978-0324651140 Chapter 13 Lecture Note

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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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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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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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