Session- 17

Analysis of Inter-corporate Investment Activities: Investments

in securities, analysis of marketable securities, equity method
of accounting.

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 Intercorporate Investments
2

A. Modern company rarely consists of a single

corporate entity. Large MNCs may have hundreds
of subsidiaries in dozens of jurisdictions.
B. Large entities frequently invest in other entities,
including joint ventures and partnerships.

See ITC Ltd.AR-2017 PP.210 & 255

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 Reasons for investing in securities of
3
other companies
Intercorporate investments may involve temporary
purchases of equity or debt securities to capture the
following benefits:
A. Return: Dividend, interest, capital gain

B. Risk sharing: or participation in new markets of

technologies.
C. Investment may be a precursor to an acquisition.

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 Analyst’s Point
4

A. Accounting principles applicable to inter-corporate

investments.
B. Evaluate the impact of the reporting choice on
financial statements.
C. Applicable analytical techniques.

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 Degree of investor’s influence or
5
control over the investee
 Financial reporting of inter-corporate equity investments depends
primarily on the degree of investor influence or control over the
investee.
 Percentage of ownership in the investee firm is used as practical
guide to measure significant influence or control.
Ownership level Degree of Influence Reporting Method

< 20% No significant influence Cost or Market (CM)

20-50% Significant influence Equity Method (EM)

>50% Control Consolidation (Con)

Note: Percentage ownership is defined by either ownership or voting

control of investee common stock. 16/09/2020
 Implication
6

The conceptual distinction among different reporting requirements is

the extent to which the investee (affiliate) constitutes an integral part
of the investor (parent) company.
 Under Cost or Market (CM), the two firms are treated as separate entities
and the parents income from its investment is based on actual dividends
received and any change in market value of investment.
 Under Equity Method:- Parents ability to exercise significant
influence over the operating and strategic activities of the affiliate.
Income reported by parent includes its share (in proportion) of the
income reported by the affiliate.
1. What will be the share of dividends declared by the affiliate ?
2. What about changes in market price ?
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 Implication
7

1. Reported as reduction in the carrying amount of

the investment to reflect corresponding decline in
the net assets of the affiliate.
2. Reported income under EM is not affected by
changes in market prices, unless the price decline
is considered permanent or the investment is sold.
3. What about consolidated reporting views?

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 Implication
8

3. Under Consolidated Method: Legally separate but

reporting view the two companies as a unified
economic entity.
Entire income of the affiliate (net of inter company
transactions) is added to that of the parent,
adjusted for income attributable to the non-
controlling shareholder’s minority interest.

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 A. Investments in securities:
(Case of No significant influence)
9

 Over the life of the investment, total return earned on the

investment equals to:
Dividends and Interest received + Capital gain or Loss
Following accounting methods used to report the investments in
securities.
1. Cost Method-recognizes changes in market value only in the
period the securities are sold.
2. Market method: Mirrors the actual economic performance of
the security and recognizes changes in market prices in the
period they occur.

Note: Across all methods recognize dividends and interest as part

of income in the year they are earned. They differ as to when
changes in market value of the assets are recognized.
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 Example:1
10

Company ‘P’ purchases 1 share (out of 100 shares

outstanding) of a company ‘S’ for Rs.100.
Company ‘S’ reports net income of Rs.25 per share for
period 1 and declares dividends of Rs10 per share on
its common stock. The market value of company ‘S’s
share rises to Rs.135 per share at the end of period 1.
Company ‘P’ sells its share of company ‘S’ for Rs.120
during period 2.

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 Analysis
11

1. Cost method: Assets are reported at their

amortized cost. Market value changes are not
recognized until there is an actual transaction (sale).
Only dividends and interest received from the
investee and realized gains and losses are
recognized.

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 Implication
12

 In absence of Dividend, sale and write down of the investment

the operating , financing and investing activities of the company
‘S’ have no impact on the financial statements of the company ‘P’.
 The carrying value of the investments remains Rs.100 until the
investment is sold.
_________________________________________
 A write down of the investment to its estimated market value is
required only when company P determines that it has been
permanently impaired (i.e. due to financial problems of the
company S). In that case the write down is recognized in current
period income. The estimated market value becomes the new
carrying amount.
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 Analysis
13

2. Market method: Under the market method,

securities with a public market are carried at their
current market value. Unrealized changes in market
value (from period to period) are included in net
income along with dividend, interest and realized
gains and losses.

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 Analysis
14

 The total two period return remains Rs 30/- (in

Example-1) as under the cost method. However, the
returns recognized each period differ considerably.
 The market method reflects the actual economic
return earned on the investment in each time period.

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 Summary
15

Method Balance Sheet Income Statement

(Carrying Value) (Recognized as Income)
Cost Cost Dividend and Interest
Realized gains and losses
Market Market value Dividend and Interest
Realized and unrealized gains and losses

Note: 1. The cost method is used for securities with no readily

available market price (they are not publicly traded).
2. Securities that have a public market or readily determined fair
value must be classified into three categories: 16/09/2020
 Practices
16

 US Accounting Standards for investment in

securities- SFAS 115 (1993) requires a hybrid of
cost and market methods.
 Securities that have a public market or readily
determined fair value must be classified (US-
Accounting standards) into three categories:
1. Held to maturity:
2. Available for sale:
3. Trading securities:

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 Investment in Securities

Debt Securities Equity Securities

A. No influence (below 20% holding

A. Held –to-Maturity
1. Trading
B. Trading 2. Available-for Sale
C. Available for sale B. Significant influence (between
20% and 50% holding)
C. Controlling Interest
(above 50% holding)

17 16/09/2020
 Analyst’s Point: Classification Criteria
18

 Classification decision depends on management’s

intent, an inherently subjective standard. However,
it is not a completely free choice. The criteria are
intended to ensure that the portfolio holdings
conform to the conceptual basis for the accounting
principles.
 Management discretion is more.

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 A. Held to Maturity (HTM)
19

1. To classify debt securities as held to maturity: the firm must

have both intent and ability to do so. Intent requirement means
that HTM securities can not be sold prior to maturity except in
exceptional circumstances1.
2. The HTM classification is used only for debt securities.
3. They could be either short term (current assets) or long term (as
non-current assets)
4. Actively managed portfolios, therefore must be classified as
available for sale.
Note: 1. Exceptional changes in circumstances: significant
deterioration in credit ratings, changes in tax laws or regulatory
requirements, a major acquisition or disposition.
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 Held to maturity (HTM):
20

1. The cost method is used to report holdings of debt securities

at amortized cost.
2. Interest income and realized gain and losses are reported in
income.
3. No unrealized gains or losses from these securities are
recognized in income.

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 B. Trading Securities (TS)
21

1. TS include both debt and non-influential equity

securities. In other words, trading classification is
used for both debt and equity securities.
2. Intention of the investor (buyer) for actively
managing them and selling them for profit in the
near future.
3. TS are current assets.
4. Securities acquired mainly for short-term trading
gains (usually less than three months).

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 Trading securities (TS)
22

 The market method is used to report these debt

and equity securities as current assets at fair
market value.
 Dividends, interest income, and all gains and losses
(realized and unrealized) are reported in income.

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 C. Available–For–Sale Securities (AFS)
23

1. AFS include both Debt and non-influential equity securities.

2. AFS securities are included among current and non-current
assets, depending on their maturity or management’s intent
regarding their sale.
 The market method is applied to record these debt and
equity securities as assets at fair market value.
 Although dividends, interest income, and realized gains and
losses are reported in income.
 Unrealized gains and losses are reported (net of deferred
income tax) as a separate component of other comprehensive
income.
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 Classification and Accounting for Debt Securities
Category Description Balance Income Statement
Sheet Unrealized Realized gain/Losses
gains/Losses
Held to Maturity Securities acquired with both Amortized Not recognized in Recognize realized gains and
the intent and ability to hold Cost either net income or losses and interest income
till maturity comprehensive including amortization of any
(Only Debt Income premium or discount on long
Securities) term securities are included in
income.

Trading Securities acquired mainly Fair Value Recognize in net Recognize realized gains/losses
for short-term trading gains income and interest income in net
(both Debt & (usually less than three income
equity) months)

Available for sale Securities neither held for Fair Value Not recognize in net Recognize realized gains and
trading nor held-to-maturity income but losses and interest income
recognize in including amortization of any
(Both Debt & comprehensive premium or discount on long
equity) income. term securities are included in
income.

24 16/09/2020
 Fair Value (FV)
25

 FV is the amount at which the assets can be

exchanged for in a current, normal transaction
between willing parties.
 When an asset is regularly traded, its fair value is-
published market price.
 If no published market price exist- fair value is
determined using historical cost.

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 Classification and Accounting for Equity Securities
NO INFLUENCE Significant Influence Controlling Interest
Attribute Available-For-Sale Trading

Ownership Less than 20% Less than 20% >=20% and <= 50% Above 50%
Purpose Long or intermediate Short term Considerable business Full business control
term investment investment or influence
Trading
Valuation Basis Fair Value Fair Value Equity Method Consolidation
Balance sheet: Fair value Fair value Acquisition cost adjusted Consolidated Balance
Asset value for proportionate share of sheet
investee’s retained
earnings and appropriate
amortization.

Income Statement: Not recognize in net In net Income Not recognized Not Recognized
Unrealized income but
Gains/Losses recognize in
comprehensive
income.
Income Statement: Recognize dividends Recognize dividends Recognize proportionate Consolidated Income
Other income and realized gains and realized gains share of investee’s net Statement.
effects (Realized and losses in net and losses in net income less appropriate
Gains and Losses) income income amortization in net
26 income. 16/09/2020
 Transfer between portfolios
27

 Transfer between portfolios are subject to special rules:

1. Securities are transferred to the trading portfolio at fair
market value, any unrealized gains or loss must be included
in income.

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 Transfer Between Categories
28

 Normally debt securities classified as HTM cannot

be transferred to another class except under
exceptional circumstances i.e. M&A, Divestiture,
major deterioration in credit rating.
 Transfers from AFS to trading are normally not
permitted
 Whenever transfers of securities between classes
occur, the securities must be adjusted to their fair
value.

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 Accounting for Transfers Between Security Classes

Transfer
Effect on Asset value in
From To Balance sheet Effect on income statement

Held-to-maturity Available-for- Asset reported at fair value Unrealized gain or loss on date
(HTM) sale instead of (amortized ) cost of transfer included in
comprehensive income

Trading Securities Available-for- No effect Unrealized gain or loss on date

(TS) sale of transfer included in Net
income

Available-for-sale Trading No Effect Unrealized gain or loss on date

(AFS) of transfer included in Net
income.

Available-for-sale Held-to-Maturity No effect at transfer: Unrealized gain or loss on date

(AFS) however asset reported at of transfer included in
amortized cost instead of comprehensive income
fair value at future dates.
29 16/09/2020
 Example-2: Comparison of Accounting Methods for
Intercorporate Investments (under SFAS 115)
30

Assumption Quantity of Shares Purchase or sale Market

Year Purchased (sold) Price/Share Price/

2011 100 $80 70

2012 -30 60 80
2013 40 70 90
Note: All sales and purchases assumed to occur on January 1
Price may vary from price on previous day (December 31)
Accounting Year Jan-December
2011 2012 2013
Investee earnings per share $7 $8 $7
Investee dividend per share 2 2 2
Refer Excel Sheet-Example-2
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 Interpretation
31

A. Only the trading portfolio is marked to market for both

reported income and balance sheet purposes.
B. Changes in market value of AFS securities are excluded from
reported income, although included in comprehensive income.
C. Market value is used on the balance sheet for AFS securities as
it is for the trading portfolio.
D. Finally reported operating performance of the investee
(earnings or cash flow) doesn’t affect the accounting in any of
these cases.

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 II. Analysis of Marketable Securities
32

 The following issues are important to the analysis of

marketable securities.
1. Need to segregate the operating results of the
firm from its investment results.
2. Differential effects of portfolio classification
3. Assessment of investment results.

Refer Excel for analysis

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 1. Segregation of operating from
investment performance
33

 Segregation of operating from investment

performance facilitates the analysis:
1. Operating performance relative to other firms in
its industry.
2. Investment performance compared to investment
benchmarks.

Refer Excel-example-2 for Analysis

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 2. Effects of classification of marketable
securities under SFAS 115
34

Classification choice under SFAS 115 can affect both:

1. Firm’s reported financial performance
2. Firm’s financing and investment decisions

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 2.1Effect on reported performance
35

1. Unrealized market value changes do not affect reported

income for securities in the AFS and HTM portfolio.
2. On the other hand such changes are components of reported
income for trading securities, regardless of whether they are
sold.
3. SFAS-115 requires that transfers from trading to other
categories takes place at current market price.
4. This provision is designed to ensure that firms cannot avoid
reporting unrealized losses by classification.
____________________________________________
SFAS 115- application for HTM, AFS and TS
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 2.2 Effect on investment and financing decisions
36

 Balance sheet carrying values of debt securities can be

insulated from market value changes by classifying these
securities as HTM.
 FASB guarded against abuse of this provision by restricting
sales (and reclassification) of HTM debt securities.
 SFAS-115 states that HTM securities cannot be sold prior to
maturity except under unusual circumstances.

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 3. Analysis of investment performance
37

 Assessment of investment results- To analyze actual

investment returns, the analyst must go beyond the reported
results. All securities should be shown at current market value
and all gains and losses should be attributed to the period
earned rather than the period realized. The period in which
market value changes and those in which they are recognized
(by sale) may be completely different.
 The analyst should track investment performance on a mark-to-
market basis, measuring the actual investment performance for
each period.

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 Mark-to-Market Accounting
38

The total return of a firm’s investment portfolio equals the sum of:
 Dividends and interest income
 Realized gains and losses
 Unrealized (holdings) gains and losses
1. Dividends and interest income, as well as realized gains and
losses, are always reported in the period they occur.
2. Thus, calculation of the mark-to-market return requires
measurement of the unrealized (holding) gain and losses.
3. This amount can be calculated easily as long as both cost and
market values are reported.

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 Calculation of Mark-to-Market Return
39

 If we define the market valuation adjustment (MVA) as the

difference between market and cost at each balance sheet
date, then for each time period,
Unrealized Holding Gains and Losses = Change in MVA
 This holds true whether or not new securities are added to the
portfolio during the year. Thus, the actual portfolio performance
(mark-to-market return) equals the sum of:
1. Dividends and interest incomes
2. Realized gains and losses
3. Change in the market valuation adjustment (MVA).
Exercise: The Chubb Corporation
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 III. Equity Method of Accounting
40

 EM must be used when the investor can exercise

significant influence on the management, operations
and investing and financing decisions of the
investee.
 The investor must report its proportionate share of
the investee’s net assets and recognize a
proportionate share of the income of the investee,
regardless of whether it is received as a dividend
or is reinvested.
 Ownership of 20% is presumed to meet this test.
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 Equity Method Accounting
41

• Investment account:
– Initially recorded at acquisition cost
– Increased by % share of investee earnings
– Decreased by dividends received
• Income:
– Investor reports % share of investee company earnings as
“equity earnings” in its income statement
– Dividends are reported as a reduction of the investment
account, not as income

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 Limitation for application of EM
42

 Despite 20% (or greater) ownership if any of the

following conditions is present:
1. Litigation between the investor and investee
2. Standstill agreement or similar restrictions in play
3. The investee has a majority holder that controls its
operations.

Note: In practice, the EM has been applied to holdings

as low as 10% when significant influence has been
demonstrated. 16/09/2020
 Analyst’s point
43

 The user of financial statements can not take for

granted that the equity method will be used if and
only if the voting interest is in the range of 20% to
50%.

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 Equity Method Accounting
44

Equity Method Mechanics

• Assume that Global Corp. Synergy, Inc.
acquires for cash a 25% interest
in Synergy, Inc. for $500,000, Current assets 700,000
representing one-fourth of
Synergy’s stockholders’ equity PP&E 5,600,000
as of the acquisition date. Total assets 6,300,000

• Acquisition entry: Current liabilities 300,000

Long-term debt 4,000,000
Investment A/c Dr. 500,000 Stockholders’ Equity 2,000,000
Cash Cr 500,000 Total liabs and equity 6,300,000

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 Equity Method Accounting
45

• Subsequent to the acquisition Investment 25,000

date, Synergy reports net Equity earnings 25,000
income of $100,000 and pays (to record proportionate share of
dividends of $20,000. Global investee company earnings)
records its proportionate share
of Synergy’s earnings and the
receipt of dividends as follows: Cash 5,000
Investment 5,000
(to record receipt of dividends)

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 Example-3: illustration of equity method
46

Case: Unquoted investment:

On 31st December 2000, company P invests $300 in company S
and receives 30% of the shares of company S in return. Assumed
that company S’s equity (book value) at the time of purchase was
$ 1000 (i.e. P paid book value 30% of $1000= $300).
1. During the year ended December 31, 2001 Company S earns
$100 and pays cash dividends of $ 20.
2. Company S earns $150 and pays dividends $60 in 2002.

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 Interpretation
47

 Company P receives $6 as cash dividends (30% of $20).

 In contrast to the cost and market methods, these dividends
are not included directly as part of P’s income.
 Under the equity method, investment income (i.e. dividend) is a
function of the earnings of the investee and is independent of
dividends received.
 Company P records dividends received as a reduction in the
“Investment in Company S” Account
 P’s investment account in S = 300+30-6= 324

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 Rationale
48

 The rationale for this reporting method is that

company S’s equity and net assets decline due to
the declaration of dividends . The dividend of $20
reduces company S’s equity by $20, company P’s
share of that decrease in equity is $6.

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 Implication
49

 The investment account , therefore contains the

original cost of the investment plus the equity in the
undistributed earnings of the investee.
 When investment is sold, any realized gain or loss is
based on a comparison of the proceeds with the
adjusted cost basis of $324, not the original cost of
$300.
 Note: The investment account contains the original
cost of investment plus the equity in the
undistributed earnings of the investee.
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 Second Year
50

 P’s investment account is increased by $27 (i.e. $45-

18$). Dividend = .30*60 =18, proportion of
earnings = .30*150= 45.
 P’s Investment in S as on 2002 = 324+27 = 351.
 From 31/12/2000 to 31/12/2002 the equity in S
is increased by 100-20+150-60= 170 * .30 = 51.
 Hence, the terminology EM reflects that the parent’s
investment account mirrors (changes) the investee’s
equity.
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 Comparison of Equity Method SFAS-115
P’S statement of income
51

Income Reported Cash Received

Year SFAS 115 Equity Method SFAS 115 Equity
Cost/Market Cost/market

2001 $6 $30 $6 $6

2002 18 45 18 18

SFAS- 115 US practice for accounting marketable security.

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 Implication
52

 Under SFAS 115 (Cost/Market method) company

P’s income includes only dividend received.
 Use of equity method results in higher earnings for
company P as it reports its proportionate share of
the reinvested earnings of company S.
 When the investee has earnings and a dividend
pay-out ratio of less than 100%, use of equity
method will increase the earnings of the investor
relative to those reported under SFAS 115. Cash
flows however are unchanged.
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 Implication
53

 Under SFAS cash flows and income are identical,

they differ under equity method.

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 Implication
54

 When the equity method recognizes income in

excess of dividends received, interest coverage and
ROI ratios for company P will improve. Its total
assets and stockholder’s equity rise due to
recognition of its share of the reinvested earnings
(earnings-dividend paid) of company S.

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 Equity Method of Accounting and Analysis
55

1. Given a profitable investee and a low dividend

pay-out ratio, the equity in reinvested earnings is
a significant factor in the carrying amount under
the equity method.
2. In years, when the market value of the investee
changes significantly, reported investor earnings
and carrying values can differ considerably
depending on the choice of accounting method.

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 Equity Method of Accounting and Analysis
56

 Carrying Value: Even when an investee’s shares are publicly

traded , changes in market prices are not recognized by the
EM (unless there is permanent impairment).
 For financial analysis, the value placed by the securities
markets on the investee should be considered a better
indicator of value than the carrying amount in the financial
statements of the investor.
 Earnings: Only under the equity methods do the earnings of
the investee directly affect the reported performance of the
parent. The underlying premise is that the parent has or will
have access to the earnings directly or indirectly.
 This confirms to which accounting principle of cash generating
ability of the firm. 16/09/2020
 Comparison of consolidation with EM
57

 EM incorporates the investor’s share of the net income and net

assets of the investee in investor company’s results, reporting
them as equity in the earnings of the subsidiary and investment
in the subsidiary respectively.
 Under consolidation, all the assets, liabilities, revenue, expense,
and cash flows of the subsidiary are included in the
corresponding accounts of the parents. When ownership is
less than 100%, a non-controlling interest (MI) results.

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 Analyst’s point
58

 The venture’s often-significant debt may have been an important incentive

to use the EM rather than consolidate. In such cases proportionate
consolidation depicts the higher risk level.
 The EM can distort firm performance in several ways:
 Profitability measure: Investor’s ROA is overstated.
 Investors return on sales is overstated.
 Interest coverage ratio is overstated.
 Solvency measures: investee assets and liabilities are excluded from BS- Liabilities
are hidden in investees, the nature of the investee’s assets is unknown are they
tangible or intangible
 Information Loss: Investor’s foot notes exclude the information relating to the
investee in areas i.e. leases, derivatives, debt covenants, and employee benefit
plans.

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 Equity Method Accounting
59

 Important points:
 Investment account reported at an amount equal to the proportionate share of the
stockholders’ equity of the investee company. Substantial assets and liabilities may
not be recorded on balance sheet unless the investee is consolidated.
 Investment earnings should be distinguished from core operating earnings (unless
strategic).
 Investments are reported at adjusted cost, not at market value.
 Should discontinue equity method when investment is reduced to zero and should
not provide for additional losses unless the investor has guaranteed the obligations
of the investee or is otherwise committed to providing further financial support to
the investee.
 Resumes once all cumulative deficits have been recovered via investee earnings.
 Excess of initial investment over the proportionate share of the book value is
allocated to identifiable tangible and intangible assets that are
depreciated/amortized over their respective useful lives. Investment income is
reduced by this additional expense. The excess not allocated in this manner is
treated as goodwill and is no longer amortized.

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