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Notes
CHAPTER 13
INTERCORPORATE INVESTMENTS IN COMMON STOCK
I. Learning Objectives
1. Understand why firms invest in the common stock issued by other entities
and how the purpose of the investment determines the method of
accounting for those investments.
2. Develop skills to apply the equity method to minority, active investments,
contrasting its financial statement effects with those of measuring
marketable securities at fair value.
3. Understand the concepts underlying consolidated financial statements for
majority, active investments, contrasting the financial statement effects of
consolidation with those of the equity method.
4. Understand the accounting for a joint venture, an entity in which no owner
has control.
5. Understand consolidation policy for a variable interest entity (VIE), an
entity for which the analysis of voting interests does not reveal whether
another entity controls the VIE.
II. Organization of Class Sessions
We generally find that students are gasping for breath by the time we
reach this chapter. Chapter 12 discusses the accounting for investments in
securities when the investor owns less than 20% of the voting stock of another
entity, for investments in debt securities, and for derivatives. In this chapter,
we discuss accounting for investments in common stock when the ownership
percentage is 20% or more. Exhibit 13.8 guides us in understanding that with
passive holdings, the investor cannot influence dividend policy, so having
income reflects dividends provides no opportunity for earnings management.
Active investors can influence dividend policy so we need a method for income
recognition independent of dividends.
We would like students to have exposure to the differences in the financial
statements effects of the market value, equity, and consolidation methods and
the conditions when each method is appropriate. Coverage of these topics
takes at least two hours of class time. When we can devote more class time to
this chapter, we add material on variable interest entities (VIEs).
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III. Lecture Outline
1. Understand why firms invest in the common stock issued by other
entities and how the purpose of the investment determines the
method of accounting for those investments.
We place Figure 13.1 from the text on an overhead display. We then
ask students to indicate the business purpose for each of the three
categories of intercorporate investments. Firms generally make minority,
passive investments for their interest, dividends, and capital gain
potential. The ownership percentage is typically so small that the investor
cannot control or significantly influence the activities of the investee.
Firms may acquire such securities as a temporary investment of excess
cash or for long-term expected returns. Chapter 12 discusses the
accounting for minority, passive investments in marketable securities.
Income includes interest and dividends each period. The balance sheet
reports the securities at their market value and the unrealized capital gain
or loss appears in a separate shareholders' equity account.
Firms generally make minority, active investments with a long-term
investment horizon in mind and with the intention of exerting significant
influence over the investee. The minority ownership position, however,
does not usually permit the investor to control the activities of the
investee. The equity method reflects the purpose of these investments.
Accruing the investor's share of the investee's earnings each period
recognizes the influence of the investor over the investee. However,
showing the investment on one line in the investor's balance sheet instead
of all of the assets and liabilities of the investee reflects the investor's
minority ownership position. Also, showing the investor's equity in the
earnings of the investee on one line in the income statement instead of the
individual revenues and expenses of the investee reflects the investor's
minority ownership position.
Firms generally make majority, active investments in order to control
the activities of the investee on both a broad strategy level and a day-to-
day operational level. Full consolidation of the assets, liabilities, revenues,
and expenses of the investee reflects this active control.
2. Develop skills to apply the equity method to minority, active
investments, contrasting its financial statement effects with those of
measuring marketable securities at fair value.
Start off by a comparison between the accounting for equity method for
active investments and passive investments. We find the analogy between
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Notes
the equity method and a savings account useful. In both cases, the
accountant records the initial investment in the investment account at
acquisition cost, increases the investment account for the earnings from
the investment (share of the investee's earnings in the case of the equity
investment, interest earned in the case of the savings account), and
reduces the investment account for cash received (dividends in the case of
the equity investment, cash withdrawals in the case of the savings
account). Thus, the investment account increases and decreases in direct
relation to changes in the profitability of the underlying investment. The
analogy is not perfect. The investor in an equity-method investee can
influence the earnings generated by the investee, whereas the interest
earned on savings accounts is usually set by financial institutions in
response to market forces. Also, the investor probably has more flexibility
to withdraw cash from a savings account than from an equity-method
investee. Another dimension in which the analogy breaks down occurs
when the acquisition cost of the investment exceeds the investor's share of
the net assets of the investee. The investor may have to amortize this
excess over some period of years. The concept of such an excess does not
arise for a savings account.
Consider the Example 5 provided in the text to explain the accounting
treatment of investments in case of active investments. Introduce them to
the fair value concept and advice them that determining fair value rests
on the assumption that the transaction would occur in the principal
market for the asset or liability or, in the absence of a principal market, in
the most advantageous market from the viewpoint of the reporting entity.
Example 10 provided in Chapter 12 could be taken up, which clearly
explains the concept of valuing securities at fair value. (Exercises 13.15,
13.16, 13.17, 13.18, and 13.22)
3. Understand the concepts underlying consolidated financial
statements for majority, active investments, contrasting the
financial statement effects of consolidation with those of the equity
method.
We try to get students to see that the equity method and consolidation
differ with respect to the level of aggregation. The equity method shows
the investor's share of the net assets of the investee on the balance sheet;
consolidation shows all of the assets and liabilities of the investee on the
consolidated balance sheet. The equity method shows the investor's share
of the net income of the investee on the income statement; consolidation
shows the individual revenues and expenses of the investee on the
consolidated income statement. The greater level of disaggregation in
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consolidation reflects the investor's ability to control the activities of the
investee.
Students seem to have trouble with the reporting of the non-
controlling, or minority interest. Consolidation adds all of the assets,
liabilities, revenues and expenses of the investee to those of the investor
and then subtracts the claim of the non-controlling interest. An
alternative would be to consolidate only the investor's share of these items.
Accounting's preference for the first approach reflects the investor's ability,
because of its ownership interest, to control the use of all of the investee's
assets, control the amount of all liabilities incurred, and direct the use of
all of the investee's resources to generate revenues and expenses. Exhibit
13.5 provided in the text could be used to illustrate how consolidation of
financial statements is carried out. In addition, Exercise 13.21 provides an
additional understanding of consolidated concepts and important
consolidation relations. It would be ideal to state that the amount of of the
consolidated income for a period is exactly equal to the amount that the
parent company would show on its separate company books if it used the
equity method for all its subsidiaries.
Assignment material that compares and contrasts these two methods
of accounting for intercorporate investments includes Questions 13.3, 13.8,
13.9, Exercises 13.25, 13.36.
4. Understand the accounting for a joint venture, an entity in which no
owner has control.
Consider the Exhibit 13.1 provided in the text which illustrates a
typical joint venture in which neither of the firms has control.
The accounting for these joint ventures could be as per the below 3
methods: (1) Use of an equity method, (2) fully consolidating the joint
venture and reporting the interest of the joint owner as an external
interest, similar to the noncontrolling interest in a consolidated subsidiary,
(3) Partially consolidating the joint venture to the extent of the 50%
ownership percentage, a method referred to as proportionate consolidation.
Focusing on our Exhibit 13.1, we can observe that the joint venture
accounting is under the equity method. Also, GAAP requires firms to
account for joint ventures using the equity method unless the firm elects
the fair value option for investments in joint ventures. Take up the
Problem 13.33 for further exposure on the accounting for joint ventures.
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Notes
5. Understand consolidation policy for a variable interest entity (VIE),
an entity for which the analysis of voting interests does not reveal
whether another entity controls the VIE.
According to U.S. GAAP, a variable interest entity is an entity that
meets one or both of the following criteria: (1) The invested equity is so
small that the entity requires other financial support to sustain its
activities. (2) The equity owners lack meaningful decision rights. Students
so far would have a perception that consolidation is always carried out in
cases where voting control is achieved through majority of the investment
in the common stock. However, for some entities common stock ownership
does not indicate control because the common stock of the entity lacks one
or more of the economic characteristics associated with equity. Figure 13.2
provides a rationale for why control, alone, is insufficient to set criteria for
consolidation. (Problem 13.34)
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