978-0078025679 Chapter 16 Lecture Note

Financial Reporting and Analysis 6e Intercorporate Equity Investments

CHAPTER 16

INTERCORPORATE EQUITY INVESTMENTS

CHAPTER OVERVIEW

Financial reporting for intercorporate equity investments depends upon the degree to which the

investor is able to influence the investee’s operating decisions. Proportionate share size is a

presumptive factor used to infer an investor’s influence over an investee.

When the ownership share is less than 20%, it is presumed that the investor cannot exert influence on

the decisions of the investee. These minority passive investments are shown at fair value on the balance

sheet. Unrealized gains or losses on the trading portfolio go through the income statement, and unrealized

gains and losses on the available–for-sale portfolio are recorded as a component of other comprehensive

income (OCI), which is closed out to a special stockholders’ equity account, Accumulated Other

Comprehensive Income (AOCI). Other than temporary impairments of available-for–sale and held–to–

maturity securities are recorded as an adjustment to net income. Minority active investments generally

involve between 20% and 50% ownership. Investment at this level presumably conveys the ability to

influence investee’s operating decisions significantly—and thus, the equity method is used to account

for such investments whereby the investor records its proportionate share of the investee’s profits and

losses, net of any excess cost amortization, with a corresponding adjustment to the investment account.

GAAP allows firms to elect the fair value option for equity investments. Unrealized gains and losses

resulting from fair value changes are reported on the investor’s income statement. Full consolidation is

required when ownership in voting common stock exceeds 50% in a subsidiary. Prior to July 1, 2001,

the purchase and pooling–of-interests methods were used to account for business combinations. From

that date through 2008, only the purchase method was allowed. Beginning in 2009, the acquisition

method must be used to account for all business combinations. The key differences between these three

methods are: (1) how to measure the subsidiary’s net assets (assets minus liabilities) at the acquisition

date, (2) the amount of goodwill recognized, and (3) how the noncontrolling (minority) interests are

measured and reported on the consolidated balance sheet.

Accounting goodwill is recorded under the acquisition and purchase methods and this intangible

asset may be written down using the impairment test approach based on an annual impairment test. If

goodwill is determined to be impaired, it is written down with an offsetting charge to consolidated

earnings.

The acquisition and purchase methods of accounting complicate financial analysis because none of

the subsidiary’s profit is included in consolidated earnings in the year prior to acquisition, a partial

year’s profit is included from the date of acquisition to the end of the year in the acquisition year, and

100% of the subsidiary’s profits are included in the years following the year of acquisition. This

approach distorts the year–to–year growth rates in sales and profits.

Enron’s collapse brought about a demand for increased disclosure and transparency regarding

companies’ interests in variable interest entities (VIE). A VIE is a corporation, partnership, trust, or any

other legal structure used for business purposes that either (1) does not have equity investors with voting

rights or (2) has equity investors that do not provide sufficient financial resources for the entity to

support its own activities. GAAP requires that variable interest entities (VIE) be consolidated with the

parent company if that company has the power to direct the significant economic activities of the VIE

and is subject to a majority of the risk of loss (or to receive a majority of the benefits) from the VIE’s

activities. A company that consolidates a VIE is called that entity’s primary beneficiary.

Majority-owned foreign subsidiaries also need to be consolidated. Doing so requires that foreign

currency amounts be remeasured in U.S. dollars. Foreign subsidiaries that are mere extensions of the

U.S. parent with no self-sufficiency are remeasured using the temporal method. The temporal method

treats the subsidiaries’ business transactions as if they had been undertaken by the parent, but in the

foreign currency. Foreign subsidiaries that are freestanding economic units are remeasured using the

current rate method. This method provides an easy way to re-express foreign currency amounts in

Financial Reporting and Analysis 6e Intercorporate Equity Investments

dollars while still maintaining the proportionality of most of the subsidiary’s financial ratios.

There are a number of important differences between IFRS and U.S. GAAP such as (1) measuring

and reporting of financial assets; (2) how non–controlling interests are measured on consolidated

statements; (3) determining when SPEs or VIEs must be consolidated; and (4) accounting treatment for

joint ventures.

A recent FASB exposure draft on financial instruments would, if adopted, substantially change the

classification, measurements and impairment accounting for several categories of financial assets.

CHAPTER OUTLINE

I. MINORITY PASSIVE INVESTMENTS: FAIR VALUE ACCOUNTING

A. Minority passive investments are those in which the shareholder has no ability to

influence the company’s operating policies or elect directors. Ownership of less than 20% of voting

shares constitutes a passive investment. Such investments are accounted for in one of two ways:

1. Trading securities are actively managed to achieve trading gains.

a. Investments in trading securities are initially recorded at cost.

b. Any dividends on these securities are recorded as income when declared.

c. Trading securities are reported as current assets and measured at fair value (often

referred to as mark-to-market) on each balance sheet date.

i. The total market price of all trading securities is compared to the total cost of

the securities, with the difference becoming the target balance for the fair value

adjustment account,

ii. The fair value adjustment account is increased with a debit (or decreased with

a credit) to equal its target balance and an unrealized gain (or loss) is recorded

for the same amount,

iii. Comparing the portfolio fair value to the cost of the underlying shares at

each valuation date allows for changes in the number of shares at

successive valuation dates.

d. When trading securities are sold, the realized gain or loss is recorded.

i. The amount of the realized gain or loss is the sale price of the securities

minus the fair value of the securities on the last balance sheet date..

ii. The original cost of the securities sold and the related portion of the fair

value adjustment account are removed from the accounts.

2. Available-for-sale securities are acquired because of their perceived longer-term

investment potential—not for short-term speculation purposes.

a. These securities are (usually) classified as noncurrent investments on the balance

sheet and measured at fair value.

b. The entries to record the purchase, dividend, and fair value adjustment for

available-for-sale securities are similar to the entries for trading securities.

c. The only significant difference between treating investment securities as “available–

for-sale” rather than “trading” is that the fair value (mark-to-market) adjustment is

not included in income. Instead, the upward or downward adjustment to reflect fair

value for available-for-sale securities results in a direct credit or debit to a special

owners’ equity account.

i. These unrealized gains or losses on available-for-sale securities are one of the

“other comprehensive income” components described in Chapter 2.

ii. GAAP excludes unrealized gains and losses on available-for-sale securities from

earnings because the securities are not held for active trading thus alleviating

the potential for earnings volatility unrelated to eventual investment

performance.

iii. The cumulative unrealized gain or loss is realized and recognized in income

Financial Reporting and Analysis 6e Intercorporate Equity Investments

when available-for-sale securities sold.

B. Income Tax Effects: Fair value adjustment yield tax consequences since tax laws allow

recognition of gains and losses only when securities are sold. Tax effects are deferred

otherwise.

1. For available-for-sale securities, the tax effect is automatically deferred since the gain/loss

is not reported on the income statement but rather in comprehensive income until the

security is sold.

2. These tax deferments result in a temporary difference.

C. Other-Than-Temporary Impairment of Available-for-Sale Equity Investments:

1. Other-than-temporary impairments of investments are reported directly in income

rather than as part other comprehensive income. This applies to all three classes of

investments – trading, available-for-sale, and held-to-maturity debt securities.

II. MINORITY ACTIVE INVESTMENTS: EQUITY METHOD

A. Minority active investments are those in which an investor’s stock ownership percentage in another

company is large enough to be able to exert shareholder influence.

1. GAAP presumes two things:

a. A significant ownership position like 20% implies that the investor has the

capability to exert influence over the investee’s operating and financing decisions.

b. A substantial ownership percentage implies a continuing relationship between the

two companies since investments of this magnitude are usually made to achieve

some long-run strategic objective.

c. A 20% threshold is only a guide since it is possible to exert influence even with a less-

than 20% ownership level.

3. To preclude earnings manipulation, minority active investments are accounted for using

the equity method.

a. Under the equity method, the investor records the investment in the investee at cost.

b. Subsequently, the investment account is increased (decreased) for the pro rata share

of the investee’s net income (loss) with a corresponding credit (debit) to the

investment income (loss) account.

c. Dividends from the investee are recorded as an increase (debit) to cash—or

dividends receivable—and a decrease (credit) to the investment account.

4. Under the equity method, the carrying amount in the investment account at any point in

time is comprised of the initial investment amount plus the investor’s pro-rata share of the

investee’s income minus the investor’s pro-rata share of the investee’s dividends

declared.

a. In contrast to treatment of balance sheet amounts for minority passive investments,

the carrying amount under equity method accounting is not at fair value (mark-to–

market).

b. The reason is that a substantial ownership percentage implies some long-term

strategic intent, so the sale of the investment is not imminent, and fair value is

presumably less important to statement readers.

5. An informed buyer may pay more than book value for two reasons:

a. The current value of the investee’s balance sheet items may exceed their historical

cost.

b. Goodwill may exist because thriving, successful companies are frequently worth more

than the sum of their individual net assets.

6. When Cost and Book Value Differ – when the cost of the shares exceeds the underlying

book value at the acquisition date, the investor is required to amortize any excess that is

attributable to (1) inventory or (2) depreciable assets.

a. Amortization is recorded as a reduction (debit) to investment income and a reduction

(credit) to the investment account.

Financial Reporting and Analysis 6e Intercorporate Equity Investments

b. The rationale for amortizing the excess of the investor’s cost over book value is

based on the matching principle.

c. According to current GAAP, goodwill is not amortized but is tested for impairment.

7. Fair Value Option for Equity Method Investments – Firms that would employ the

equity method in cases where they later do not have controlling interest may instead

elect to switch to fair value of reporting these investments.

a. This is an irrevocable election and must be elected on specific dates.

b. Under the f air value op tion, unr ealized ga ins/losses aris ing from cha nges in the

investment’s fair value are reported in the investor’s income statement.

c. Assets and liabilities measured at fair value must be reported in the balance sheet

separately from other investments.

III. CONTROLLING (MAJORITY) INTEREST: CONSOLIDATION

A. When the investor owns a controlling financial interest (acquirer or parent), generally

deemed to occur when more than 50% of the voting shares of the investee (subsidiary) are

owned directly or indirectly, the financial statements of the investee are combined—line by

line—with those of the investor, using a process called consolidation.

1. When control exists, the two companies are really one in an economic sense.

2. Consolidated financial statements are designed to cut across artificial corporate

boundaries to portray the economic activities of the parent and subsidiary as one entity.

3. The process for preparing consolidated financial statements has undergone major changes

where the acquisition method has replaced the purchase method.

B. Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)

The acquisition method assigns the fair value of the consideration given to the acquired

entity’s identifiable net assets (assets minus liabilities) at the acquisition date. If the

consideration given exceeds the fair value of the acquired entity’s identifiable net assets,

then goodwill is recognized. Therefore, the purchase price will consist of the recorded book

value of the investee’s net assets, the unrecorded difference between the fair value and book

value of the investee’s net assets, and the unrecorded book value of the investee’s goodwill.

1. This purchase price breakdown explains why we do not add the two balance sheets

together to get the consolidated balance sheet.

a. Adding the two balance sheets together would double-count the book value of the

investee’s net assets.

b. The full purchase price is already on the investor’s balance sheet, and this amount

includes all three components of the purchase price listed in #1 above.

c. To avoid double–counting, the book value of the investee’s net assets is removed

from the investor’s investment account, leaving only the unrecorded difference

between the fair value and book value of the investee’s net assets, and the

unrecorded book value of the investee’s goodwill in the investment account.

C. Adjustments to the Consolidated Balance Sheet –

1. Elimination the Investment Account: The remaining balance in the investment account

must be assigned to the items they represent: (1) an increase to current and long-term

assets, and (2) the acquisition of goodwill.

2. Reclassification of the Remainder of the Investment Account: After these adjustments,

the investment account has been eliminated and thus does not appear in the consolidated

balance sheet.

3. The process above is solely for the purpose of preparing consolidated statements since the

adjustments are not recorded on the books of the acquirer (parent company).

D. Analysis of stockholder equity accounts:

1. If the stockholder equity accounts of the parent and subsidiary were simply added together,

Financial Reporting and Analysis 6e Intercorporate Equity Investments

ownership of the investee would be counted twice.

2. To avoid this double-counting, the equity of the investee is eliminated in preparing the

consolidated balance sheet.

E. Other consolidation adjustments:

1. Intra-entity Loans must be eliminated since the investor and the investee are part

of the same economic unit.

a. The loan amount is not payable to (or receivable from) outsiders.

b. To include the intra-entity receivable and payable in the consolidated balance

sheet would overstate assets and overstate liabilities.

F. Acquisition Method with Noncontrolling Interests (Less Than 100% Acquisition)

1. The Consolidation Topic (ASC 810) embraces the economic unit concept of

consolidation.

2. This method requires the subsidiary to be valued at business fair value as a whole at

acquisition date even if the parent acquires less than 100% of the subsidiary. This means

the subsidiary’s individual accounts should not be divided and measured differently along

ownership lines. Based on this view, a controlled company must be consolidated as a

whole at business fair value regardless of the parent’s level of ownership.

G. Income Statement Consolidation –

1. Another frequently encountered consolidation adjustment arises when the investor and

investee make sales to one another. These must be eliminated as well so that only revenues

realized from outsiders and costs paid to outsiders are reflected.

2. An allocation of the noncontrolling interest’s share of net income should also be done.

3. Accounting for Goodwill – Goodwill is valued at full fair value. It is not amortized but is

tested for impairment (at least annually) and written down if it found to be impaired.

a. The first step is to determine the fair value of the reporting unit using stock price, or

some combination of other methods, including the discounted cash flow model,

comparable multiple, etc. If the book value of a reporting unit’s net assets exceed their

fair value, goodwill is initially considered as impaired.

b. The second step establishes the amount of the impairment charge. The impairment

charge is the difference between the goodwill recorded on the balance sheet and the

implied goodwill.

IV. PREVIOUS APPROACHES TO CONSOLIDATED STATEMENTS

G. Several changes have taken place in consolidation of financial statements in recent past.

Although only the acquisition method is currently permitted, transactions originally accounted

for under either the purchase or the pooling methods continue to be accounted for under those

methods depending on when the parent acquired the subsidiary.

A. The Purchase Method – Noncontrolling (minority) interest is created when a parent company

owns less than 100% interest in a subsidiary.

1. The parent’s acquisition cost is allocated only to the acquired percentage of the subsidiary

assets and liability accounts – subsidiary’s assets and liabilities are valued at the parent’s

proportional interest in the net asset fair values plus the noncontrolling interest in the book

value of the subsidiary’s net assets at the acquisition date.

2. The noncontrolling interest equity is reported as the proportionate share of the subsidiary’s

book value of net assets.

3. Goodwill is only recognized for the controlling interest portion.

portion of earnings assigned to noncontrolling shareholders is deducted from the total

combined earnings to arrive at consolidated net income.

4. Direct combination costs are capitalized on the consolidated balance sheet.

5. Contingent consideration – accounted for as postcombination adjustments to the purchase

Financial Reporting and Analysis 6e Intercorporate Equity Investments

price.

6. Bargain purchases – When a bargain purchase occurs, the asset values are not adjusted and

a gain on the bargain purchase is recorded on the acquisition date.

7. Acquired in-process research and development – Intangible assets related to research and

development must be measured at fair value at date of acquisition and recognized on the

consolidated balance sheet as intangible assets with indefinite lives subject to impairment

rules.

B. The Pooling of Interests – Even though a significant number of combinations were

accounted for as poolings prior to 2001, the effects of this treatment will be found in financial

statements for years to come. Reporting rules treat the two formerly independent companies as

though they have decided to join resources and “keep house together.” No buyout is

considered to have taken place.

1. Intra-entity transactions and double-counted items must be eliminated.

2. The only elimination is to the Investment in Subsidiary account. No other adjustments or

reclassifications are needed because the Investment Account equals the subsidiary’s net book

value of equity.

3. No write-up of assets or recognition of goodwill.

C. Financial Analysis – Acquisition Method and Purchase Methods –

1. The disclosure rules for business combinations accounted for under the acquisition or

purchase methods complicate financial analysis.

a. Trend analysis becomes difficult because comparative financial statements are not

retroactively adjusted to include data for the acquired company for periods prior to

the acquisition.

b. To aid inter-period comparisons, existing disclosure rules require a pro forma—

meaning as if–—footnote that provides information for key income statement items as

if the acquisition had taken place on the first day of the earliest year for which

comparative data are shown.

i. Notice that these pro forma data do not encompass all income statement items

and do not include periods prior to the earliest year for which comparative data

is shown.

ii. Consequently, even with the supplemental disclosure, it is usually not possible

for analysts to make comparisons of complete income statements adjusted for

the acquisition.

iii. If the acquired company is large in relation to the size of the acquirer, serious

distortions exist in trends and other comparative data derived from the

consolidated financial statements.

2. When a business combination is accounted for as a pooling of interests, this comparability

problem does not arise since all past financial statement data are retroactively consolidated

to include both parties to the combination.

D. Financial Analysis Issues – Acquisition Method and Pooling of Interests –

1. The pooling–of-interests method has been widely criticized for various reasons:

a. Critics argue that pooling permits acquiring companies to record acquisitions at

artificially low amounts which distorts the balance sheet as well as subsequent income

statements.

b. No goodwill exists under pooling and therefore no potential goodwill impairment to

reduce future earnings.

c. The effects above result in higher income under pooling.

d. Critics also argue that the lower valued balance sheet numbers for assets and equity

make return–on–assets and return–on–equity ratios lower.

e. Critics also argue that pooling provided an opportunity to buy companies and the

record the acquisition at artificially low numbers, hence improving the appearance of

Financial Reporting and Analysis 6e Intercorporate Equity Investments

subsequent financial statements.

V. VARIABLE INTEREST ENTITIES – Enron’s collapse in 2001 created a demand for increased

disclosure and transparency about companies’ interest in special purpose entities (SPE) or

variable interest entities (VIE). The critical issue is determining when VIEs have to be

consolidated into the financial statements of the sponsoring entity.

1. A VIE is an entity that either does not have equity investors with voting rights or

does have equity investors that do not provide sufficient financial resources for the entity to

support its activities.

2. VIEs are created for structured financing arrangements that allow a company to borrow money

based on the value of a specific project or asset rather than on its own credit rating.

2. A VIE must be consolidated using the acquisition method if the parent has a controlling

financial interest in the VIE. A company is deemed to have a controlling financial interest

if is has both the following:

a. power to direct the activities of the VIE that significantly impact the VIE’s performance

b. obligation to absorb losses (or receive benefits from) of the VIE that could potentially be

significant to the VIE

VI. ACCOUNTING FOR FOREIGN SUBSIDIARIES AND FOREIGN CURRENCY

TRANSACTIONS

A. Foreign Currency Transactions:

1. Foreign currency transactions are simply any business transaction denominated in units

of a foreign currency.

a. A receivable or payable denominated in a foreign currency must be re-expressed in

home-currency units to prepare financial statements, using the exchange rate in

effect at the transaction date.

b. Changes in the exchange rate prior to settlement will result in foreign currency

transaction gains and losses.

c. Monetary assets, like accounts receivable that arise from foreign currency

transactions, are shown in the financial statements at their dollar equivalent using the

exchange rate in effect at the financial statement date.

d. Monetary liabilities, like accounts or bonds payable, are similarly translated using

the exchange rate in effect at the statement date.

e. The statement date rate is referred to as the current rate.

2. Nonmonetary assets, such as inventory, equipment, land, buildings and trucks whose

value is determined by supply and demand, are translated (throughout each asset’s life)

using the exchange rate in effect at the time of the transaction.

3. This rate is called the historical exchange rate.

A. Foreign Subsidiaries – When consolidating a foreign subsidiary the subsidiary’s numbers

must first be translated into the parent’s currency units before the consolidation process

begins.

B. The translation under U.S. GAAP specifies one of two procedures, depending on

the operating characteristics of the foreign subsidiary:

1. Foreign subsidiaries that are mere extensions of the parent with no self-sufficiency are

remeasured using the temporal method.

2. Foreign subsidiaries that are essentially freestanding units with self-contained foreign

operations are translated using the current rate method.

3. The procedure selected is called the functional currency choice since it is based on

whether the currency in which the subsidiary effectively operates is the local currency or

the parent company’s currency.

D. Accounting for Non-freestanding Foreign Subsidiaries –

Financial Reporting and Analysis 6e Intercorporate Equity Investments

1. Under GAAP, non-freestanding subsidiaries are treated as if they were invented for

the sole purpose of facilitating foreign currency transactions.

2. As a result, the numbers included when consolidating a non-freestanding subsidiary are

identical to the numbers that would have been included had the subsidiary not existed and

instead the parent engaged in the foreign currency transactions directly.

3. To achieve this effect in the financial statements, the temporal method is used to

translate the subsidiary’s foreign currency statements into dollars.

a. Monetary assets and liabilities are continuously revalued to the current rate.

b. Nonmonetary assets and liabilities are not revalued when exchange rates change.

c. When a transaction results in the recognition of a new asset/liability, the new

asset/liability is valued using the exchange rate in effect at the time of the transaction.

d. All revenue and expense accounts (except those listed in d. below) are translated

using the rate at the time of the transaction.

e. Cost of goods sold and depreciation are translated at the historical rate (i.e., the rate

in effect when the assets were acquired).

E. Accounting for Self-contained Foreign Subsidiaries:

1. When the majority-owned foreign subsidiary operates independently from the parent, the

translation of its financial statements into dollars uses the current rate method.

2. Since the ultimate exchange rate effects on U.S. dollar cash flows are uncertain, the U.S.

GAAP requires that such subsidiaries should be translated using the current rate method,

with any debit or credit arising from translation “gains” or “losses” flowing directly into

an owners’ equity account (Other Comprehensive Income), bypassing the income

statement.

a. All balance sheet accounts are translated at the current exchange rate in effect at the

balance sheet date.

b. All income statement accounts are translated at the weighted average rate of

exchange in effect over the period covered by the statement.

c. If all accounts in a statement are translated at the same rate—which is what happens

under the current rate method—then the translated statements have the same

proportionality as the untranslated statements expressed in foreign currency units.

d. In other words, the current rate method provides a practical way to get from foreign

currency units to dollars while still maintaining the subsidiary’s financial ratios.

VII. Global Vantage Point: Four key differences exist between IFRS and U.S. GAAP

A. Accounting for Financial Assets (Marketable Securities and Investments) – See Exhibit

16.13. IFRS accounting for financial assets is contained in IAS 32, “Financial Instruments:

Presentation”; IAS 39, “Financial Instruments: Recognition and Measurement”; and IFRS 7,

“Disclosures.” IASB has begun to replace IAS 39 with IFRS 9 that was issued in 2009.

Having received numerous comment letters, IASB is redeliberating its proposed guidance on

impairment of financial assets.

1. For available-for-sale securities (AFS), IFRS includes non-marketable equity securities if

FV can be determined while and FV unrealized gains/losses are reported in Other

Comprehensive income (OCI). U.S. GAAP does not allow non-marketable equity securities to

be included.

2. IFRS isolates the unrealized gains and losses due to foreign exchange component and

reports it in income while U.S. GAAP does not isolate this portion and reports the entire FV

unrealized gains/losses in Other Comprehensive Income.

3. IFRS allows firms to include conventional loans and receivables in the AFS category

while U.S. GAAP does not.

4. When firms transition to IFRS 9, financial assets will default into one of two categories: (1)

Financial Reporting and Analysis 6e Intercorporate Equity Investments

a financial asset to be measured at amortized cost or (2) a financial asset to be measured at fair

value through profit or loss (net income). Conceptually, (1) is similar to U.S. GAAP held-to–

maturity category.

5. Unlike U.S. GAAP, IFRS does not allow firms to use the fair value option for equity-method

investments (ownership greater than 20% but less than 50%).

6. U.S. GAAP measures the impairment loss for held-to–maturity debt securities as the

difference between the amortized cost basis and the fair value of the security while IFRS

compares the amortized cost to the present value of estimated future cash flows discounted at

the original effective rate. IFRS reports all impairment losses for AFS-debt securities in income

regardless of the reason.

7. IFRS allows reversals of impairment losses while U.S. GAAP does not.

B. As of summer 2013, the IASB was redeliberating its March 2013 Exposure Draft that proposed

to require firms to recognize immediately expected credit losses on financial assets.

C. Consolidated Financial Statements and Accounting for Business Combinations – IFRS and

U.S. GAAP are fairly well converged with respect to when consolidation is deemed necessary

and the approach for measuring subsidiary assets and liabilities on the consolidated balance

sheet. A few areas of substantive differences include:

1. IFRS defines control more broadly than does U.S. GAAP.

2. Under U.S. GAAP, a parent and its subsidiary can have differing accounting policies while

for IFRS firms, the accounting policies of the subsidiary must conform to those of the parent

or special adjustments must be made in the consolidation worksheet to meet conformance.

3. The initial valuation (measurement) of noncontrolling interest differs.

D. Accounting for Special Purpose Entities (SPEs) or Variable Interest Entities (VIESs)

1. While U.S. GAAP refers to these entities as VIEs, IFRS refers to them as SPEs.

2. Consolidation criteria differ between U.S. GAAP and those of IFRS.

E. Accounting for Joint Ventures

1. IFRS allows a choice between the use of the equity method of accounting or proportionate

consolidation for jointly controlled entities. U.S. GAAP generally requires the equity method

of accounting: proportionate consolidation is only allowed when it is industry practice.

F. FASB Exposure Draft on Financial Instruments – Based on both IASB and FASB

deliberations, FASB’s exposure draft, if adopted, would substantially change the accounting for

financial instruments (to be similar to IFRS 9 in several key areas. Refer to Exhibit 16.14 for a

summary differences.

VII. APPENDIX A: ACCOUNTING FOR INVESTMENTS IN DEBT SECURITIES

A. Held-to-Maturity Securities – GAAP mandates that debt securities that a firm intends to hold

to maturity be accounted for at amortized cost.

1. Interest income is recognized following the effective interest method

2. The investment account is adjusted for the amortization of premium/discount in each

period.

3. No adjustments are made for changes in the market value of debt securities in this

portfolio.

4. Debt securities in the held-to-maturity portfolio that suffer other-than-temporary

impairment are required to be measured at fair value with the loss flowing to the income

statement.

5. Firms may choose to use the fair value option and the cumulative unrealized gains and

losses as of the date of fair value election are included as a cumulative effect adjustment to

retained earnings based on the rules for changes in accounting principles.

B. Available-for-Sale Securities – .

Financial Reporting and Analysis 6e Intercorporate Equity Investments

1. Securities are presented in the balance sheet at fair value

2. An adjustment is made at each balance sheet date

3. The adjustment is reported as part of the comprehensive income

4. When the securities are ultimately sold, the full gain/loss is recognized in income and the

related amount in Accumulated Other Comprehensive Income is “recycled.”

C. Trading Securities – The accounting for trading securities is similar to available-for-sale

securities, except that fair value adjustments are recognized in income rather than in OCI.

1. Because gains/losses are recorded in the income statement each period as the bond’s value

fluctuates, there is no additional gain/loss recognized on the sale. Only changes in value are

recognized.

D. Other-Than-Temporary Impairments – If a firm does not intend to sell the security and it is

unlikely that the firm will be required to sell the security before recovery of its amortized cost

basis less any current-period loss, then the other-than-temporary impairment is separated into

the following two components:

a. The amount representing the credit loss – recognized in earnings

b. The amount related to all other factors – recognized in OCI

1. The previous amortized cost basis less the other-than-temporary impairment recognized in

earnings becomes the new amortized cost basis of the investment.

2. The new amortized cost basis is not adjusted for subsequent recoveries in fair value.

3. However, the new amortized cost basis is adjusted for accretion and amortization.

Financial Reporting and Analysis 6e Intercorporate Equity Investments

CHAPTER QUIZ

1. Investment in trading securities should be valued on the balance sheet at:

a. Acquisition cost.

b. Lower of cost or market for the portfolio.

c. Lower of cost or market for individual securities.

d. Fair value.

2. A decline in the value of an available-for-sale security below cost that is deemed to be other than

temporary should:

a. Be accumulated in a valuation allowance.

b. Be treated as a realized loss and included in the determination of net income for the period.

c. Not be realized until the security is sold.

d. Be treated as an unrealized loss and included in the equity section of the balance sheet as a

separate item.

3. The following information was taken from Gil Co.’s December 31, 2015 balance sheet:

Investments in available-for–sale securities (at fair value) $96,450

Net unrealized loss on available-for–sale securities (shareholders’ equity) (19,800)

Historical cost of the available-for–sale securities was:

a. $63,595.

b. $76,650.

c. $96,450.

d. $116,250.

4. On December 31, 2015, Otto Co. had investments in trading securities with cost of $30,000 and fair

value of $28,000. The current (pre-adjustment) balance in the market adjustment account was a

$3,000 debit balance. What is the unrealized gain or loss on these trading securities?

a. $2,000 un realized loss.

b. $5,000 unrealized loss.

c. $3,000 un realized g ain.

d. $5,000 unre alized gain.

5. When an investor uses the equity method to account for investments in common stock, the

investment account will be increased when the investor recognizes:

a. A proportionate interest in the net income of the investee.

b. A cash dividend received from the investee.

c. Periodic amortization of the goodwill related to the purchase.

d. Depreciation related to the excess of market value over book value of the investee’s

depreciable assets at the date of purchase by the investor.

6. The investor’s accounting procedure under the equity method is to debit the investment account to

record investee income and credit the investment account to record investee dividends. In

substance, the net effect is to:

a. Recognize only distributed income of the investee.

b. Not consider distributed income of the investee as income.

c. Increase the investment account for investee distributed income.

d. Recognize both distributed and undistributed income of the investee.

Financial Reporting and Analysis 6e Intercorporate Equity Investments

7. Mill Corp. acquired a 100% interest in Vore Corp for a cash price of $3,000,000. At the acquisition

date, Vore’s plant and equipment had a carrying amount of $750,000 and a fair value of $875,000.

The total assets of Vore Company were $10,000,000 and the total liabilities were valued at

$6,000,000. What value will the combined entity record the plant and equipment and goodwill as a

result of the purchase?

Plant and equipment Goodwill

a. $750,000 $1,000,000

b. $750,000 $ 875,000

c. $875,000 $ 875,000

d. $875,000 $1,000,000

8. Which of the following is a potential method of earnings management under pre-Codification SFAS

No. 142?

a. “The Big Bath”

b. Intentional errors based on materiality

c. Cookie Jar reserves

d. Aggressive revenue recognition

9. A subsidiary may be acquired by issuing common stock or by paying cash. Which of the following

items may be recognized as a result of the business combination?

a. Goodwill.

b. Retained earnings.

c. Minority interest.

d. Both a and c.

10. Poe, Inc. acquired 100% of Shaw Co. in a business combination on September 30, 2015. During

2015, Poe declared quarterly dividends of $25,000, and Shaw declared quarterly dividends of

$10,000. What amount should be reported as dividends declared in the December 31, 2015

consolidated statement of retained earnings?

a. $100,000

b. $100,000

c. $130,000

d. $130,000

Financial Reporting and Analysis 6e Intercorporate Equity Investments

QUIZ ANSWERS:

1. d. Trading securities are those held principally for sale in the near term. They are classified as

current and consist of debt securities and equity securities with readily determinable fair values.

Unrealized holding gains and losses on trading securities are reported in earnings. On the balance

sheet, these securities are reported at fair value.

Financial Reporting and Analysis 6e Intercorporate Equity Investments

RECOMMENDED EXHIBITS

Figure 16.1—Financial Reporting Alternatives for Intercorporate Equity Investments

Figure 16.2 – Good Impairment Test

Figure 16.3 – M&A Accounting Rules Over Time

Figure 16.5 —Translation Approach Used in U.S. GAAP

Exhibit 16.10—Translation Exchange Rates under the Temporal Method

Exhibit 16.13 (a)—U.S. GAAP vs IFRS – Classification, Measurement, and

Reporting of Financial Assets

Exhibit 16.13 (b)—U.S. GAAP vs IFRS – Summary of Impairment

Determination, Measurement, Reporting and Reversal

Exhibit 16.14 – Summary of Proposed Changes in FASB Exposure Draft

on Financial Instruments