Analyzing Investing Activities: Intercorporate Investments

Investment Securities

Investment (marketable) securities:
      Debt Securities
• Government or corporate debt obligations Equity Securities
• Corporate stock that is readily marketable

Investment Securities

• Departure from the traditional lower-of-cost-or-market principle.
• Prescribes that investment securities be reported on the balance sheet at cost or fair (market) value, depending on the type of security and the degree of influence or control that the investor company has over the investee company.
• Accounting is determined by its classification.

Accounting for Debt Securities

Accounting for Debt Securities

Accounting for Transfers between Security Classes  

Accounting for Transfers between Security Classes  

Classification and Accounting for Equity Securities  

Analyzing Investment Securities

Two main objectives: 

To separate operating performance from investing (and financing) performance

• Remove all gains (losses) relating to investing activities
• Separate operating and nonoperating assets when determining RNOA

To analyze accounting distortions from securities

• Opportunities for gains trading
• Liabilities recognized at cost
• Inconsistent definition of equity securities
• Classification based on intent

Required for intercorporate investments in which the investor company can exert significant influence over, but does not control, the investee.

Reports the parent’s investment in the subsidiary, and the parent’s share of the subsidiary’s results, as line items in the parent’s financial statements (one-line consolidation)

Note: Generally used for investments representing 20 to 50 percent of the voting stock of a company’s equity securities--main difference between consolidation and equity method accounting rests in the level of detail reported in financial statements 

Equity Method Accounting 

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

Equity Method Mechanics

Assume that  Global Corp. acquires for cash a 25% interest in Synergy, Inc. for $500,000, representing  one-fourth of Synergy’s stockholders’ equity as of the acquisition date. 

Acquisition entry:

Investment  500,000

Cash 500,000 

  Synergy, Inc.

Current assets 700,000

PP&E           5,600,000

Total assets           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

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 (unless strategic).
• Investments are reported at adjusted cost, not at market value. 
• Should discontinue equity method when investment is reduced to zero and should not provide for additional losses unless the investor has guaranteed the obligations of the investee or is otherwise committed to providing further financial support to the investee. 
• Resumes once all cumulative deficits have been recovered via investee earnings.
• 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.

Business Combinations

The merger, acquisition, reorganization, or restructuring of two or more businesses to form another business entity

                        

                         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 

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

Consolidated Financial Statements 

Consolidated financial statements report the results of operations and financial condition of a parent corporation and its subsidiaries in one set of statements

 

Basic Technique of Consolidation

Consolidation involves two steps: aggregation and elimination

 

Aggregation of assets, liabilities, revenues, and expenses of subsidiaries with the  parent

 

Elimination of intercompany transactions (and accounts) between subsidiaries and the parent

  

Note: Minority interest represents the portion of a subsidiary’s equity securities owned by other than the parent company 

Consolidation Illustration

On December 31, Year 1, Synergy Corp. purchases 100% of Micron Company by exchanging 10,000 shares of its common stock ($5 par value,  $77 market value) for all of the common stock of Micron. 

 

On the date of the acquisition, the book value of Micron is $620,000. Synergy is willing to pay the market price of $770,000 because it feels that Micron’s property, plant, and equipment (PP&E) is undervalued by $20,000, it has an unrecorded trademark worth $30,000 and intangible benefits of the business combination (corporate synergies, market position, and the like) are valued at $100,000. 

The purchase price is, therefore, allocated as follows:

    Purchase price 770,000

    Book value of Micron 620,000

    Excess 150,000    

    Excess allocated to –   useful life        annual                         deprec/amort.

   Undervalued PP&E  20,000          10      2,000

   Trademark  30,000            5      6,000

   Goodwill 100,000   indefinite        -0-

150,000

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 Micron’s 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 Micron’s earnings.
4. Record the depreciation of the fair value adjustment for Micron’s PP&E and the amortization of the trademark. Note, there is no amortization of goodwill under current GAAP.

• Income statement of Synergy is combined with that of Micron.
• Depreciation / amortization of excess of purchase price over the book value of Micron’s assets is recorded as an additional expense in the consolidated income statement.
• Any intercompany profits on sales of inventories held by the consolidated entity at year-end, along with any intercompany profits on other asset transactions, are eliminated.
• Equity investment account on Synergy’s balance sheet is replaced with the Micron assets / liabilities to which it relates.
• Consolidated assets / liabilities reflect the book value of Synergy plus the book value of Micron, plus the remaining undepreciated excess of purchase price over the book value of Micron assets.
• Goodwill, which was previously included in the investment account balance, is now broken out as a separately identifiable asset on the consolidated balance sheet.

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 Synergy’s 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 Synergy’s consolidated income statement. 
• A portion of the goodwill contained in Synergy’s investment account is written off, and the balance of goodwill in the consolidated balance sheet is reduced accordingly.

Issues in Business Combinations

• Contingent Consideration - a company usually records the amount of any contingent consideration payable in accordance with a purchase agreement when the contingency is resolved and the consideration is issued or issuable.
• Allocating Total Cost - once a company determines the total cost of an acquired entity, it is necessary to allocate this cost to individual assets received; the excess of total cost over the amounts assigned to identifiable tangible and intangible assets acquired, less liabilities assumed, is recorded as goodwill.
• In-Process Research & Development (IPR&D) - some companies are writing off a large portion of an acquisition’s costs as purchased research and development. Pending accounting standard will require capitalization of IRR&D and annual testing for impairment.
• Debt in Consolidated Financial Stetements - Liabilities in consolidated financial statements do not operate as a lien upon a common pool of assets.
• Gain on subsidiary stock sales  - The equity investment account is increased via subsidiary stock sales. Companies can record the gain either to income or to 
• Consequences of Accounting for Goodwill - goodwill is not permanent and the present value of super earnings declines as they extend further into the future – future impairment losses are 
• Push‑Down Accounting  - a controversial issue is how  the acquired company (from a purchase) reports assets and liabilities in its separate financial statements (if that company survives as a separate entity) 

Additional Limitations of Consolidated Financial Statements

• Financial statements of the individual companies composing the larger entity are not always prepared on a comparable basis. 
• Consolidated financial statements do not reveal restrictions on use of cash for individual companies. Nor do they reveal intercompany cash flows or restrictions placed on those flows. 
• Companies in poor financial condition sometimes combine with financially strong companies, thus obscuring analysis.
• Extent of intercompany transactions is unknown unless the procedures underlying the consolidation process are reported.
• Accounting for the consolidation of finance and insurance subsidiaries can pose several problems for analysis. Aggregation of dissimilar subsidiaries can distort ratios and other relations. 

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.
• In many cases goodwill is nothing more than mechanical application of accounting rules giving little consideration to value received in return.
• Goodwill on corporate balance sheets typically fails to reflect a company’s entire intangible earning power

Pooling Accounting 

Used prior to the passage of the current business combination accounting standards. 

• Disallowed for combinations initiated post June 30, 2001.
• Companies may continue its use for acquisitions accounted for under that method prior to the effective date of the standard.

Under the purchase method, the investment account is debited for the purchase price. Under the pooling method, this debit is in the amount of the book value of the acquired company. Assets are not written up from the historical cost balances reported on the investee company balance sheet, no new intangible assets are created in the acquisition, and no goodwill is reported. The avoidance of goodwill was the principle attraction of this method.

Pooling method Illustration

On December 31, Year 1, Synergy Corp. purchases 100% of Micron Company by exchanging 10,000 shares of its common stock ($5 par value,  $77 market value) for all of the common stock of Micron. 

 

On the date of the acquisition, the book value of Micron is $620,000. Synergy is willing to pay the market price of $770,000 because it feels that Micron’s property, plant, and equipment (PP&E) is undervalued by $20,000, it has an unrecorded trademark worth $30,000 and intangible benefits of the business combination (corporate synergies, market position, and the like) are valued at $100,000.