Tài chính doanh nghiệp - Chapter 16: Intercorporate equity investments

Intercorporate Equity InvestmentsRevsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 16 Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill EducationLearning objectivesHow and why an investor’s percentage ownership share determines the accounting treatment for equity investments.How fair value accounting is applied to securities held in trading and available-for-sale portfolios and how impairments are recorded.How to apply the equity method and the fair value option.What consolidated financial statements are, how they are prepared under the acquisition and purchase methods, and how noncontrolling interests are measured and reported.What goodwill is and when it is shown on financial statements.16-*Learning objectives:ConcludedWhat variable interest entities (VIEs) are and when they must be consolidated.How operations reported in foreign currencies affect the preparation of financial statements in U.S. dollars.The major differences between IFRS and U.S. GAAP related to accounting for financial assets, consolidations, special purpose entities (SPEs) or VIEs , and joint ventures.How business combinations were previously accounted for under the pooling of interests method.16-*OverviewFigure 16.1Financial reporting alternatives for intercorporate equity investments16-*Minority passive investments:Trading securitiesThe entry to record the shares purchased on 1/1/2014:The entry to record dividends declared:16-*Minority passive investment:Trading securities—fair value accountingStep 1: The total market value of all trading securities is compared to the total cost of the securities. Any difference becomes the target balance for the Fair value adjustment account.Step 2: Increase or decrease the Fair value adjustment account so that it equals the target balance.16-*Minority passive investment:Trading securities—fair value accounting 2014Principal Financial makes the following entry at year end for 201416-*Amount reported on the balance sheet: $29,000Minority passive investment:Trading securities—fair value accounting 2015The fair value adjustment for 2015 is:16-*Principal Financial purchases Company C and Company D on July 1, 2015Minority passive investment:Trading securities—fair value accounting 2016The fair value adjustment for 2016 is:16-*Notice that this is a gain since the fair value is higher than the costMinority passive investment:Trading securities—fair value accountingWhen trading securities are sold, a realized gain or loss is recorded.Realized gain or loss=Selling priceMost recentmark-to-marketprice-16-*Here’s what happens when Company B preferred stock is sold:Fair value accounting is used, but the adjustment is not included in income.Instead, the upward or downward adjustment to reflect fair value is a direct (net of tax) credit or debit to a special owners’ equity account.This special owners’ equity account is one of the “Other comprehensive income” components described in Chapter 2.Minority passive investment:Available-for-sale securities16-*The 2014 year-end fair value adjustment entry:Minority passive investment:Available-for-sale securities illustrationThe entry to record the sale of Company B preferred stock in 201716-*The tax effect for 2014 on the loss on trading securitiesMinority passive investment:Income Tax Effects 16-*$1,000 loss x assumed 35% marginal tax rateThe tax effect for 2014 on the loss on available-for-sale securitiesThe tax effect in subsequent yearsMinority active investments:Equity methodWhen the ownership percentage equals or exceeds 20%, GAAP presumes two elements:The investor can exert influence over the company.The investment represents a continuing relationship between the two companies.The accounting approach used for minority passive investments is nolonger suitable.16-*Minority active investments:Equity method illustration16-*Minority active investments:Equity method when cost and book value differThere are two reasons why Willis willingly paid more than book value for a 30% stake in Planet Burbank:The books show balance sheet items at GAAP historical cost rather than current fair value.The business is worth more than the sum of its individual assets (i.e., more than the current fair value of all balance sheet items). This is goodwill.16-*Minority active investments:Equity method—purchase price allocation16-*Minority active investments:Equity method illustration16-*Now let’s assume that Willis decided to pay $24,000,000, or $15,000,000 more than book value.Fair Value Option for Equity Method InvestmentsFirms may elect the fair value option for investments that would otherwise be accounted for under the equity method (this method is irrevocable). Can elect the fair value option on election dates, which include: The date the firm first acquires an investment that is eligible for equity method treatmentThe date the investment becomes subject to the equity method of accountingThe date the investor ceases to consolidate a subsidiary16-*Unrealized gains and losses from changes in fair value are reported in the income statement.Assets and liabilities measured at fair value are reported on the balance sheet separately from investments not reported at fair valueFair Value Option for Equity Method InvestmentsAssume that Willis elects the fair value option for this investment at the acquisition date and that the $24 million paid reflects fair value. As of December 31, 2014, the fair value has increased to $30 million.16-*Income StatementBalance SheetReports an unrealized gain from equity investment of $6 million ($30 million - $24 million)Reports $150,000 as investment income for its share of Planet Burbank’s declared dividendReports Investment In Burbank stock at the $30 million fair value amountControlling (Majority) Interest: ConsolidationWhen the ownership percentage exceeds 50% of the voting shares, GAAP presumes the parent controls the subsidiary.The financial statements of the subsidiary are then combined—line by line—with those of the parent using a process called consolidation.This consolidation process occurs each reporting period.If the ownership percentage is exactly 50% of the voting shares, the equity method is used and no line-by-line consolidation is necessary.16-*Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)Alphonse Corporation paid $10 million cash to buy all of the outstanding shares of Gaston Corporation. Following is the balance sheet of Alphonse Corporation immediately before the acquisition:16-*Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)Since Alphonse acquired 100% of Gaston Corporation, Alphonse prepares a consolidated balance sheet. However the individual balance sheets of the two companies are not simply added together, doing so would result in double-counting. The 2 steps to provide the adjustments to the consolidated balance sheet include:Elimination of the Investment in Gaston Account against Gaston’s EquityNeed to show the difference between the acquisition price of $10,000,000 and net assets of $8,000,000 in their proper accountsReclassification of the Remainder of the Investment in Gaston AccountThe remaining balance represents the amount of the acquisition value that is not reflected in Gaston’s book values.16-*Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)16-*Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)Step 1 – Elimination of the original investmentStep 2 – Elimination of the remaining investment account balance16-*Acquisition Method with Noncontrolling InterestsThe Consolidation Topic (ASC 810) in the FASB Accounting Standards Codification effect for 2009 fiscal years says that the subsidiary’s individual accounts should not be divided and measured differently along ownership lines.GAAP says that the parent company includes in its consolidated statements 100% of the subsidiary’s individual assets acquired and liabilities assumed at their full fair values determined as of the acquisition date even when the parent owns < 100% of the controlled subsidiary.Business value is the sum ofThe controlling interest fair valueThe noncontrolling interest fair valueAssume the same facts as in the previous example, however, Alphonse purchases 80% of Gaston’s outstanding shares for $8,000,000. Gaston’s total net assets equal $8,000,000 ($8,500,000 of assets minus $500,000 of liabilities).16-*Acquisition Method with Noncontrolling Interests16-*Entry A: Eliminates the Investment in Gaston account against stockholders’ equity accounts and sets up noncontrolling interest in GastonEntry B: Reclassifies the remainder of the investment account by writing up net assets to fair value and recording goodwill attributed to the controlling interestEntry C: Recognizes the noncontrolling interest in the total business fair value of GastonAcquisition Method with Noncontrolling Interests16-*Other Consolidation Adjustments: Intra-entity transactions—loansSuppose that, prior to the acquisition, Gaston had borrowed $300,000 from Alphonse. The adjusting entry made to eliminate this “internal” transaction is:Gaston’s payableAlphonse’s receivable$300,000 cash loan16-*Other Consolidation Adjustments: Intra-entity transactions—salesSuppose that Alphonse sold goods to Gaston as follows:Two things must happen to eliminate this intra-entity sale:Gaston’s COGSAlphonse’s revenueNo change to gross margin16-*Accounting for goodwillGoodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business.Goodwill is written off only when it is deemed to be impairedGoodwill$10 million$8 million$1.5 million$0.5 millionExcess of net asset FMV over BVNet asset BVPurchase priceAllocation16-*Accounting for goodwill:ImpairmentFigure 16.2Goodwill impairment test16-*Accounting for goodwill:Implementing the impairment test16-*Accounting for goodwill:When to test for impairmentGAAP says impairment must be tested at least annually or when there is reason to suspect that the value of goodwill has been diminished.Circumstances that might prompt an impairment test include:Significant adverse change in business climate.Adverse regulatory action or assessment.Unanticipated competition.Loss of key personnel.The reporting unit (to which the goodwill is attached) is likely to be sold.A significant asset group is being tested for recoverability.Recognition of a goodwill impairment loss in the financial statement of a subsidiary that is a component of a reporting unit.16-*Previous Approaches to Consolidated StatementsThe only acceptable method for merger and acquisition transactions entered into today is the acquisition method But what about transaction originally accounted for under the other two methods?The purchase method andThe pooling of interests method16-*The method applied depends on: when the parent company acquired the subsidiarynot the date of the financial statements being presentedPrevious Approaches to Consolidated Statements16-*Determine the date of when the parent acquired the subsidiary to determine which method to usePrevious Approaches to Consolidated Statements: The Purchase Method16-*The price paid by the parent is allocated only to the acquired portion of the subsidiary’s asset and liability accounts. As a result, the subsidiary’s assets and liabilities are not reported at their full fair values on the consolidated balance sheet.Recall that Alphonse acquires an 80% interest in Gaston by paying $8 million.Difference between amount paid by Alphonse and its equity in the book value of Gaston’s net assetsPrevious Approaches to Consolidated Statements:The Purchase Method 16-*Same as the acquisition method, but no entry C to recognize the noncontrolling interestPrevious Approaches to Consolidated Statements:The Purchase Method16-*Key differences between the consolidated balance sheet under these two methodsBesides net asset write-ups and treatment of noncontrolling interests, the following four items are treated differently:Direct combination costsContingent considerationBargain purchasesAcquired in-process research and developmentMore differencesPrevious Approaches to Consolidated Statements:The Purchase Method16-*Difference of $0.4 million is due to no allocation to goodwill and separately identifiable net assetsPrevious Approaches to Consolidated Statements: Pooling of interests16-*The owners of both Alphonse and Gaston continue as equity investors in the newly merged corporation.Instead of acquiring a 100% ownership in Gaston with cash, assume that Alphonse exchanges 8 million shares of its own stock with a fair value of $10 million for all of Gaston’s outstanding stock:Previous Approaches to Consolidated Statements:Pooling of interests16-*Only Adjustment A is needed.Previous Approaches to Consolidated Statements:Financial Analysis Issues –Acquisition Method vs. Purchase Method16-*Trend analysis becomes difficult because under U.S. GAAP, comparative financial statements are not retroactively adjusted to include data for the acquired company for periods prior to the acquisition. Therefore, income statements over three years are noncomparable.Includes subsidiary for 12 monthsIncludes subsidiary for 9 monthsDoes not include subsidiary at allCan’t Compare!Previous Approaches to Consolidated Statements:Financial Analysis Issues –Acquisition Method vs. Pooling of interests16-*Assets are shown at net book value in pooling of interestsDifference due to cash paid in acquisition method and stock issued in pooling of interestsVariable Interest EntitiesA corporation, partnership, trust or other legal structure.Does not have equity investors with voting rights, orHas equity investors that do not provide sufficient financial resources for the entity to support its activities.Major uses include selling receivables, securitizing loans and mortgages, synthetic leases, take-or-pay contracts.GAAP requires the VIE to be consolidated if that company has a controlling financial interest in the VIE and is the VIE’s primary beneficiary if it has both of the following characteristics:The power to direct the activities of a VIE that most significantly impact the VIE’s economic performanceThe obligation to absorb losses of the VIE that could be potentially be significant to the VIE16-*Accounting for foreign subsidiaries:OverviewAll majority-owned subsidiaries—foreign and domestic—must be consolidated.An additional complication arises when consolidating a foreign subsidiary because the financial records are expressed in the foreign currency.One of two procedures is used, depending on the operating characteristics of the foreign subsidiary:Temporal method(remeasured)Current rate method(translated)Foreign sub is not self-sufficientForeign sub has self-contained foreign operationsFunctional currency choice16-*Accounting for foreign subsidiaries:Foreign currency transactionsOn January 1, 2014 Yankee Corporation sells 100 units of its product to a U.K customer. The selling price is £10 per unit or £1,000 total. Payment is due on April 1, 2014. One British pound is worth $2 U.S., and the per-unit cost of production incurred by Yankee is $8.16-*Accounting for foreign subsidiaries:Foreign currency transactions—monetary assetsOn January 1, 2014 Yankee Corporation sells 100 units of its product to a U.K customer. The selling price is £10 per unit or £1,000 total. Payment is due on April 1, 2014. One British pound is worth $2 U.S., and the per-unit cost of production incurred by Yankee is $8. By the end of the quarter, the value of a pound has fallen to only $1.80 U.S.16-*Accounting for foreign subsidiaries:Foreign currency transactions—nonmonetary assetsSuppose Yankee decides to purchase a warehouse in London for £300,000 when the exchange rate is $1.75 U.S. per British pound.16-*Accounting for foreign subsidiaries:Non-freestanding subsidiariesForeign subsidiary is merely an extension of the parent.GAAP says subsidiaries like this one are treated as if they were created for the sole purpose of facilitating foreign currency transactions.The numbers included when consolidating the subsidiary are identical to the numbers that would have been included if the parent had engaged in the foreign transaction (temporal method).DandyLtdDoodle CorpInventoriesCustomers receiptsCash to pay expensesUnshipped customer inventoryWarehouseU.S. parentForeign sub16-*Accounting for foreign subsidiaries:Non-freestanding subsidiaries16-*Accounting for foreign subsidiaries:Non-freestanding subsidiaries exampleDandy Ltd. received inventory cost $800 (£1 = $2) and sold the goods on credit for £1,000. The pound then falls to $1.80 when the receivables are collected. The company also purchased a building in London for £300,000 when the pound was worth $1.75. 16-*Accounting for foreign subsidiaries:Self-contained foreign subsidiariesForeign subsidiary is self-contained—no transactions with the parent.In this case, the effect of changes in exchange rates on future dollar cash flows to the parent is uncertain.GAAP requires the use of the current rate method, with translation “gains” or “losses” be reported as Other comprehensive income which becomes part of Accumulated other comprehensive income in stockholders’ equity.SwisscompanyU.S.FoodForeigncustomersParentForeign subShip inventoriesCustomer receipts16-*Accounting for foreign subsidiaries:SummaryFigure 16.5Translation approach used in U.S. GAAP16-*Accounting for foreign subsidiaries:Illustrative disclosure16-*Global Vantage PointThere are many key differences between IFRS and U.S. GAAP in the following four areas.Accounting for financial assets (marketable securities and investments)Consolidated financial statements and accounting for business combinationsAccounting for special purpose entities (SPEs) or variable interest entities (VIEs)Accounting for joint ventures16-*SummaryFinancial reporting for intercorporate equity investments depends on the degree to which the investor is able to influence the investee’s operating decisions.When the ownership share is less than 20% (minority passive investment), fair value accounting is used.When the ownership share is from 20% to 50% (minority active investment), the equity method is used.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.Consolidated financial statements are required when one entity acquires more than 50% of another entity.16-*Summary concludedGoodwill is typically recorded in business combinations using the acquisitions or purchase method, and is not amortized, but is subject to annual impairment tests.Acquisition and purchase methods of accounting complicate financial analysis because of the differing treatment of subsidiary’s net income.Majority-owned foreign subsidiaries must also be consolidated. This requires foreign currency amount to be re-expressed in dollars.There are a number of important differences between IFRS and U.S. GAAP.16-*