Week 5 Slides s06

8/11/2019 Week 5 Slides s06

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Module 6

Reporting andAnalyzingIntercorporateInvestments


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Equity Securities

What is an equity investment?

Why would a firm invest in theequity of another firm?


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Accounting for InvestmentsGAAP identifies three levels ofinfluence/control:

PassiveSignificant influenceControl


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Accounting Treatment andFinancial Statement Effects


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Intercorporate Investments


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PassivePassive. In this case the purchasingcompany is merely an investor andcannot exert any influence over theinvestee company. Its goal for theinvestment is to realize dividend andcapital gain income. Generally, passiveinvestor status is presumed if the investorcompany owns less than 20% of theoutstanding voting stock of the investeecompany.


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Significant influenceSignificant influence. In certaincircumstances, a company can exert

significant influence over, but not control,the activities of the investee company.Generally, significant influence ispresumed if the investor company owns

20-50% of the voting stock of theinvestee company.


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Some terms

Mark-to-marketRealizedRecognizedReady marketTrading securityAvailable for sale security


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Passive - No ready market

Account for at costNo mark-to-market


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Investment ClassificationsGAAP allows for two possible classificationis equity investments:Available-for-sale. Investments insecurities that management intends tohold for capital gains and dividendincome; although it may sell them if theprice is right.Trading. Investments in securities thatmanagement intends to actively trade(buy and sell) for trading profits asmarket prices fluctuate.


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Passive - Ready marketTrading or Available for sale depending onmanagements intentions Both are marked-to-marketFor trading securities the gain/loss isrecognized prior to being realized (onincome statement)

For available for sale securitiesrecognition is at realization. Until thenthe holding gain/loss is kept in an theequity section of the balance sheet (noton income statement)


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Example of Trading andAvailable 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


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American ExpressStockholders Equity


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Held To MaturityInvestments


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Equity Method InvestmentsEquity Method accounting is required forinvestments in which the investorcompany can exert significant influence

over the investee.Significant influence is the ability of theinvestor to affect the financial oroperating policies of the investee.


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Equity Method InvestmentsOwnership levels of 20-50% of the outstandingcommon stock of the investee company presumesignificant influence.Significant influence can also exist whenownership is less than 20% if, for example,

the investor company is able to gain a seat on theboard of directors of the investee company, or

when the investor controls technical know-how orpatents that are used by the investee company, or

when the investor company is able to exert controlby virtue of legal contracts between it and theinvestee company.


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Accounting for EquityMethod Investments

Initially record investment at cost.Increase asset to reflect proportionateshare of net income. Essentially treatstheir income as yours.Dividends decrease investment. Treatedas a return of investment. They are notconsidered income.No mark-to-marketIncome recognized rarely equals eithercash flow or actual change in market

value.


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Equity Method Accounting

Assume that HP acquires a 30% interest inMitel Networks. On the date of acquisition,

Mitel reports $1,000 of stockholdersequity, and HP purchases its 30% stakefor $300.Assume that Mitel reports net income of

$100 and pays dividends of $20 (30% or$6 to HP)


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Equity Method AccountingFollowing are the balance sheet and income statement impacts for thepreceding transactions:


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Your turnInitially L purchases 30% of S for$9 when the book value of S = $30

1. S has income of $20 and pays totaldividends of $102. S has a loss of $10 and pays total

dividends of $20Record Ls yearly income from Sand investment in S


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Equity method

Why would a firm prefer using theequity method over consolidation?

Blue and Yellow = Green example


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Equity method cautions!

Income shown on income statementis not really income.

The asset shown is not at marketvalue.Potentially liabilities are hidden off

balance sheet.


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Business Combinations (Over50%)

2 companies brought together as singleaccounting entity.Results in a combination of both theinvestor and investment firms financialstatements.Purchase method must be used foracquisition of another company.Prior to 2002 and outside of U.S., undercertain conditions the pooling of interestsmethod was/is used.


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Investments with Control Consolidation Accounting

Accounting for business combinations(acquisitions) involves one additionalstep to equity method accounting.Consolidation accounting replaces theinvestment balance with the assetsand liabilities to which it relates, andit replaces the equity income reportedby the investor company with thesales and expenses of the investeecompany to which it relates .


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Consolidation Accounting


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HPs Allocation of CompaqPurchase


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Consolidation with PurchasePrice Above Book Value


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Pooling Accounting forBusiness Combinations

The main difference between the pooling andpurchase methods is in the amount recorded asthe initial investment in the acquired company.

Under the purchase method the investmentaccount is recorded at the fair market value ofthe acquired company on the date ofacquisition.Under the pooling method, this account isrecorded using the book value amounts fromthe acquired company.As a result, no goodwill was created. Further,since goodwill amortization was requiredunder previous GAAP, subsequent income waslarger under pooling because no amortization

arose.


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Documents

Week 5 Slides s06