Module 6

1
Module 6

• Reporting and Analyzing Intercorporate
  Investments

2
Introduction

• Companies often engage in investment operations
  that fall outside of the direct operation of
  their primary businesses.
• These investment operations often involve the
  purchase of equity positions in other firms.
• The economic results of investment operations are
  reported in different ways, depending on the
  economic utility suggested by the level of
  investment.

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Intercorporate Investments
4
Accounting for Investments

• GAAP identifies three levels of
  influence/control
• Passive. an investor that cannot exert any
  influence over the investee company. Its goal for
  the investment is to realize dividend and capital
  gain income.
• Significant influence. In certain circumstances,
  a company can exert significant influence over,
  but not control, the activities of the investee
  company. This level of influence may result from
  the percentage of voting stock owned. It may also
  result from legal agreements, such as a license
  to use technology, a formula, or a trade secret
  like production know-how.
• Control. When a company has control over
  another, it has the ability to elect a majority
  of the board of directors and, as a result, the
  ability to affect its strategic direction and
  hiring of executive management.

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Accounting Treatment and Financial Statement
Effects
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Passive Investments -Market Method

• Initially record at purchase price (fair market
  value on purchase date)
• Gain (loss) on sale Proceeds Book value of
  investment
• During holding period, investment is recorded at
  current market value (marked-to-market)

7
Are Changes in Asset Value Income?

• Changes in the carrying amount of the investment
  (asset) has a corresponding effect on equity
• Assets ?? Liabilities Equity ??
• The central issue in the accounting for
  investments is whether this change in equity is
  reported as income.

8
Investment Classifications

• GAAP allows for two possible classification is
  equity investments
• Available-for-sale. Investments in securities
  that management intends to hold for capital gains
  and dividend income although it may sell them if
  the price is right.
• Trading. Investments in securities that
  management intends to actively trade (buy and
  sell) for trading profits as market prices
  fluctuate.

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Financial Statement Effects
10
Bond Investment Classifications

• Available-for-sale. Investments in securities
  that management intends to hold for capital gains
  and dividend income although it may sell them if
  the price is right.
• Trading. Investments in securities that
  management intends to actively trade (buy and
  sell) for trading profits as market prices
  fluctuate.
• Held-to-maturity. Investments in debt securities
  that management intends to hold until maturity.
  Since debt securities yield their face value at
  maturity, market fluctuations during intervening
  years are less relevant for this investment
  strategy.

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American Express Footnote
12
American Express Stockholders Equity
13
Held To Maturity Investments
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Equity Method Investments

• Equity Method accounting is required for
  investments in which the investor company can
  exert significant influence over the investee.
• Significant influence is the ability of the
  investor to affect the financial or operating
  policies of the investee.
• Ownership levels of 20-50 of the outstanding
  common stock of the investee company presume
  significant influence.

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Equity Method Investments

• Significant influence can also exist when
  ownership is less than 20 if, for example,
• the investor company is able to gain a seat on
  the board of directors of the investee company by
  virtue of its equity investment, or
• when the investor controls technical know-how or
  patents that are used by the investee company, or
  
• when the investor company is able to exert
  control by virtue of legal contracts between it
  and the investee company.

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Accounting for Equity Method Investments

• Investments are initially recorded at their
  purchase cost
• Dividends received are treated as a recovery of
  the investment and, thus, reduce the investment
  balance (they are not recorded as income)
• The investor reports income equal to its
  percentage share of the reported income of the
  investee the investment is increased (decreased)
  in the amount of income (loss) recorded
• The investment is not reported at market value

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Equity Method Accounting

• Assume that HP acquires a 30 interest in Mitel
  Networks. On the date of acquisition, Mitel
  reports 1,000 of stockholders equity, and HP
  purchases its 30 stake for 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 Accounting
Following are the balance sheet and income
statement impacts for the preceding transactions
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Equity Method Accounting

• Companies sometimes pay more than book value when
  acquiring equity interest in other companies.
• For example, if HP paid 400 for its 30 stake in
  Mitel, HP would
• Report its investment at its 400 purchase price
• It would increase and decrease that investment by
  30 of Mitels increases and decreases in its
  stockholders equity.
• If the 100 excess purchase cost (400-300) is
  treated as goodwill, as is common, it remains on
  HPs balance sheet without adjustment unless it
  becomes impaired
• Absent any goodwill impairment, the carrying
  amount of the investment on HPs balance sheet
  always equals 100 plus 30 of Mitels
  stockholders equity.

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Effects of Equity Method Investments on ROE
Components

• Net operating profit margin (NOPMNOPAT/Sales).
  If equity income is treated as operating (usually
  the case), NOPM is overstated due to
  nonrecognition of investee sales and recognition
  of investee income
• Net operating asset turnover (NOATSales/Avg.
  NOA). If the equity investment is treated NOPAT
  is treated as an operating asset (usually the
  case), NOAT is understated due to nonrecognition
  of investee sales and overstated by
  nonrecognition of investee assets in excess of
  the investment balance. The net effect is
  indeterminate (overstated if NOASales, and
  understated otherwise.
• Financial leverage (FLEVAvg. NFO/Avg. equity).
  Financial leverage is understated doe to
  nonrecognition of investee liabilities and
  recognition of investee equity.

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Investments with Control Consolidation
Accounting

• H-Ps footnote on consolidated entities
• Accounting for business combinations
  (acquisitions) involves one additional step to
  equity method accounting.
• Consolidation accounting replaces the investment
  balance with the assets and liabilities to which
  it relates, and it replaces the equity income
  reported by the investor company with the sales
  and expenses of the investee company to which it
  relates.

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Consolidation Accounting
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Acquired Intangible Assets

• Tangible assets and liabilities assumed are
  valued at their fair market values on the
  acquisition date. These amounts for assets and
  liabilities are initially recorded on the
  consolidated balance sheet.
• The remaining purchase price is then allocated to
  acquired identifiable intangible assets, which
  include the following
• Marketing-related assets like trademarks and
  internet domain names
• Customer-related assets like customer lists,
  production backlog, and customer contracts
• Artistic-related assets like plays, books, and
  video
• Contract-based assets like licensing and royalty
  agreements, lease agreements, franchise
  agreements, and servicing contracts
• Technology-based assets like patents, computer
  software, databases and trade secrets

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HPs Allocation of Compaq Purchase
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Consolidation with Purchase Price Above Book Value
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Impairment of Goodwill

• Goodwill recorded in the consolidation process
  has an indefinite life and is not amortized. It
  is, however, subject to annual review for
  impairment.
• This review is a two-step process.
• First, the fair market value of the investee
  company is compared with the book value of its
  associated investment account on the investors
  books. The fair market value of the investee
  company can be determined using a number of
  alternative methods, such as quoted market prices
  of comparable businesses or a discounted free
  cash flow valuation method.
• Second, if the current market value is less than
  the investment balance, goodwill is deemed to be
  impaired and an impairment loss is computed and
  recorded in the consolidated income statement.

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Goodwill Impairment Example

• Assume that an investment currently reported on
  the investor's balance sheet in the amount of 1
  million has a current fair market value of
  900,000. Further assume that the fair market
  value of the net assets of the investee company
  is 700,000 and the current value of goodwill on
  the consolidated balance sheet is 300,000. This
  indicates an impairment loss of 100,000, which
  is computed as follows

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Intels Goodwill Write-Off
29
Purchased In-Progress RD (IPRD)

• IPRD refers to the value of those acquired
  projects that have not reached technological
  feasibility at the acquisition date and for which
  no alternative uses exist. The IPRD value is
  often computed as the present value of their
  estimated (by the investor) prospective cash
  flows.
• An investor company must value the IPRD assets
  of an investee company before writing them off.
• However, there is no guidance on how to value
  IPRD.
• Hewlett-Packard, in its 24.1 billion acquisition
  of Compaq Computer, allocated 735 million to
  IPRD, which it immediately expensed in its 2002
  income statement.

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Stock Sales by Subsidiaries

• Stock sales by subsidiaries result in an increase
  in the subs stockholders equity and a
  corresponding increase in the parent companys
  investment account under equity method
  accounting.
• Under GAAP, the increase in the investment as a
  result of subsidiary IPOs can be treated either
  as a gain or as an increase in additional
  paid-in-capital.

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Stock Sales by Subsidiaries

• Reported as a gain
• Reported as an increase in paid-in capital

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Limitations of Consolidated Financial Statements

• Consolidation income does not imply that cash is
  received by the parent company
• Comparisons across companies are often
  complicated by the mix of subsidiaries included
  in the financial statements
• Segment profitability can be affected by
  intercorporate transfer pricing and allocaiton of
  overhead

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Pooling Accounting for Business Combinations

• Prior to 2001, companies had a choice in their
  accounting for business combinations. They could
  use the purchase method as described in this
  module, or they could use the pooling-of-interests
  (pooling) method.

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Pooling Accounting for Business Combinations

• The main difference between the pooling and
  purchase methods is in the amount recorded as the
  initial investment in the acquired company.
• Under the purchase method, as we showed, the
  investment account is recorded at the fair market
  value of the acquired company on the date of
  acquisition.
• Under the pooling method, this account is
  recorded using the book value amounts from the
  acquired company.
• As a result, no goodwill is created. Further,
  since goodwill amortization was required under
  previous GAAP, subsequent income was larger under
  pooling because no amortization arose.
• This feature spawned the widespread use of
  pooling, especially for high tech companies.

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Pooling Accounting for Business Combinations

• Acquisitions previously accounted for under
  pooling remain unaffected under current GAAP.
  Accordingly, we must be aware of at least two
  effects
• Assets were usually understated when using
  pooling since investee companies were recorded at
  book rather than market value. This means that
  such companies asset turnover ratios are
  overstated.
• Incomes of companies using pooling were nearly
  always overstated due to the elimination of
  goodwill amortization. This continues to create
  difficulties for comparisons across companies
  that applied different accounting methods.