Analyzing Investing Activities: Intercorporate Investments

5-1
Analyzing Investing Activities:

Intercorporate Investments
05
CHAPTER
5-2
Intercorporate
Investment
Investment
Securities
Derivative
securities
Equity
Method
Accounting
Accounting
Classification
&
Accounting
Business
Combinations
Analysis
Analysis
5-3
Intercorporate
Investment
Investment
Securities
5-4
Investment Securities
Composition
Investment
Investment (marketable)
(marketable) securities:
securities:
Debt
Debt Securities
Securities
Government
Government or
or corporate
corporate debt
debtobligations
obligations
Equity
Equity Securities
Securities
Corporate
Corporatestock
stockthat
thatis
isreadily
readilymarketable
marketable
5-5
Intercorporate
Investment
Investment
Securities
Accounting
5-6
Accounting for Debt Securities
5-7
Accounting for Transfers between Security Classes
5-8
Classification and Accounting for Equity Securities
5-9
Intercorporate
Investment
Investment
Securities
Accounting
Analysis
5-10
Analyzing Investment Securities
Two main objectives:
To separate operating performance from investing (and
financing) performance
Remove all gains (losses) relating to investing activities
To analyze accounting distortions from securities
Opportunities for gains trading

Liabilities recognized at cost
Inconsistent definition of equity securities
Classification based on intent
5-11
Intercorporate
Investment
Investment
Securities
Equity
Method
Accounting
Accounting
Analysis
5-12
Equity Method Accounting

Required for intercorporate investments in which
the investor company can exert significant
influence over, but does not control, the investee.
Reports the parents investment in the subsidiary, and
the parents share of the subsidiarys results, as line
items in the parents financial statements (one-line
consolidation)
Note: Generally used for investments representing
20 to 50 percent of the voting stock of a companys
equity securities--main difference between
consolidation and equity method accounting rests in
the level of detail reported in financial statements
5-13

Investment account:
Initially recorded at acquisition cost
Increased by % share of investee earnings
Decreased by dividends received
Income:
Investor reports % share of investee company earnings
as equity earnings in its income statement
Dividends are reported as a reduction of the investment
account, not as income
5-14

Equity Method Mechanics
Assume that Global Corp.

acquires for cash a 25%
interest in Synergy, Inc. for
$500,000, representing onefourth of Synergys
stockholders equity as of the
acquisition date.
Acquisition entry:
Investment
Cash
500,000
500,000
Synergy, Inc.
Current assets
PP&E
Total assets
700,000
5,600,000
6,300,000
Current liabilities
300,000
Long-term debt
4,000,000
Stockholders Equity 2,000,000
Total liabs and equity 6,300,000
5-15
Equity Method Mechanics

Subsequent to the
acquisition date, Synergy
reports net income of
$100,000 and pays
dividends of $20,000.
Global records its
proportionate share of
Synergys earnings and
the receipt of dividends
as follows:
Investment 25,000
Equity earnings 25,000
(to record proportionate share of
investee company earnings)
Cash 5,000
Investment
5,000
(to record receipt of dividends)
5-16

Important points:
Investment account reported at an amount equal to the
proportionate share of the stockholders equity of the investee
company. Substantial assets and liabilities may not be recorded
on balance sheet unless the investee is consolidated.
Investment earnings should be distinguished from core operating
earnings.
Investments are reported at adjusted cost, not at market value.
Excess of initial investment over the proportionate share of the
book value is allocated to identifiable tangible and intangible
assets that are depreciated/amortized over their respective useful
lives. Investment income is reduced by this additional expense.
The excess not allocated in this manner is treated as goodwill and
is no longer amortized.
5-17
Intercorporate
Investment
Investment
Securities
Equity
Method
Accounting
Accounting
Business
Combinations
Analysis
5-18
Business Combinations
The merger, acquisition, reorganization, or restructuring of two or more
businesses to form another business entity. Example ???
Motivations
enhance company image and growth potential
acquiring valuable materials and facilities
acquiring technology and marketing channels
securing financial resources
strengthening management
enhancing operating efficiency
encouraging diversification
rapidity in market entry
achieving economies of scale
acquiring tax advantages
management prestige and perquisites
management compensation
5-19
Accounting for Business Combinations
Purchase method of accounting

Companies are required to recognize on their balance sheets
the fair market value of the (tangible and intangible) assets
acquired together with the fair market value of any liabilities
assumed.
Tangible assets are depreciated and the identifiable intangible
assets amortized over their estimated useful lives.
Nonamortization of goodwill
5-20
Consolidated Financial Statements
Consolidated
Consolidated financial
financial statements
statements report
reportthe
theresults
resultsof
ofoperations
operations
and
andfinancial
financialcondition
conditionof
ofaaparent
parentcorporation
corporationand
andits
itssubsidiaries
subsidiariesin
inone
one
set
setof
ofstatements
statements
Basic Technique of Consolidation

Consolidation
Consolidationinvolves
involvestwo
twosteps:
steps:aggregation
aggregationand
andelimination
elimination
Aggregation
Aggregationof
ofassets,
assets,liabilities,
liabilities,revenues,
revenues,and
and
expenses
of
subsidiaries
with
the
parent
expenses of subsidiaries with the parent
Elimination
Eliminationof
ofintercompany
intercompanytransactions
transactions
(and
(andaccounts)
accounts)between
betweensubsidiaries
subsidiariesand
andthe
theparent
parent
Note:
Note:Minority
Minority interest
interestrepresents
representsthe
theportion
portionof
ofaasubsidiarys
subsidiarysequity
equity
securities
securitiesowned
ownedby
byother
otherthan
thanthe
theparent
parentcompany
company
5-21
Consolidation Illustration
On
OnDecember
December 31,
31,Year
Year 1,
1, Synergy
SynergyCorp.
Corp. purchases
purchases100%
100%of
of
Micron
MicronCompany
Companyby
by exchanging
exchanging10,000
10,000shares
shares of
of its
its common
common
stock
stock($5
($5par
par value,
value, $77
$77market
marketvalue)
value)for
forall
allof
of the
thecommon
common
stock
stockof
ofMicron.
Micron.
On
Onthe
thedate
dateof
ofthe
theacquisition,
acquisition, the
the book
bookvalue
valueof
of Micron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
market price
priceof
of
$770,000
$770,000because
becauseititfeels
feelsthat
that Microns
Micronsproperty,
property,plant,
plant, and
and
equipment
equipment(PP&E)
(PP&E) isisundervalued
undervaluedby
by$20,000,
$20,000, itithas
hasan
an
unrecorded
unrecorded trademark
trademarkworth
worth $30,000
$30,000and
andintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporatesynergies,
synergies,market
market
position,
position,and
andthe
thelike)
like)are
arevalued
valued at
at $100,000.
$100,000.
Consolidation Illustration
The
Thepurchase
purchaseprice
priceis,
is,therefore,
therefore,allocated
allocatedas
asfollows:
follows:
Purchase
770,000
Purchaseprice
price
770,000
Book
620,000
Bookvalue
valueof
ofMicron
Micron
620,000
Excess
150,000
Excess
150,000
Excess
useful
Excessallocated
allocatedto
to
usefullife
life
Undervalued
UndervaluedPP&E
PP&E
Trademark
Trademark
Goodwill
Goodwill
20,000
10
20,000
10
30,000
55
30,000
100,000
100,000 indefinite
indefinite
150,000
150,000
annual
annual
deprec/amort.
deprec/amort.
2,000
2,000
6,000
6,000
-0-0-
5-22
5-23
Synergy Corp and Micron Company
Consolidated Income Statement Steps
The four consolidation entries are

1. Replace $620,000 of the investment account with the book
value of the assets acquired. If less than 100% of the subsidiary
is owned, the credit to the investment account is equal to the
percentage of the book value owned and the remaining credit is
to a liability account, minority interest.
2. Replace $150,000 of the investment account with the fair value
adjustments required to fully record Microns assets at fair
market value.
3. Eliminate the investment income recorded by Synergy and
replace that account with the income statement of Micron. If
less than 100% of the subsidiary is owned, the investment
income reported by the Synergy is equal to its proportionate
share, and an additional expense for the balance is reported for
the minority interest in Microns earnings.
4. Record the depreciation of the fair value adjustment for
Microns PP&E and the amortization of the trademark. Note,
there is no amortization of goodwill under current GAAP.
5-24
5-25
Impairment of Goodwill
Goodwill recorded in the consolidation process is subject to

annual review for impairment.
The fair market value of Micron is compared with the book
value of its associated investment account on Synergys books.
If the current market value is less than the investment balance,
goodwill is deemed to be impaired and an impairment loss
must be recorded in the consolidated income statement.
Impairment loss reported as a separate line item in the
operating section of Synergys consolidated income statement.
A portion of the goodwill contained in Synergys investment
account is written off, and the balance of goodwill in the
consolidated balance sheet is reduced accordingly.
5-26
Consequences of Accounting for Goodwill
Superior competitive position is subject to change.
Goodwill is not permanent.
Residual goodwill - measurement problems.

Timing of goodwill write-off seldom reflects prompt
recognition of this loss in value.
Goodwill on corporate balance sheets typically fails to reflect
a companys entire intangible earning power
5-27
Intercorporate
Investment
Investment
Securities
Derivative
securities
Equity
Method
Accounting
Accounting
Business
Combinations
Analysis
5-28
Derivative Securities
Background
Hedges
Hedgesare
arecontracts
contractsthat
thatseek
seekto
toinsulate
insulatecompanies
companiesfrom
from
market
marketriskssecurities
riskssecuritiessuch
suchas
asfutures,
futures,options,
options,and
andswaps
swapsare
are
commonly
commonlyused
usedas
ashedges
hedges
Derivative
Derivative securities,
securities, or
or simply
simply derivatives
derivatives are
arecontracts
contracts
whose
whosevalue
valueis
isderived
derivedfrom
fromthe
thevalue
valueof
ofanother
anotherasset
assetor
or
economic
economicitem
itemsuch
suchas
asaastock,
stock,bond,
bond,commodity
commodityprice,
price,
interest
interestrate,
rate,or
orcurrency
currencyexchange
exchangerate
rate
they
theycan
canexpose
exposecompanies
companiesto
toconsiderable
considerable
risk
riskbecause
becauseititcan
canbe
bedifficult
difficultto
tofind
findaa
derivative
derivativethat
thatentirely
entirelyhedges
hedgesthe
therisks
risksor
or
because
becausethe
theparties
partiesto
tothe
thederivative
derivativecontract
contract
fail
failto
tounderstand
understandthe
therisk
riskexposures
exposures
5-29
Definitions
Futures
Futurescontractan
contractanagreement
agreementbetween
betweentwo
twoor
ormore
moreparties
partiesto
to
purchase
purchaseor
orsell
sellaacertain
certaincommodity
commodityor
orfinancial
financialasset
assetat
ataafuture
futuredate
date
(called
(calledsettlement
settlementdate)
date)and
andat
ataadefinite
definiteprice.
price.
Swap
Swapcontractan
contractanagreement
agreementbetween
betweentwo
twoor
ormore
moreparties
partiesto
to
exchange
exchangefuture
futurecash
cashflows.
flows.ItItisiscommon
commonfor
forhedging
hedgingrisks,
risks,especially
especially
interest
interestrate
rateand
andforeign
foreigncurrency
currencyrisks.
risks.
Option
Optioncontractgrants
contractgrantsaaparty
partythe
theright,
right,not
notthe
theobligation,
obligation,to
toexecute
execute
aatransaction.
transaction.AAcall
calloption
optionisisaaright
rightto
tobuy
buyaasecurity
security(or
(orcommodity)
commodity)at
at
aaspecific
specificprice
priceon
onor
orbefore
beforethe
thesettlement
settlementdate.
date.AAput
putoption
optionisisan
an
option
optionto
tosell
sellaasecurity
security(or
(orcommodity)
commodity)at
ataaspecific
specificprice
priceon
onor
orbefore
before
the
thesettlement
settlementdate.
date.
5-30
Intercorporate
Investment
Investment
Securities
Derivative
securities
Equity
Method
Accounting
Accounting
Business
Combinations
Analysis
Classification
&
Accounting
5-31
5-32
Intercorporate
Investment
Investment
Securities
Derivative
securities
Equity
Method
Accounting
Accounting
Classification
&
Accounting
Business
Combinations
Analysis
Analysis
5-33
Analysis of Derivatives
Identify Objectives for Using Derivatives

Risk Exposure and Effectiveness of Hedging
Strategies
Inclusion in Operating or Nonoperating Income
5-34
Question
10th edition
11st edition
Page 314
5-1
5-2
5-5
5-6
5-8
5-16
Page 323
5-1
5-2
5-5
5-6
5-8
5-16
Page 317
Problem 5-1, 5-3, 5-6
Page 326
Problem 5-1, 5-3, 5-6

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5-1

Analyzing Investing Activities:

To analyze accounting distortions from securities

Opportunities for gains trading

Equity Method Accounting

Equity Method Accounting

Equity Method Accounting

Assume that Global Corp.

Equity Method Accounting

Equity Method Mechanics

(to record receipt of dividends)

Equity Method Accounting

Purchase method of accounting

Basic Technique of Consolidation

The four consolidation entries are

Goodwill recorded in the consolidation process is subject to

Residual goodwill - measurement problems.

Identify Objectives for Using Derivatives

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