Chapter One: Accounting for Intercorporate Investments

Accounting for Intercorporate Investments

companies can invest in other companies

-the accounting for investments in the voting shares of other companies depend on the degree to which the company making the investment )investor) can influence the operating activities of the company in which it is investing (the investee)

-the degree of influence or control that the investor company can exert over the investee company’s operating activities determines the method that the investor must use to report its equity investment in the financial statements

Insignificant influence (fair value method)

-the investment account is reported on the balance sheet at its current fair value at each statement date.

-dividends are recognized as income, and increases in the fair value of the investment are reported in current income.

-This method is required if the investment is passive in nature (ie the investor cannot exert significant influence over or control the investee company)

Significant influence (equity method)

-the investment account is not reported at fair value, but at an amount that is equal to the proportion of the stockholders equity of the investee company that the investor owns (and typically also includes the acquisition-date fair value adjmts)

Control (consolidation)

after the investor company is deemed to control the investee, the financial statements of the two companies must be consolidated, or combined

When should the equity method be used?

GAAP prescribes that the equity method should be used to account for Equity Investments and i nvestments in corporate joint ventures when the investor has the ability to exercise significant influence over operating and financial policies of an investee

-FASB says that an investment of 20% or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor has the ability to exercise significant influence over an investee,,, BUT some investments of 20% or more might not result in significant influence

The ability to exercise significant influence may be indicated in a number of ways:

-investor representation on the BOD of the investee

-investor participation in the policy making processes of the investee

-the extent of ownership of investee voting shares b the investor in relation to the concentration of other shareholdings

-material intercompany transactions between the investor and the investee

-technological dependency of the investee on the investor

all these criteria do not have to be met, at least one

—> the investor must account for the equity investment using the equity method when it can exert significant influence over the investee company.

—> When the investor obtains control of the investee it must consolidate the financial statements of both companies when reporting to external perties such as shareholders of the SEC

—> for preconsilidation internal reportin, the investor can use the equity method to account for its equity investmentment in the investee compant

Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee

-The investee challenges the investor’s ability to exercise significant influence, such as by litigation or complaints to governmental regulatory authorities

-the investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder

-majority ownership of the investee is conentrated amoung a small group of shareholders who operate the investee without regard to teh views of the investor

-the investor needs or wants more financial information to apply the equity method than is avaliable to the investees other shareholder, tireis to obtian that information, and fails

-the investor tries and fails to obtain representation on the investees BOD

When any of these conditions are present, the investor company may be justified in NOT employing the equity method in accounting for the investment despite ownership of more than 20% of the outstanding voting stock of the investee

Accounting procedures for an investment using the equity method (basics)

-looking at the equity method assuming an acquiring company owns 100% of the common stock of the acquired company

-equity investment account= the proportion of the owners’ equity of the acquired company that is owned by the acquiring company

-provided that the aquisition is made at book value, the balance reported in the equity investment account will always be equal to the proportion of the investee company equity that we own

Accounting for changes in the reported amount of the equity investment subsequent to its purchase

if the investee earns a profit of and pays a dividend to the investor, the investees stockholder equity would increase by the profit and decrease by the divided

—> profit increases to recognize the investors share of the increase in the investees stockholders equity resulting from the profit

—> dividend decreases to recognize the investors share of the decrease in the investees stockholders equity resulting from the payment of the dividends (reduction of retained earnings)

-as the investee earns a profit, its SE (retained earnings) increases by that amount and the Equity investment account on the investers BS must increase accordingly

-The pmt of dividends to the investor results in a decrease in the Equity Investment on the investors balance sheet

—> the equity method of accounting then results in an equity investment account that increases and decreases together with the stockholders equity of the investee company

Three observations relating to the investor’s accounting for its Equity Investment under the equity method

1. The investor does not report the receipt of dividends as income like it does under the fair value method of accounting for passive investments. Dividends are treated as a return ‘of’ investment not a return ‘on’ investment and the Equity Investment account is reduced accordingly. Instead, the investor reports income from the investment equal to the percentage of the investees net income that it owns

2. the investor only reports Equity Income commencing with the date on which it purchases the Equity Investment

3. Under the Equity method, the investor does not adjust the Equity Investment account for changes in its fair value. Because of this, there may be substantial unrealized gains that are not reported on the balance sheet, and the investor does not report these gains in its income statement. Instead all unrealized gains are recognized in full when the investment is sold

Accounting for the sale of the Equity Investment

We account for the sale of a non-controlling Equity Investment in the same way as we do for the sale of any other asset that we own

-record the receipt of cash (or other assets)

-remove the Equity Investment from the balance sheet

-recognize the difference between the cash received and the reported amount (bv) of the equity investment as a fain or loss on the sale

Accounting for Equity Investments when the purchase price exceeds book value