of equity ownership, such as voting and residual return rights


Issue of Control with VIEs

Consequences of control Must have the power to direct the VIE’s

activities Must absorb the majority of the VIE’s risks and

rewards

Reporting is the same as for stock investments

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Voting rights are not an indicator of controlling a VIE



Discuss International Financial Reporting Standards (IFRS) for intercorporate

investments.

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IFRS for Marketable Debt and Equity Investments

Currently accounted for the same as U.S. GAAP (IAS 39)

IFRS 9 (effective 2015): Default: FV-NI Option for equity investments not held for

trading: FV-OCI, never reclassified to income Option for debt securities held for principal and

interest payments: amortized cost

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IFRS for Marketable Debt and Equity Investments continued

Impairment losses Focus on observance of ‘loss events’ related to

the decline in value Such as decline in credit rating, or Investee misses scheduled debt payments

New standards for impairment testing under consideration

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IFRS for Significant Influence Investments

Investee is defined as an associate Principles-oriented view to significant

influence Representation on the investee’s board Participation in policy-making process Material transactions between the investor and

the investee Interchange of managerial personnel Provision of essential technical information

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IFRS for Significant Influence Investments continued

Equity method required Similar to U.S. GAAP procedures Impairment testing

Compare the investment carrying value with the higher of its market value or value-in-use

Value-in-use is the present value of the investment’s future expected cash flows

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Possible differences in impairment loss recognition between IFRS and

U.S. GAAP


IFRS and Joint Ventures

IFRS 11, effective 2013 Two kinds of joint arrangements:

Joint operations (rights to entity’s assets and liabilities)

Joint ventures (rights to entity’s returns and disposal value)

Joint ventures are most common Reported using the equity method

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IFRS and Joint Ventures continued

Until 2013, joint ventures may be reported using proportionate consolidation Investor includes proportionate share of JV’s

assets and liabilities on its balance sheet Affects investor’s leverage No effect on investor’s equity or income

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IFRS and Controlling Investments

IFRS 10: When should an entity be consolidated: all of the following Power to direct the activities that significantly

affect the investee’s returns Exposure to variable returns from investee Ability to use power to affect the amount of

investor’s returns

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IFRS and Controlling Investments continued

IFRS 10 applies to all control relationships Investments in stock of a company Control achieved through financial

relationships Variable interest entities

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Should an entity controlled through a financial relationship be consolidated? Possible differences between IFRS and

U.S. GAAP


End of Chapter 1

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Chapter 1: Intercorporate Investments: An Overview Susan S.Ronald J.James A. Hamlen Huefner Largay...

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