Ifsa Chapter15

CHAPTER 15
INTERCORPORATE INVESTMENTS
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INTERCORPORATE INVESTMENTS
Intercorporate investments include investments in the debt and

equity securities of other companies.
Reasons for investing in other companies:
- To achieve additional profitability.
- To enter new markets through companies established in those areas.
- To diversify.
- To obtain competitive advantages.
The classification of intercorporate investments is based on the degree
of influence or control that the investor is able to exercise over the
investee.
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CLASSIFYING INTERCORPORATE INVESTMENTS
Investments are classified into four categories based on the degree of

influence or control:
Investments in financial assets (ownership percentage < 20%):
Investments in which the investor has no significant control over the
investee.
Investments in associates (ownership percentage between 20% and
50%): Investments in which the investor has significant influence but
not control over the investee.
Business combinations (ownership percentage > 20%):
Investments in which the investor has control over the investee.
Joint Venture: An entity operated by companies that share control.

ACCOUNTING FOR
INVESTMENTS IN FINANCIAL ASSETS
Type Intent Accounting Treatment
Has intent and ability to Reported at amortized cost.

Held to maturity
hold the debt until it Changes in value ignored unless
(for debt securities)
matures. deemed as impaired.
Does not intend to sell in

Recorded at fair value.
the near term, elect fair
Available for sale Changes in value are recognized
value accounting, or hold
in other comprehensive income.
until maturity.
Held for trading

Intends to sell in the near Recorded at fair value.
and
term (i.e., held for trading ) Changes in value are recognized
those designated as fair
or has otherwise elected in profit or loss on income
value through profit or
fair value accounting. statement.
loss

ACCOUNTING FOR
INVESTMENTS IN FINANCIAL ASSETS
Both IFRS and U.S. GAAP permit reclassification of intercorporate
investments, although certain criteria must be met.
- IFRS generally prohibit the reclassification into or out of the designated at fair
value category, and reclassification out of the held for trading category is
severely restricted.
- U.S. GAAP allow reclassifications between all categories using fair value at
the date of reclassification.
Impairment occurs when the carrying value of a financial asset is expected to

permanently exceed the recoverable amount.
- Regardless of classification, a loss will be recorded on the income statement
in the period impairment occurs.
- For available-for-sale securities that have become impaired, the cumulative
loss that had been recognized in other comprehensive income (OCI) will be
reclassified from equity to profit or loss.

INVESTMENTS IN FINANCIAL ASSETS: EXAMPLE
On 1 January 2008, Baxter Inc. invested 300,000 in Cartel Co. debt securities
(with a 6% stated rate on par value, payable each 31 December). The par value
of the securities was 275,000. On 31 December 2008, the fair value of Baxters
investment in Cartel is 350,000.
Assume the market interest rate when the bonds were purchased was 4.5%. If the
investment is designated as held to maturity, the investment is reported at
amortized cost using the effective interest method. A portion of the amortization
table is as follows:
End of Interest Interest Carrying
Year Payment Income Amortization Value
0 300,000
1* 16,500 13,500 3,000 297,000
2 16,500 13,365 3,135 293.865
3 16,500 13,224 3,276 290,589
*6% Par value (275,000) = 16,500; 4.5% Carrying value (300,000) =
13,500

1. How would this investment be reported on the financial statements at 31
December 2008 under either IFRS or U.S. GAAP (accounting is essentially the
same in this case) if Baxter designated the investment as (1) held-to-maturity,
(2) held for trading, (3) available-for-sale, or (4) designated at fair value?
Statement of
Income Statement Balance Sheet Owners Equity
Held-to- Reported at amortized
maturity Interest income: 13,500 cost: 297,000 No effect
Interest income: 13,500
Held for and 53,000 unrealized gain Reported at fair value: No effect
trading recognized through profit 350,000
53,000
Reported at fair value: unrealized gain
Available- Interest income: 13,500 350,000 (net of tax)
for-sale reported as OCI
Interest income 13,500 Reported at fair value:
Designated and 53,000 unrealized gain 350,000 No effect
at fair value recognized through profit

2. How would the gain be recognized if the debt securities were sold on
1 January 2009 for 352,000?
Held-to-maturity 352,000 297,000 = 55,000
Fair value through profit or loss 352,000 350,000 = 2,000

(held for trading)
Available-for-sale (352,000 350,000) + 53,000

(removed from OCI) = 55,000
3. How would this investment appear on the balance sheet at

31 December 2009?
If the investment was held-to-maturity, the reported amount at amortized cost
on the balance sheet would be 293,865.
If it was classified as either held for trading, available-for-sale, or designated at
fair value, it would be reported at its fair value at 31 December 2009.

ACCOUNTING FOR
INVESTMENTS IN ASSOCIATES
The equity method is used to account for investments in associates.
To qualify, a company must have significant influence over the
investee. Significant influence is presumed with 2050% ownership,
but exceptions can be made based on other indicators of influence,
including
- Representation on the board of directors
- Participation in policymaking
- Material transactions between companies
- Interchange of management
- Technological dependency
Because of this influence, it is presumed that the investees income is
at least partially attributed to the influence of the investor. As such, the
investor recognizes a proportionate amount of investees income.

EQUITY METHOD
The investors share of the investees income and dividends is

recognized on the income statement.
The investment is classified as noncurrent on the balance sheet. It is
recorded at cost plus the investors share of post-acquisition income
less any dividends paid.

EQUITY METHOD: EXAMPLE
Branch Inc. purchases a 20% interest in Williams Inc. for 200,000 on 1
January 2008. Williams reports income and dividends as follows:
Income Dividends
2008 200,000 50,000
2009 300,000 100,000
2010 400,000 200,000
900,000 350,000
Calculate the investment in Williams that appears on Branchs balance

sheet as of the end of 2010:
200,000 + 20% (900,000 350,000) = 310,000

INVESTMENTS IN ASSOCIATES:
WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE
When investment costs exceed the investors proportionate share of the

investees net identifiable assets, the difference is allocated to the
following:
- Any specific assets whose fair values exceed book values. These
amounts are then amortized over the useful life of these specific
assets.
- Any remaining difference between the investment cost and the fair
value of net identifiable assets that cannot be allocated to specific
assets is treated as goodwill.
- Goodwill is not amortized; it is checked for impairment annually.

WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE:
EXAMPLE
Assume that Blake Co. acquires 30% of the outstanding shares of Brown Co.
At the acquisition date, information on Browns recorded assets and liabilities is
as follows:
Book Value Fair Value
Current assets 10,000 10,000
Plant and equipment 190,000 220,000
Land 120,000 140,000
320,000 370,000
Liabilities 100,000 100,000
Net assets 220,000 270,000
Blake Co. believes the value of Brown Co. is higher than the fair value of its
identifiable net assets. They offer 100,000 for a 30% interest in Brown Co.
Calculate goodwill.

WHEN INVESTMENT COSTS > BOOK VALUE OF INVESTEE:
EXAMPLE
Purchase price 100,000

30% of book value of Brown (30% 220,000) 66,000
Excess purchase price 34,000
Attributable to net assets:
Plant and equipment (30% 30,000) 9,000
Land (30% 20,000) 6,000
Goodwill 19,000
34,000

FAIR VALUE OPTION AND IMPAIRMENT
Fair value option: The option at the time of initial recognition to record
an equity method investment at fair value.
- Under IFRS, only venture capital firms may opt for fair value.
- Under U.S. GAAP, the fair value option is available to all entities.
Equity method investments need periodic reviews for impairment.
- Under IFRS, an impairment is recorded only if there is objective
evidence that one (or more) loss event(s) has occurred since the
initial recognition and that loss event has an impact on the
investments future cash flows, which must be reliably estimated.
- U.S. GAAP take a different approach. An impairment must be
recognized if the fair value of the investment falls below its carrying
value and if the decline is considered permanent.

TRANSACTIONS WITH ASSOCIATES
An investor company can influence the terms and timing of transactions

with its associates. Thus, the investor companys share of any profits
resulting from transactions with associates must be deferred until the
transactions are confirmed with a third party.
- In an upstream sale, the investee sells goods to the investor.
- In a downstream sale, the investor sells goods to the investee.
- Regardless of directions, IFRS and U.S. GAAP require the
elimination of profits to the extent of the investors ownership of the
investee.

JOINT VENTURE
A joint venture can be a convenient way to enter foreign markets,

conduct specialized activities, and engage in risky projects.
Joint ventures are defined differently under IFRS and U.S. GAAP.
Under IFRS:
- Three types of joint ventures: jointly controlled operations, jointly
controlled assets, and jointly controlled entities.
- Proportionate consolidation is the preferred accounting treatment.
It requires the venturers share of assets, liabilities, income, and
expenses of the joint venture to be combined on a line-by-line basis.
Under U.S. GAAP:
- Joint venture refers only to jointly controlled separate entities.
- Requires the use of the equity method to account for joint ventures.

ACCOUNTING FOR JOINT VENTURE
Because the single line item on the income statement under the equity
method reflects the net effect of the sales and expenses of the joint
venture, the total income recognized is identical under the equity
method and proportionate consolidation.
Similarly, because the single line item on the balance sheet item
(investment in joint venture) under the equity method reflects the
investors share of the net assets of the joint venture, the total net
assets of the investor is identical under both methods.
But there can be significant differences in ratio analysis between the
two methods because of the differential effects on values for total
assets, liabilities, sales, expenses, and so on.

EQUITY METHOD VS.
PROPORTIONATE CONSOLIDATION: EXAMPLE
Company A Venturer
Joint Equity Proportionate
Venture Method* Consolidation
Income Statement
Sales 400000 1000000 1200000
Equity in joint venture income 60,000
Cost of sales 200,000 500,000 600,000
Other expenses 80,000 240,000 280,000
Net income 120000 320000 320000
Balance Sheet
Cash 40000 400000 420000
Inventory 500,000 500,000
Investment in joint venture 450,000
Other assets 1,160,000 1,500,000 2,080,000
1200000 2850000 3000000
Accounts payable 200000 200000
Long-term debt 300000 1,650,000 1,800,000
Capital stock 600,000 600,000
Retained earnings 400,000 400,000
Venturers equity (Companies A and B) 900,000
1200000 2850000 3000000

EQUITY METHOD VS.
PROPORTIONATE CONSOLIDATION: EXAMPLE
Equity Proportionate
Method Consolidation
Net profit margin 32.0% 26.7%
Return on assets 11.2% 10.7%
Debt/Equity 1.65 1.80
Analysts will observe differences in performance ratios based on the

accounting method used for joint ventures.
IFRS prefer proportional consolidation because it more effectively
conveys the economic scope of an entitys operation when those
operations include interests in one or more jointly controlled entities.

BUSINESS COMBINATIONS
Business combinations involve the combination of two or more entities

into a larger economic entity. They are motivated by expectations of
added value through synergies.
Types of business combinations
- Under IFRS, there is no distinction among business combinations
based on the resulting structure of the larger economic entity.
- Under U.S. GAAP, business combinations are categorized as merger,
acquisition, or consolidation based on the structure after the
combination.

ACCOUNTING FOR BUSINESS COMBINATIONS
IFRS and U.S. GAAP now require that all business combinations be accounted
for using the acquisition method.
- Identifiable assets and liabilities of the acquired company are measured at
fair value on the date of the acquisition.
- Assets and liabilities that were not previously recognized by the acquiree
must be recognized by the acquirer.
- At the acquisition date, the acquirer can reclassify the financial assets and
liabilities of the acquiree (e.g., from trading security to available for sale
security).
- Goodwill is recognized as
- Partial goodwill under IFRS: the difference between purchase price and
the acquirers share of acquirees assets and liabilities.
- Full goodwill under U.S. GAAP: the difference between total fair value of
the acquiree and fair value of the acquirees identifiable net assets.

ACCOUNTING FOR BUSINESS COMBINATIONS
Noncontrolling interests are shown as a separate component of equity

on the balance sheet and a separate line item in the income statement.
IFRS and U.S. GAAP differ on the measurement of noncontrolling
interest:
- Under IFRS, the value of the noncontrolling interest is either its fair
value (full goodwill method) or the noncontrolling interests
proportionate share of the acquirees identifiable net assets (partial
goodwill method).
- Under U.S. GAAP, the parent must use the full goodwill method and
measure the noncontrolling interest at fair value.

100% ACQUISITION: EXAMPLE
Franklin Co. acquired 100% of Jefferson, Inc. by issuing 1,000,000 shares of its
1 par common stock (15 market value). Immediately before the transaction,
the two companies had the following information:
Franklin Book Jefferson Book Jefferson Fair

Value (000) Value (000) Value (000)
Cash and receivables 10000 300 300
Inventory 12,000 1,700 3,000
PP&E (net) 27,000 2,500 4,500
49000 4500 7800
Current payables 8,000 600 600
Long-term debt 16,000 2,000 1,800
24,000 2,600 2,400
Net assets 25000 1900 5400
Shareholders equity:
Capital stock (1 par) 5000 400
Additional paid in capital 6,000 700
Retained earnings 14000 800
Show the postcombination balance sheet using the acquisition method.

100% ACQUISITION: EXAMPLE
The postacquisition balance sheet of the combined entity:

Franklin Consolidated Balance Sheet ( thousands)
Cash and receivables 10,300

Inventory 15,000
PP&E (net) 31,500
Goodwill 9,600
Total assets 66,400
Current payables 8,600
Long-term debt 17,800
Total liabilities 26,400
Capital stock (1 par) 6,000
Additional paid in capital 20,000
Retained earnings 14,000
Total stockholders equity 40,000
Total liabilities and stockholders equity 66,400

LESS THAN 100% ACQUISITION: EXAMPLE
On 1 January 2009, Parent Co. acquired 90% of Subsidiary Co. in exchange

for shares of Parent Co.s no par common stock with a fair value of 180,000.
The fair market value of the subsidiarys shares on the date of transaction was
200,000. Below is selected financial information from the two companies
immediately before the parent recorded the acquisition:
Subsidiary
Parent Book
Value Book Value Fair Value
Cash and receivables 40,000 15,000 15,000
Inventory 125,000 80,000 80,000
PP&E (net) 235,000 95,000 155,000
400,000 190,000 250,000
Payables 55,000 20,000 20,000
Long-term debt 120,000 70,000 70,000
175,000 90,000 90,000
Net assets 225,000 100,000 160,000
Shareholders equity:
Capital stock (no par) 87,000 34,000
Retained earnings 138,000 66,000

1. Calculate the value of PP&E (property, plant, and equipment) on the

consolidated balance sheet under both IFRS and U.S. GAAP.
235,000 + 155,000 = 390,000
2. Calculate the value of goodwill and the value of the noncontrolling

interest at the acquisition date under the full goodwill method.
Fair value of subsidiary 200,000
Fair value of subsidiarys identifiable net assets 160,000
Goodwill 40,000
The value of noncontrolling interest = 10% 200,000 = 20,000

3. Calculate the value of goodwill and the value of the noncontrolling

interest at the acquisition date under the partial goodwill method.
Purchase price 180,000
90% of fair value of subsidiarys identifiable net
assets 144,000
Goodwill 36,000
Value of noncontrolling interest = 10% 160,000 = 16,000

MORE ON GOODWILL
Because the full goodwill method and the partial goodwill method
result in different total assets and stockholders equity, the impact of
these methods on financial ratios would differ.
Goodwill is not amortized, but it is tested for impairment.
- Under IFRS, goodwill is impaired when the recoverable value of a
business unit is below the carrying value (one-step approach).
- Under U.S. GAAP, goodwill is impaired when the carrying value of
a business unit exceeds its fair value. The amount of impairment
loss is the difference between the implied fair value of the reporting
units goodwill and its carrying amount (two-step approach).

VARIABLE INTEREST AND
SPECIAL PURPOSE ENTITIES
A VIE (variable interest entity) or SPE (special purpose entity) is an

enterprise that is created to accommodate specific needs of the
sponsoring entity. It may be used to securitize receivables, lease
assets, and so on.
In the past, sponsors were able to avoid consolidating SPEs on their
financial statements because they did not have control (i.e., own a
majority of the voting interest) of the SPE.
By avoiding consolidation, sponsors did not have to report the assets
and the liabilities of the SPE; financial performance as measured by
unconsolidated financial statements was potentially misleading. The
benefit to the sponsoring company was improved asset turnover, lower
operating and financial leverage, and higher profitability.

VARIABLE INTEREST AND
SPECIAL PURPOSE ENTITIES
Under IFRS, a SPE must be consolidated if the substance of the

relationship indicates control.
Under U.S. GAAP, the primary beneficiary of a VIE (which is often the
sponsor) must consolidate it as its subsidiary regardless of how much
of an equity investment it has in the VIE.
- VIE, a more general term than SPE, refers to an entity that is
financially controlled by one or more parties that do not hold a
majority voting interest.

SPE: EXAMPLE
Odena wants to raise 55 million in capital by borrowing against its financial

receivables. To accomplish this objective, Odena can choose between the
following:
- Alternative 1: Borrow directly against the receivables
- Alternative 2: Create a SPE, invest 5 million in the SPE, have the SPE
borrow 55 million, and then use the funds to purchase 60 million of
receivables from Odena.
Using the financial information provided, describe the effect of each
alternative on Odena, assuming Odena will not have to consolidate the
SPE.

SPE: EXAMPLE
Odena Balance Sheet Alternative 1 Alternative 2

Cash 30000000 85000000 85000000
Accounts receivable 60,000,000 60,000,000 0
Investment in SPE 5,000,000
Other assets 40,000,000 40,000,000 40,000,000
Total assets 130000000 185000000 130000000
Current liabilities 27000000 27000000 27000000
Non-current liabilities 20,000,000 75,000,000 20,000,000
Total liabilities 47000000 102000000 47000000
Shareholder equity 83000000 83000000 83000000
Total liabilities and equity 130000000 185000000 130000000
Current ratio 3.33 5.37 3.15
Long-term debt to equity 0.24 0.9 0.24
Equity to total assets 0.64 0.44 0.64

SUMMARY OF ACCOUNTING TREATMENT
FOR INTERCORPORATE INVESTMENTS
Joint
Type Financial Assets Associates Combinations
Ventures
Influence None/Little Significant Controlling Shared
Typical ownership % < 20% 20%50% > 50% Varies
Depends on the intent:
Held-to-maturity (debt
only): amortized cost
Equity
Held for trading:
method
fair value, changes (U.S. GAAP & IFRS)
recognized in P/L Equity
Accounting treatment Consolidation or
method
Available-for-sale: proportionate
Fair value, changes consolidation
recognized in equity (IFRS Only)
Designated at fair value:

fair value, changes
recognized in P/L

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CHAPTER 15

Intercorporate investments include investments in the debt and

Copyright 2013 CFA Institute 2

Investments are classified into four categories based on the degree of

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Type Intent Accounting Treatment

Has intent and ability to Reported at amortized cost.

Does not intend to sell in

Held for trading

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Impairment occurs when the carrying value of a financial asset is expected to

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Fair value through profit or loss 352,000 350,000 = 2,000

Available-for-sale (352,000 350,000) + 53,000

3. How would this investment appear on the balance sheet at

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The investors share of the investees income and dividends is

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Calculate the investment in Williams that appears on Branchs balance

200,000 + 20% (900,000 350,000) = 310,000

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When investment costs exceed the investors proportionate share of the

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Purchase price 100,000

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An investor company can influence the terms and timing of transactions

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A joint venture can be a convenient way to enter foreign markets,

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Analysts will observe differences in performance ratios based on the

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Business combinations involve the combination of two or more entities

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Noncontrolling interests are shown as a separate component of equity

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Franklin Book Jefferson Book Jefferson Fair

Show the postcombination balance sheet using the acquisition method.

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The postacquisition balance sheet of the combined entity:

Cash and receivables 10,300

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On 1 January 2009, Parent Co. acquired 90% of Subsidiary Co. in exchange

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1. Calculate the value of PP&E (property, plant, and equipment) on the

2. Calculate the value of goodwill and the value of the noncontrolling

The value of noncontrolling interest = 10% 200,000 = 20,000

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3. Calculate the value of goodwill and the value of the noncontrolling

Value of noncontrolling interest = 10% 160,000 = 16,000

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A VIE (variable interest entity) or SPE (special purpose entity) is an

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Under IFRS, a SPE must be consolidated if the substance of the

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