Intercorporate Investments
READING 8
INTERCORPORATE INVESTMENTS
EXAM FOCUS
There are no shortcuts here. Spend the time necessary to learn how and when to use each method of accounting for intercorporate investments because the probability of this material being tested is high. Be able to determine the effects of each method on the financial statements and ratios. Pay particular attention to the examples illustrating the difference between the equity method and the acquisition method.
MODULE 8.1: CLASSIFICATIONS
CATEGORIES OF INTERCORPORATE INVESTMENTS
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LOS 8.a: Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
LOS 8.b: Compare and contrast IFRS and US GAAP in their classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Intercorporate investments in marketable securities and ownership interests are categorised for financial reporting as one of the following:
- Investments in financial assets - when the investing firm has no significant control over the operations of the investee firm.
- Investments in associates - when the investing firm has significant influence over the operations of the investee firm, but not control.
- Business combinations - when the investing firm has control over the operations of the investee firm.
Percentage of ownership (or voting control) is typically used as a guideline to determine the appropriate category for reporting. Ultimately, the category depends on the investor's ability to influence or control the investee.
Investments in financial assets
An ownership interest of less than 20% is usually considered a passive investment. In this case the investor cannot significantly influence or control the investee.
Investments in associates
An ownership interest between 20% and 50% is typically considered to give significant influence. Significant influence can be evidenced by the following:
- Board of directors representation.
- Involvement in policy making.
- Material intercompany transactions.
- Interchange of managerial personnel.
- Dependence on technology.
It may be possible to have significant influence with less than 20% ownership. In that case, the investment is considered an investment in associates. Conversely, without significant influence, an ownership interest between 20% and 50% is considered an investment in financial assets. The equity method is used to account for investments in associates.
Business combinations
An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used.
It is possible to own more than 50% and not have control (for example, temporary control limitations such as bankruptcy or governmental intervention). Conversely, it is possible to control with less than 50% ownership (for example, dispersed other shareholders), and such an investment is still treated as a business combination.
Joint ventures
A joint venture is an entity where control is shared by two or more investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In rare cases, IFRS and U.S. GAAP allow proportionate consolidation as an alternative to the equity method.
Figure 8.1 summarises the accounting treatment for investments (see figure placeholder/caption references where provided in source materials).
MODULE QUIZ 8.1
1.
Tall Company owns 30% of the common equity of Short Incorporated. Tall has been unsuccessful in its attempts to obtain representation on Short's board of directors. For financial reporting purposes, Tall's ownership interest is most likely considered a(n):
A. investment in financial assets.
B. investment in associates.
C. business combination.
MODULE 8.2: INVESTMENTS IN FINANCIAL ASSETS (IFRS 9)
IFRS 9
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IASB and FASB have each issued similar new standards for accounting for investments in financial assets (minor differences remain). Consistent with the curriculum, the terminology used here is the IFRS terminology.
Under IFRS, financial assets are categorised depending on whether they are carried at amortized cost or at fair value. The result is three classifications:
- Amortized cost
- Fair value through profit or loss (FVPL)
- Fair value through other comprehensive income (FVOCI)
Corresponding classifications under U.S. GAAP are held-to-maturity, held for trading, and available for sale (historical terminology).
Amortized Cost (for debt securities only)
Debt securities that meet both of the following criteria are accounted for using the amortized cost method:
- Business model test: Debt securities are being held to collect contractual cash flows.
- Cash flow characteristic test: The contractual cash flows are either principal, or interest on principal, only.
Such debt securities are reported on the balance sheet at amortized cost. Amortized cost equals the original cost adjusted for amortisation of any discount or premium to date. Interest income (coupon cash flow adjusted for amortisation of premium/discount) is recognised in the income statement, and subsequent changes in fair value are ignored.
Fair Value Through Profit or Loss (FVPL) - for debt and equity securities
Debt securities may be classified as FVPL if held for trading or if accounting at amortized cost would produce an accounting mismatch. Equity securities that are held for trading must be FVPL. Other equity securities may be classified either as FVPL or FVOCI. The classification choice for equity securities is irrevocable once made. Derivatives not used for hedging are always carried at FVPL. If an asset has an embedded derivative (e.g., convertible bonds), the asset as a whole is valued at FVPL.
FVPL securities are reported on the balance sheet at fair value. Changes in fair value, both realised and unrealised, are recognised in the income statement together with any dividend or interest income.
Fair Value Through OCI (FVOCI) - for debt and equity securities
Securities classified as FVOCI are carried at fair value and any unrealised gains or losses are reported in other comprehensive income (OCI). Dividends and interest income are reported in the income statement.
Figure 8.2 summarises the effects of the different classifications for financial assets on the balance sheet and income statement (refer to figure source in original materials).
EXAMPLE: Investment in financial assets
At the beginning of the year, Midland Corporation purchased a 9% bond with a face value of $100,000 for $96,209 to yield 10%. The coupon payments are made annually at year-end. Suppose that the fair value of the bond at the end of the year is $98,500.
Determine the impact on Midland's balance sheet and income statement if the bond investment is classified as (1) amortized cost, (2) FVPL, and (3) FVOCI.
Answer:
Amortized cost:
Interest revenue recognised = $96,209 × 10%
= $9,621
Coupon cash received = $100,000 × 9%
= $9,000
Amortised discount recognised = Interest revenue - Coupon cash
= $9,621 - $9,000
= $621
Carrying value at year-end = Beginning carrying amount + Amortised discount
= $96,209 + $621
= $96,830
Fair value through profit or loss:
Balance sheet value = Fair value = $98,500
Interest revenue recognised = $96,209 × 10% = $9,621
Unrealised gain recognised in income statement = Fair value - (beginning carrying amount + amortised discount)
= $98,500 - ($96,209 + $621)
= $1,670
Fair value through OCI:
Balance sheet value = Fair value = $98,500
Interest revenue recognised = $96,209 × 10% = $9,621
Unrealised gain reported in OCI = Fair value - (beginning carrying amount + amortised discount)
= $98,500 - ($96,209 + $621)
= $1,670
Reclassification under IFRS 9
Reclassification of equity securities under IFRS 9 is not permitted: the initial designation (FVPL or FVOCI) for equity securities is irrevocable. Reclassification of debt securities is permitted only if the business model has changed. For example, if debt securities previously at amortized cost are reclassified as FVPL, unrecognised gains/losses at the reclassification date are recognised in the income statement. If securities are reclassified out of FVPL and measured at amortized cost, they are transferred at fair value on the transfer date and that fair value becomes the carrying amount.
Loan impairment under IFRS 9
A key feature of IFRS 9 is replacement of the incurred loss model by the expected credit loss model. Companies must evaluate current, historical, and forward-looking information in assessing expected losses. This leads to earlier recognition of impairment: 12-month expected losses are recognised for performing loans and lifetime expected losses for nonperforming loans.
MODULE QUIZ 8.2
Use the following information to answer Questions 1 through 5. Kirk Company acquired shares of both Company A and Company B. We have the following information from the public market about Company A and Company B's investment value at the time of purchase and at two subsequent dates (full data included in source materials).
1.
Kirk Company will report the initial value of its investment in financial assets as:
A. $700.
B. $950.
C. $1,200.
2.
At t = 1, Kirk will:
A. carry the financial assets at cost.
B. write down the financial assets to $1,030 and recognise an unrealised loss of $170.
C. write down the financial assets to $1,030 and recognise a realised loss of $170.
3.
At t = 2, Kirk will report the carrying value of its financial assets as:
A. $1,030.
B. $1,200.
C. $1,250.
4.
Based on the information provided, which of the following statements is most accurate?
A. Classifying the shares as fair value through profit or loss would result in greater reported earnings volatility for Kirk.
B. Classifying the shares as fair value through OCI would result in a $220 realised gain for Kirk between t = 1 and t = 2.
C. It is optimal for Kirk to classify its shares in Company A and Company B as fair value through profit or loss since it results in a net $50 gain recognised on the income statement at t = 2.
5.
Suppose for this question only that Security A and Security B are both debt securities carried at amortized cost and purchased initially at par. At t = 2, Kirk will report the carrying value of these securities as:
A. $1,030.
B. $1,200.
C. $1,250.
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MODULE 8.3: INVESTMENT IN ASSOCIATES, PART 1 - EQUITY METHOD
Investments in associates
Investment ownership between 20% and 50% is usually considered influential and is accounted for using the equity method. Under the equity method the initial investment is recorded at cost and reported on the balance sheet as a non-current asset.
In subsequent periods the investor recognises its proportionate share of the investee's earnings which increases the investment account on the investor's balance sheet and is recognised in the investor's income statement. Dividends received from the investee are treated as a return of capital and therefore reduce the investment account; dividends are not recognised as income under the equity method.
If the investee reports a loss, the investor's proportionate share of the loss reduces the investment account and lowers the investor's earnings. If investee losses reduce the investment account to zero, the investor usually discontinues the equity method; it resumes when the proportionate share of subsequent investee earnings exceeds the share of losses not recognised during the suspension period.
Fair value option
Under U.S. GAAP, equity method investments may be recorded at fair value. Under IFRS, the fair value option is available only to venture capital firms, mutual funds, and similar entities. The decision to use the fair value option is irrevocable and changes in value (together with dividends) are recorded in the income statement.
EXAMPLE: Implementing the equity method
Suppose:
On 31 December 20X5, Company P invests $1,000 for 30% of the common shares of Company S.
During 20X6, Company S earns $400 and pays dividends of $100.
During 20X7, Company S earns $600 and pays dividends of $150.
Calculate the effects of the investment on Company P's balance sheet and reported income for 20X6 and 20X7.
Answer:
For 20X6, under the equity method Company P will recognise its share of Company S's net income:
Equity income recognised in 20X6 = 30% × $400
= $120
Investment account increase due to equity income = $120
Dividends received = 30% × $100
= $30
Investment account decrease due to dividends = $30
Carrying value at end of 20X6 = Initial investment + Equity income - Dividends received
= $1,000 + $120 - $30
= $1,090
For 20X7, Company P recognises equity income = 30% × $600
= $180
Dividends received = 30% × $150
= $45
Carrying value at end of 20X7 = Beginning carrying value + Equity income - Dividends received
= $1,090 + $180 - $45
= $1,225
Excess of purchase price over book value acquired
Rarely does the purchase price equal the investor's proportionate share of the investee's book value. The excess of purchase price over the proportionate share of the investee's book value is allocated to the investee's identifiable assets and liabilities based on their fair values; any remainder is recognised as goodwill.
In subsequent periods the investor recognises expense based on the excess amounts assigned to the investee's assets and liabilities, consistent with the investee's recognition of expense (for example, additional depreciation on fixed assets allocated a step-up in fair value). The purchase price allocation is included in the investor's balance sheet investment account. The additional expense resulting from fair value allocations is recognised in the investor's income statement by adjusting the investor's equity income and investment account under the equity method.
PROFESSOR'S NOTE
Under the equity method the investor does not separately report the investee's individual assets and liabilities. The investor reports one line item: investment in associate. That one-line account includes the proportionate share of the investee's net assets at fair value and goodwill.
EXAMPLE: Allocation of purchase price over book value acquired
At the beginning of the year, Red Company purchased 30% of Blue Company for $80,000. On the acquisition date the book value of Blue's identifiable net assets was $200,000. The fair value and book value of Blue's identifiable assets and liabilities were equal except for Blue's equipment: book value $25,000; fair value $75,000 on the acquisition date. Blue's equipment is depreciated over 10 years on a straight-line basis. At the end of the year Blue reported net income of $100,000 and paid dividends of $60,000.
Part A: Calculate the goodwill created as a result of the purchase.
Part B: Calculate Red's income at year-end from its investment in Blue.
Part C: Calculate the investment in Blue that appears on Red's year-end balance sheet.
Answer:
Part A:
The excess of purchase price over the proportionate share of Blue's book value is allocated to the equipment. The remainder is goodwill.
Part B:
Red recognises its proportionate share of Blue's net income for the year. Also Red must recognise additional depreciation expense resulting from the purchase price allocation to equipment.
Part C:
The beginning balance of Red's investment account is increased by the equity income from Blue and decreased by dividends received from Blue.
Professor's alternative method (numerical expression preserved):
% acquired × (book value of net assets at beginning of year + net income - dividends) + unamortized excess purchase price = 0.3 × (200,000 + 100,000 - 60,000) + (20,000 - 1,500) = $90,500
MODULE QUIZ 8.3
1.
If a company uses the equity method to account for an investment in another company:
A. income is combined to the extent of ownership.
B. all income of the affiliate is included except intercompany transfers.
C. earnings of the affiliate are included but reduced by any dividends paid to the company.
Use the following information to answer Questions 2 through 4.
Suppose Company P acquired 40% of Company A for $1.5 million on 1 January 2023. During the year Company A earned $500,000 and paid dividends of $125,000.
2.
At the end of 2023, Company P reported investment in Company A as:
A. $1.5 million.
B. $1.65 million.
C. $1.7 million.
3.
For 2023, Company P reported investment income of:
A. $50,000.
B. $150,000.
C. $200,000.
4.
For 2023, Company P received cash flow from the investee of:
A. $50,000.
B. $150,000.
C. $200,000.
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MODULE 8.4: INVESTMENT IN ASSOCIATES, PART 2
Impairments of investments in associates
Equity method investments must be tested for impairment.
Under U.S. GAAP, if the fair value of the investment falls below the carrying value (investment account on the balance sheet) and the decline is considered other-than-temporary, the investment is written down to fair value and a loss is recognised in the income statement.
Under IFRS, impairment must be evidenced by one or more loss events. Under both IFRS and U.S. GAAP, if there is a recovery in value in the future, the asset cannot be written up (i.e., reversals of impairment are restricted under U.S. GAAP; IFRS has its own reversal rules for many assets but for equity accounted investments reversals are limited).
Transactions with the investee
Intercompany transactions between investor and investee require special treatment because the investor may be able to influence or control transaction terms. Profit from transactions must be deferred to the extent the profit is unconfirmed by sale to third parties or by use.
Transactions are described as upstream (investee → investor) or downstream (investor → investee).
Example - upstream sale:
Investor owns 30% of Investee. Investee reports $15,000 of profit on sales to Investor. At year-end half of the goods remain in Investor's inventory (50% unconfirmed).
Investor must reduce its equity income by Investor's proportionate share of the unconfirmed profit:
Reduction = ($15,000 total profit × 50% unconfirmed) × 30% ownership
= $2,250
When the inventory is sold by Investor, $2,250 of equity income will be recognised.
Example - downstream sale:
Investor owns 30% of Investee. Investor sold $40,000 cost of goods to Investee for $50,000. Investee sold 90% of the goods by year-end; 10% of the profit remains unconfirmed.
Investor's profit on sale = $50,000 - $40,000
= $10,000
Unconfirmed profit portion = 10% of $10,000 = $1,000
Investor must reduce its equity income by:
= $1,000 × 30% ownership
= $300
When Investee sells the remaining inventory, Investor can recognise the $300 of profit.
Analytical issues for investments in associates
When an investee is profitable and its dividend payout ratio is less than 100%, the equity method usually results in higher earnings for the investor compared to accounting for minority passive investments. Analysts should check the appropriateness of the equity method because an investor could apply it to report proportionate share of investee earnings even when it cannot actually influence the investee.
Under the equity method the investee's individual assets and liabilities are not reported on the investor's balance sheet - only the one-line investment account. By ignoring the investee's debt, the investor's reported leverage appears lower, and profitability ratios (margins) may be higher because the investee's revenues are not consolidated.
The investor recognises a proportionate share of the investee's earnings in its income statement, but those earnings may not be available as cash unless dividends are paid.
Under the acquisition (consolidation) method all assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent (intercompany transactions excluded). If the parent owns less than 100% of the subsidiary, a noncontrolling (minority) interest account is required for the portion of net assets and net income not owned by the parent.
MODULE 8.5: BUSINESS COMBINATIONS - BALANCE SHEET
Business combinations
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Under IFRS, business combinations are not differentiated based on the structure of the surviving entity. Under U.S. GAAP, historically, business combinations have been categorised as:
- Merger: Acquiring firm absorbs all assets and liabilities of acquired firm; acquired firm ceases to exist.
- Acquisition: Both entities continue to exist in a parent-subsidiary relationship (consolidation required).
- Consolidation: A new entity is formed that absorbs both combining companies.
Historically two accounting methods existed: the purchase method and the pooling-of-interests method. The pooling method has been eliminated. The acquisition method (which replaces the purchase method) is now required.
PROFESSOR'S NOTE
The acquisition method is often referred to as consolidation or the consolidation method.
Under the pooling-of-interests method the two firms were combined using historical book values, prior period results were restated as if always combined, and the acquisition price did not appear in the balance sheet - fair values played no role. Pooling-of-interests accounting is no longer allowed for new transactions, but transactions accounted under pooling pre-2001 (or pre-2004 under some standards) may still be presented historically.
EXAMPLE: Acquisition method (balance sheet comparison)
Suppose that on 1 January 2023 Company P acquires 80% of the common stock of Company S by paying $8,000 cash to the shareholders of Company S. Pre-acquisition balance sheets of Company P and Company S are given in the source figures (see original figures).
Under the equity method Company P reports its 80% interest in Company S as a one-line investment account. Under the acquisition method Company P reports 100% of Company S's assets and liabilities and recognises a noncontrolling interest for the portion not owned by Company P.
Post-acquisition, Company P's current assets are lower by the $8,000 cash used for the purchase.
Current assets under acquisition method = P current assets + S current assets - cash paid
Current assets under equity method = P current assets - cash paid
PROFESSOR'S NOTE
The $8,000 consideration goes to the departing shareholders from whom the shares were purchased.
In an acquisition Company P reports 100% of Company S's assets and liabilities even though it only owns 80%; the remaining 20% belongs to minority investors and is accounted for as noncontrolling interest in equity. Noncontrolling interest = subsidiary equity × % not owned. In the example, minority interest = $10,000 × 20% = $2,000 and is reported in stockholders' equity.
MODULE 8.6: BUSINESS COMBINATIONS - INCOME STATEMENT
Figure 8.5 in the source contains the separate income statements of Company P and Company S for the year ended 31 December 2023 (refer to original material).
Under the equity method Company P records its 80% share of Company S's net income in a single line on the income statement. Under the acquisition method revenues and expenses of P and S are combined. A minority interest is created in the income statement for the portion of Company S's net income not owned by Company P.
Figure 8.6 compares income statement effects of acquisition vs equity methods (refer to source figures). Acquisition method results in higher reported revenues and expenses compared to equity method, but consolidated net income attributable to the parent is the same after minority interest deduction.
PROFESSOR'S NOTE
The example assumed the parent paid the proportionate share of the subsidiary's book value. If the parent pays more than its proportionate share, excess purchase price is allocated to tangible and intangible assets and affects minority interest calculations; this is covered later.
MODULE QUIZ 8.4, 8.5, 8.6
Use the following information to answer Questions 1 and 2. Company M acquired 20% of Company N for $6 million on 1 January 2023. Company N's debt and equity securities are publicly traded. Company N reported the following for the year ended 2023 (figures provided in source).
1.
If Company M can significantly influence Company N, what is the balance sheet carrying value of Company M's investment at the end of 2023?
A. $5,790,000.
B. $5,970,000.
C. $6,000,000.
2.
If Company M can significantly influence Company N, what amount of income should Company M recognise from its investment for the year ended 2023?
A. ($90,000).
B. ($210,000).
C. $30,000.
3.
Selected operating results for Lowdown, Inc., in 2022 and 2023 are shown in the following table (refer to source). Martha Patterson will separate operating and investment results and forecast operating income for 2024 assuming the growth trend continues. The appropriate forecast of Lowdown's operating income in 2024 based on Patterson's analysis is closest to:
A. $500.
B. $650.
C. $700.
Use the following information to answer Questions 4 through 6. Suppose Company P acquires 80% of the common stock of Company S on 31 December 2022 by paying $120,000 cash. Pre-acquisition balance sheets and pro forma income statements are provided in the source materials.
4.
Immediately after the acquisition, in its consolidated balance sheet, Company P will report total assets of:
A. $1,080,000.
B. $1,440,000.
C. $1,560,000.
5.
For the year ended 31 December 2023, Company P's pro forma consolidated net income is:
A. $300,000.
B. $348,000.
C. $360,000.
6.
On its 31 December 2023 pro forma consolidated balance sheet, Company P should report a minority ownership interest of:
A. $0.
B. $39,000.
C. $42,000.
MODULE 8.7: BUSINESS COMBINATIONS - GOODWILL
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Under the acquisition method the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remainder is reported as goodwill, which is an unidentifiable asset that cannot be separated from the business.
Under U.S. GAAP goodwill is measured as the excess of the fair value of the subsidiary over the fair value of the subsidiary's identifiable net assets (full goodwill). Under IFRS goodwill is measured as the excess of the purchase price over the fair value of the acquiring company's proportion of the acquired company's identifiable net assets (partial goodwill). IFRS permits the full goodwill approach also.
Partial goodwill formula:
partial goodwill = purchase price - (% owned × FV of net identifiable assets of the subsidiary)
or
partial goodwill = % owned × full goodwill
EXAMPLE: Goodwill
Wood Corporation paid $600 million for all outstanding stock of Pine Corporation. At acquisition date Pine's condensed balance sheet indicated that plant and equipment fair value exceeded book value by $120 million. All other identifiable assets and liabilities had fair values equal to book values.
Calculate the amount of goodwill Wood should report in its consolidated balance sheet.
Answer:
Goodwill = Purchase price - Fair value of identifiable net assets acquired
The plant and equipment is written up by $120 million; goodwill is calculated after that write-up. Pine's internally reported goodwill is ignored for the purpose of calculating Wood's acquisition goodwill.
EXAMPLE: Full goodwill vs partial goodwill
Continuing the previous example, suppose Wood paid $450 million for 75% of Pine. Calculate goodwill using both methods.
Answer:
Full goodwill method:
Implied full value of subsidiary = $450 million / 0.75 = $600 million
Acquisition goodwill = Implied full value of subsidiary - Fair value of identifiable net assets
= $600 million - (fair value of Pine's identifiable net assets)
= $40 million (as in the initial example)
Partial goodwill method:
Partial goodwill = Purchase price - (percentage owned × fair value of identifiable net assets)
Goodwill is lower using the partial goodwill method.
The value of noncontrolling interest (NCI) also depends on the chosen method:
noncontrolling interest (full goodwill) = % not owned × (purchase price / % owned)
noncontrolling interest (partial goodwill) = % not owned × (fair value of net identifiable assets of the subsidiary)
In the example, NCI (full goodwill) = 25% × $600 million = $150 million; NCI (partial goodwill) = 25% × fair value of identifiable net assets = $140 million. The $10 million difference offsets the $10 million difference in goodwill.
The full goodwill method results in higher total assets and higher total equity than the partial goodwill method; therefore return on assets and return on equity will be lower under the full goodwill approach.
Goodwill is not amortised. Instead, goodwill is tested for impairment at least annually. Impairment occurs when carrying value exceeds fair value. Goodwill is tested at the reporting-unit (cash-generating unit) level because goodwill cannot be separated from the business.
Impairment testing - comparison of IFRS and U.S. GAAP approaches
Under IFRS the impairment test uses a single-step approach: if the carrying amount of the cash-generating unit exceeds its recoverable amount, an impairment loss is recognised equal to the excess.
Under U.S. GAAP goodwill impairment potentially involves two steps. Step 1: compare carrying value of the reporting unit (including goodwill) to the fair value of the reporting unit. If carrying value exceeds fair value, impairment exists. Step 2: measure the impairment loss as the difference between the carrying value of goodwill and the implied fair value of goodwill. The impairment loss is recognised in the income statement as part of continuing operations.
EXAMPLE: Impaired goodwill
Last year Parent acquired Sub for $1,000,000. At acquisition the fair value of Sub's net assets was $800,000. Acquisition goodwill therefore was $200,000 ($1,000,000 - $800,000).
At the end of this year the fair value of Sub is $950,000 and fair value of Sub's net assets is $775,000. The carrying value of Sub is $980,000. Determine if an impairment exists and calculate the loss under U.S. GAAP and IFRS.
Answer:
U.S. GAAP (two-step):
Step 1: Carrying value of reporting unit ($980,000) compared to fair value of reporting unit ($950,000).
Since $980,000 > $950,000, an impairment exists.
Step 2: Implied goodwill = Fair value of reporting unit - Fair value of identifiable net assets
= $950,000 - $775,000
= $175,000
Carrying value of goodwill = $200,000
Impairment loss = Carrying value of goodwill - Implied goodwill
= $200,000 - $175,000
= $25,000
Goodwill is written down to $175,000.
IFRS (one-step):
Impairment loss = Carrying value of reporting unit - Fair value of reporting unit
= $980,000 - $950,000
= $30,000
Bargain purchase
In rare cases the purchase price is less than the fair value of net assets acquired. Both IFRS and U.S. GAAP require that the difference (fair value of net assets - purchase price) be recognised as a gain in the income statement (a bargain purchase gain).
MODULE QUIZ 8.7
1.
According to U.S. GAAP, goodwill is considered impaired if the:
A. implied goodwill at the measurement date exceeds the carrying value of goodwill.
B. carrying value of the reporting unit is greater than fair value of the reporting unit.
C. goodwill can be separated from the business and valued separately.
2.
Adam Corporation acquired Hardy Corporation recently using the acquisition method. Adam is preparing to report its year-end results to include Hardy according to IFRS. Which of the following statements regarding goodwill is most accurate?
A. Adam would amortise its goodwill over no more than 20 years.
B. Adam would test its goodwill annually to ensure the carrying value is not greater than the recoverable amount.
C. Adam would test its goodwill annually to ensure the fair value is not greater than the carrying value.
MODULE 8.8: JOINT VENTURES
Joint ventures
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A joint venture is an entity in which control is shared by two or more investors. Joint ventures are used for foreign investments, special projects, or risky ventures. Both U.S. GAAP and IFRS generally require the equity method for joint ventures. In rare circumstances proportionate consolidation is allowed. Proportionate consolidation is similar to acquisition consolidation except the investor reports only its proportionate share of the joint venture's assets, liabilities, revenues, and expenses; no minority interest is necessary.
PROFESSOR'S NOTE
Proportionate consolidation is not the same as full consolidation (acquisition method). Under proportionate consolidation an investor reports its pro rata share of each line item of the joint venture, resulting in higher assets and liabilities compared to the equity method, but the same net assets (equity) as under the equity method.
Example referenced earlier: Company P acquired 80% of Company S for $8,000 on 1 January 2023. Under proportionate consolidation Company P reports 80% of Company S's assets and liabilities. Current assets under proportionate consolidation = P current assets - cash paid + (S current assets × 80%). With proportionate consolidation Company P reports 80% of S's revenues and expenses. Revenues and expenses are higher than under the equity method but net income is unchanged.
MODULE QUIZ 8.8
Use the following information to answer Questions 1 through 3. Company C owns a 50% interest in joint venture JVC and accounts for it using the equity method. JVC's assets and liabilities have book values equal to fair value. JVC's 2024 results are provided in the source.
1.
Assuming consolidation using the acquisition method, Company C's stockholders' equity at the end of 2024 is closest to:
A. $5,950.
B. $6,350.
C. $6,750.
2.
Assuming consolidation using the acquisition method, Company C's total assets at the end of 2024 is closest to:
A. $15,250.
B. $15,650.
C. $17,450.
3.
Assuming proportionate consolidation, Company C's cost of goods sold and net income for the year ended 2024 are closest to:
(Options and numerical answers given in source material.)
4.
According to U.S. GAAP, which statement about the method to account for a 50% joint venture is most accurate?
A. The investor can choose between the acquisition method and the equity method.
B. The equity method is required.
C. The acquisition method is required.
MODULE 8.9: SPECIAL PURPOSE ENTITIES
Special purpose and variable interest entities
Video covering this content is available online.
A special purpose entity (SPE) is a legal structure created to isolate certain assets and liabilities of a sponsor. An SPE can be a corporation, partnership, joint venture, or trust. Typical motivation is to reduce risk and lower financing cost. SPEs are often structured so that the sponsor controls the SPE's finances or operations while third parties hold equity.
Historically SPEs were sometimes kept off-balance-sheet to enhance sponsors' reported metrics.
The FASB uses the term variable interest entity (VIE) to describe SPEs that meet certain conditions. Per FASB ASC Topic 810, Consolidation, a VIE is an entity that has one or both:
- At-risk equity that is insufficient to finance the entity's activities without additional financial support.
- Equity investors that lack any one of the following: decision-making rights; obligation to absorb expected losses; right to receive expected residual returns.
If an SPE is a VIE it must be consolidated by the primary beneficiary - the entity that absorbs the majority of the risks or receives the majority of rewards.
PROFESSOR'S NOTE
In a VIE the capital labelled as stockholders' equity may not have the risk/return characteristics of normal equity. "Variable interest" usually refers to the economic stake (or guarantees) of the primary beneficiary, which may have similar economic characteristics to ordinary equity.
The IASB continues to use the term SPE. Under IFRS 10 the sponsor must consolidate the SPE if the sponsor controls the SPE.
EXAMPLE: Special purpose entity
Company P, a textile manufacturer, wants to borrow $100 million. It has two options (full numerical balance sheet examples are given in the source materials):
- Option A: Borrow directly: Company P's cash and debt both increase by $100 million.
- Option B: Create an SPE that purchases Company P's accounts receivable; SPE borrows $100 million and pays Company P the cash. If the SPE meets consolidation criteria, the SPE's debt is consolidated with Company P's debt and the receivables are included in consolidated assets.
After consolidation the sponsor's balance sheet reflects the borrowing; Company P cannot keep the borrowing off the books if the SPE must be consolidated.
OTHER ISSUES IN BUSINESS COMBINATIONS THAT WEAKEN COMPARABILITY
Contingent assets and liabilities
Under IFRS only contingent liabilities whose fair value can be measured reliably are recognised at acquisition; contingent assets are never recognised at acquisition. Subsequently contingent liabilities are measured at the higher of the amount initially recognised or the best estimate to settle.
U.S. GAAP divides contingent items into contractual and non-contractual. Contractual contingent assets and liabilities are recorded at fair value on the acquisition date. Non-contractual contingent items are recorded if "more likely than not" they meet the definition of asset or liability. Subsequent measurement of contingent liabilities is similar under IFRS; contingent assets under U.S. GAAP are recognised at the lower of initial value and best estimate of future settlement amount.
Contingent consideration
Where acquisition terms include contingent consideration (e.g., additional payment if target attains specified earnings targets), such consideration is recognised at fair value under both IFRS and U.S. GAAP as asset, liability, or equity. Subsequent changes in fair value are recognised in the income statement unless originally classified as equity, in which case subsequent changes settle within equity.
In-process R&D
In-process research and development is capitalised as an intangible asset and included in the acquiree's identified assets under both U.S. GAAP and IFRS. It is subsequently amortised if successful or impaired if unsuccessful.
Restructuring costs
Restructuring costs are expensed when incurred and are not capitalised as part of acquisition cost under both IFRS and U.S. GAAP.
LOS 8.c: Analyze how different methods used to account for intercorporate investments affect financial statements and ratios.
The effects of method choice on reported financial results have been discussed throughout. A concise comparison of the equity method, proportionate consolidation, and acquisition method follows.
- All three methods report the same net income attributable to the combined enterprises in most situations.
- Equity method and proportionate consolidation report the same equity. The acquisition method reports equity higher by the amount of noncontrolling interest.
- Assets and liabilities are highest under the acquisition method, lowest under the equity method; proportionate consolidation lies in between.
- Revenues and expenses are highest under the acquisition method, lowest under the equity method; proportionate consolidation lies in between.
Figure 8.9 in the source illustrates reported financial results from different accounting methods.
MODULE QUIZ 8.9
1.
A company accounts for its investment in a subsidiary using the equity method. The reported net profit margin is 14%. An analyst adjusts the financials and determines that the company's own net profit margin is 8% while the subsidiary's profit margin is 10%. The net profit margin based on consolidation would most likely be:
A. less than 8%.
B. more than 14%.
C. between 8% and 14%.
KEY CONCEPTS
LOS 8.a
Accounting for investments:
- Investments in financial assets: Dividends and interest income are recognised in the investor's income statement. Amortized cost securities are reported on the balance sheet at amortized cost and subsequent fair value changes are ignored. FVPL securities are carried at fair value with unrealised gains and losses shown in the income statement. FVOCI securities are carried at fair value with unrealised gains and losses recognised in equity (OCI).
- Investments in associates/joint ventures: Under the equity method the investor's proportionate share of the investee's earnings increases the investment account and is recognised in the investor's income statement. Dividends reduce the investment account and are not recognised as income. In rare cases proportionate consolidation may be allowed; proportionate consolidation is similar to a business combination but only the investor's proportionate share of assets, liabilities, revenues, and expenses are reported; no minority interest is required.
- Business combinations: In an acquisition the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent (intercompany transactions excluded). If parent owns less than 100% a noncontrolling interest account is required for the portion of subsidiary net assets and net income not owned by the parent.
- Special purpose entities: Under IFRS the sponsor must consolidate an SPE if the sponsor controls the SPE; U.S. GAAP requires consolidation of a VIE by its primary beneficiary.
LOS 8.b
Differences between IFRS and U.S. GAAP:
- There are differences in contingent asset and liability recognition under the acquisition method between IFRS and U.S. GAAP.
- IFRS permits either partial goodwill or full goodwill methods to value goodwill and noncontrolling interest; U.S. GAAP requires the full goodwill method.
LOS 8.c
Effects of equity method versus acquisition method:
- Both methods typically report the same net income.
- Acquisition method equity will be higher by the amount of noncontrolling interest.
- Assets and liabilities are higher under the acquisition method.
- Sales (revenues) are higher under the acquisition method.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 8.1
1.
A
Usually an ownership interest between 20% and 50% would indicate the ability to significantly influence. However, in this case Tall is unable to influence Short as evidenced by its failure to obtain board representation; thus Tall's ownership interest should be considered an investment in financial assets. (LOS 8.a)
Module Quiz 8.2
1.
C
Initially, the carrying value of all security investments is cost. Initial cost = $950 + $250 = $1,200. (LOS 8.a)
2.
B
Fair value through OCI and FVPL securities are carried at market value on the balance sheet. Market value at t = 1 is $850 + $180 = $1,030. Unrealised loss = ($850 - $950) + ($180 - $250) = -$170. Recognition differs by classification; FVOCI records unrealised loss in OCI while FVPL records it in income statement. (LOS 8.a)
3.
C
The increase in value requires that investment securities be written up to $900 + $350 = $1,250. Because these are equity securities, the amortized cost classification is not available. (LOS 8.a)
4.
A
Classifying the shares as FVPL requires both realised and unrealised gains and losses to be recognised in the income statement, producing greater reported earnings volatility. There is a $220 unrealised gain between t = 1 and t = 2; classification as FVPL or FVOCI results in the same fair market value of $1,250 reported on the balance sheet at t = 2. (LOS 8.a)
5.
B
Debt securities at amortized cost are carried at amortized cost ($1,200) and no unrealised or realised gains or losses are recognised until disposition. Because these securities were purchased at par, there is no amortisation of premium/discount. (LOS 8.a)
Module Quiz 8.3
1.
A
With the equity method the proportional share of the affiliate's income (% ownership × affiliate earnings) is reported on the investor's income statement. (LOS 8.a)
2.
B
$1,500,000 + 0.4($500,000 - $125,000) = $1,650,000. (LOS 8.a)
3.
C
$500,000 × 0.4 = $200,000; dividends are not included in income under the equity method. (LOS 8.a)
4.
A
$125,000 × 0.4 = $50,000; the dividend is cash flow = $50,000. (LOS 8.a)
Module Quiz 8.4, 8.5, 8.6
1.
A
Module 8.5: $6,000,000 + 0.2(-$450,000) - 0.2($600,000) = $5,790,000. (LOS 8.a)
2.
A
0.2(-$450,000) = -$90,000. (Module 8.6, LOS 8.a)
3.
A
After removing investment gains in 2022 and 2023, operating income is $500 each year. Assuming 0% growth trend, forecast for 2024 is $500. (Module 8.6, LOS 8.a)
4.
B
Total assets = $1,200,000 + $360,000 - $120,000 = $1,440,000. (Module 8.5, LOS 8.a)
5.
B
Minority interest income = $60,000 × 0.2 = $12,000.
Consolidated net income (after minority interest) = $300,000 + $60,000 - $12,000 = $348,000. (Module 8.4, LOS 8.a)
6.
B
Beginning minority interest = $30,000 ($150,000 S equity × 0.20). Minority share of Company S's income = $12,000. Minority share of dividends = $3,000. Ending minority interest = $30,000 + $12,000 - $3,000 = $39,000. (Module 8.4, LOS 8.a)
Module Quiz 8.7
1.
B
In the goodwill impairment test the carrying value of the reporting unit (including goodwill) is compared to the fair value of the reporting unit. If carrying value is greater than fair value, impairment exists. (LOS 8.a)
2.
B
Adam is required to perform an annual impairment test to ensure carrying value is not greater than recoverable amount. (LOS 8.a)
Module Quiz 8.8
1.
B
Company C would include minority interest (50% of $800) along with its own equity of $5,950 in consolidated statements. (Module 8.5, LOS 8.a)
2.
C
Company C would include all assets of JVC and remove its equity investment in the consolidated balance sheet: $13,450 - $400 + $4,400 = $17,450. (Module 8.6, LOS 8.a)
3.
A
COGS = $7,000 (Company C) + 50% × $2,000 (JVC) = $8,000. Net income of $930 is not affected by proportionate consolidation. (Module 8.8, LOS 8.a)
4.
B
Under U.S. GAAP (and IFRS) the equity method is generally required for joint ventures. Proportionate consolidation is allowed only in rare cases. (Module 8.8, LOS 8.b)
Module Quiz 8.9
1.
C
The equity method typically yields a higher measure of net profit margin; consolidation will most likely produce a margin between the two entities' margins. (LOS 8.c)
