Intercorporate Investments

 Understand how corporations record their investments.

 Understand the logic behind “mark-to-market” for

marketable securities.

 Understand the different accounting implications of “trading

securities” vs. “available-for-sale securities”.
 Highlights of the key topics covered

 Minority passive investments – Market method

 Minority active investments – Equity method

 Majority active – Consolidation (FYI, optional)

 Five Reasons for Investments in Securities

 Safety Cushion: Microsoft

 Cyclical Cash Needs: Toys R Us
 Investment for a Return: Berkshire Hathaway
 Investment for Influence: Coca-Cola and its bottling
companies
 Purchase for Control: Cisco Systems
 Two Types of Investment Securities

 Equity Securities (stocks)

 Issuer vs. investor: issuers of stocks receive money upfront and are
expected to pay dividends, investors of stocks give out money
upfront and expect to receive dividends and capital gains
 Compared to bonds, stocks carry higher risk and yield higher return.

 Debt Securities (bonds)

 Issuer vs. buyer: issuers of bonds borrow money and are expected to
pay interests and principal, buyers of bonds lend money upfront and
expect to receive interests and principal.
 Compared to stocks, bonds carry lower risk (a steady stream of
interest payments) and yield a lower return.
Accounting for Equity Securities based on Ownership
Accounting Classification of Investment Securities

 Trading Securities
 Purchased with the intention to take advantage of short-term
price changes.
 Listed as current assets.
 Available for Sale
 Purchased as a store of wealth for safety or a normal long-run
return.
 Can be classified as current assets or long-term assets,
depending on management’s intent for holding them.
 Held-to-Maturity
 Debt securities purchased with the intent of holding the
security until it matures.
 Classified as either current or long-term assets, depending on
the intent.
Accounting for Purchase, sale, and Return on
Trading and Available-for-Sale Securities
 Purchase: cash goes down, trading security or available-for
sale security goes up

 Sale: cash goes up, securities go down, the difference goes to

either a realized gain or a realized loss

 Earning a return: interest or dividends

 Cash received relating to interests of dividends is recorded as interest
revenue or dividend revenue.
 Interest earned but not yet received or dividends declared but not
received are also recorded as revenue, with a corresponding
receivable.
 Accounting for the changes in value
Changes in the value of trading securities
 Changes in the market value (unrealized gains and losses) are recognized in
the income statement.
 This becomes the cost basis used when the investment is sold in the next
period. Only gains (losses) that occur since last reporting date are recognized
on the income statement.

Changes in the value of available-for-sale securities

 Changes in the market value are reported as other comprehensive income
under owners’ equity, not as part of net income.
 Realized gains are measured relative to original cost so, when sell, transfer
unrealized gains (losses) out of OCI and into realized gains. The holding
gains (losses) are included in earnings (income statement) when realized.
 Example
 T1: On Jan.1, 2003, Able Co. acquired 100 shares of Baker Co. for
$40/share.
 T2: On Nov.30, 2003 Able Co. received $3/share dividends from
Baker Co..
 T3: On Dec.31, 2003 when Able Co. was preparing its book for 2003,
Baker Co. was trading at $35/share. Able Co. made a corresponding
entry.
 T4: On Dec.31, 2004 when Able Co. was preparing its book for 2004,
Baker Co. was trading at $38/share. Able Co. made a corresponding
entry.
 T5: On Feb.14, 2005, Able Co. sold all 100 shares in Baker Co. for
$36/share.
 Record the transactions, assuming that Able classified
the shares as trading securities

Cash Marketabl MS = Other Retained Dividend Unrealized Realized

e adjustme Owners’ Earnings Income Gains/Losse Gains/Losse
Securities nt Equity s s

T1 - 4,000
4,000
T2 300 300 300

T3 -500 -500 -500

T4 300 300 300

T5 3,600 -4,000 200 -200 -200

 Record the transactions, assuming that Able classified
the shares as available-for-sale

Cash Marketabl MS = Other Retained Dividend Unrealized Realized

e adjustme Owners’ Earnings Income Gains/Losse Gains/Losse
Securities nt Equity s s

T1 - 4,000
4,000
T2 300 300 300

T3 -500 -500

T4 300 300

T5 3,600 -4,000 200 200 -400 -400

 Summary of the Example
In there any difference in Balance sheet?
No difference on the balance sheet, other than that for Trading Secruities, the
unrealized gains/losses go through Retained earnings, while for AFS, unrealized
gains/loss go through other Owners’ Equity.

Is there any difference in Income Statement?

Resulting Income Patterns
Trading AFS
2003 -500 0
2004 300 0
2005 -200 -400

Is there any difference in the Statement of Cash Flows?

No difference at all.
 Marketable Securities
Why does the recognition of unrealized gains and losses matter?

Federal Reserve Chairman Greenspan on derivatives (1997):

Putting the unrealized gains and losses of open derivatives contracts onto
companies' income statements would introduce "artificial" volatility to their
earnings and equity. Shareholders would become confused; management might
forgo sensible hedging strategies out of purely window-dressing concerns.

Former SEC Chairman Breeden on mark-to-market (1990):

If you are in a volatile business, then your balance sheet and income statement
should reflect that volatility. Furthermore, we have seen significant abuse of
managed earnings. Too often companies buy securities with an intent to hold them
as investments, and then miraculously, when they rise in value, the companies
decide it's time to sell them. Meanwhile, their desire to hold those securities that
are falling in value grows ever stronger. So companies report the gains and hide
the losses.
 Practice: Trading Securities
(1) Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 per share.
(2) Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman.
(3) Year-end market price of Freeman common stock is $17.50 per share.
(4) Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash.

Cash Marketable MS = Other Owners’ Dividend Unrealized Realized

Securities adjustment Equity Income Gains/Losses Gains/Losses

T1

T2

T3

T4
 Practice: AFS
(1) Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 per share.
(2) Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman.
(3) Year-end market price of Freeman common stock is $17.50 per share.
(4) Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash.
Cash Marketable MS = Other Owners’ Dividend Unrealized Realized
Securities adjustment Equity Income Gains/Losses Gains/Losses

T1

T2

T3

T4
 Practice: Trading Securities
(1) Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 per share.
(2) Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman.
(3) Year-end market price of Freeman common stock is $17.50 per share.
(4) Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash.

Cash Marketable MS = Other Owners’ Dividend Unrealized Realized

Securities adjustment Equity Income Gains/Losses Gains/Losses

T1 -80,000 80,000

T2 6,250 6,250

T3 7,500 7,500

T4 86,400 -80,000 -7,500 -1,100

 Practice: AFS
(1) Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 per share.
(2) Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman.
(3) Year-end market price of Freeman common stock is $17.50 per share.
(4) Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash.
Cash Marketable MS = Other Owners’ Dividend Unrealized Realized
Securities adjustment Equity Income Gains/Losses Gains/Losses

T1 -80,000 80,000

T2 6,250 6,250

T3 7,500 7,500

T4 86,400 -80,000 -7,500 -7,500 6,400

 Marketable Securities Example
Genesis Pharmaceuticals Enterprises, Inc.
Investments are comprised primarily of equity securities and are stated fair value. Certain of
these investments are classified as trading securities based on the Company’s intent to sell
and dispose of them within the year. Further, certain of these securities are classified as
available-for-sale based on the Company’s intent to hold them beyond one year. For trading
securities, realized and unrealized gains and losses are included in the accompanying
consolidated statements of income. For available-for-sale securities, realized gains and losses
are included in the consolidated statements of income. Unrealized gains and losses for these
available-for-sale securities are reported in other comprehensive income in the consolidated
statements of shareholders’ equity. The Company has no investments that are considered to
be held-to-maturity securities.

For the year ended June 30, 2008, realized loss on trading securities amounted to $44,881.
Unrealized loss on trading securities amounted to $651,464 for the year ended June 30, 2008.
For the year ended June 30, 2008, unrealized gain on available-for-sales securities amounted
to $1,347,852.
Minority Active Investments: Equity method
When the ownership percentage exceeds
20%, GAAP presumes two
elements:

1. The investor can exert influence over

the company.

2. The investment represents a continuing

relationship between the two
companies.

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 Equity Method
 Investment (“Investments in Affiliates”) is recorded at purchase price.
 When investee distributes a dividend, investor increases its cash and the
investment account decreases by the same amount.
 When investee reports a net income, investor reports a proportionate income
in “Equity in the Earnings of Affiliates” and the investment account increases
by the same amount.
 The investment is NOT marked to market value at the end of the period.
 When the Investment is sold, Gain /Loss (=difference between selling price
and NBV) will be reflected in reported income.
 Equity Method Illustration

Cash Investment Investment

Income
1/1/2008 -9,000,000 9,000,000
12/15/2008 150,000 -150,000
12/31/2008 3,000,000 3,000,000

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 Another Example
Example: Company S had the following balance sheet on January 1, 1999:

Current Assets 20,000 Liabilities 30,000

Non-Current Assets 50,000 Contributed Capital 15,000
Retained Earnings 25,000
Total Assets 70,000 Total Liabs & SH 70,000

On January 1, 1999, Company P purchased 30% of Company S’s outstanding common stock for
$12,000. During 1999, Company S’s net income was $11,000 and it declared and paid $5,000 in
dividends to all shareholders. At December 31, 1999, the fair market value of P’s investment in
S was $15,000. On February 1, 2000, P sold its investment in S for $16,000.

Record the journal entries for the above transactions:

Cash Investment = Investment Realized

Income Gain
Purchase -12,000 12,000
Dividend 1,500 -1,500
Net income 3,300 3,300
Value change No record.
Sale 16,000 -13,800 2,200
 Practice
 Record transactions using equity method.
 Healy Co. purchases 15,000 shares of Palepu Co. at $8 per share; the
shares represent 25% ownership of Palepu.
 Healy receives a cash dividend of $0.8 per share from Palepu.
 Palepu reports annul net income of $120,000
 Healy sells all 15,000 shares of Palepu for $140,000

Cash Investment = Investment Realized

Income Gain
Purchase
Dividend
Net income
Sale
 Practice
 Record transactions using equity method.
 Healy Co. purchases 15,000 shares of Palepu Co. at $8 per share; the
shares represent 25% ownership of Palepu.
 Healy receives a cash dividend of $0.8 per share from Palepu.
 Palepu reports annul net income of $120,000
 Healy sells all 15,000 shares of Palepu for $140,000

Cash Investment = Investment Realized

Income Gain
Purchase -120,000 120,000
Dividend 12,000 -12,000
Net income 30,000 30,000
Sale 140,000 -138,000 2,000
 Majority ownership
 When the ownership percentage exceeds 50% of
the voting shares, GAAP presumes the parent
controls the subsidiary.

 The initial merge is accounted for using

purchase method.

 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.
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 Purchase method intuition

Purchase: A buys B  There has been a change in

ownership.
Cash
 Various assets are written up to
A’s B’s their fair market value.
owners Owner’s

 The excess (if any) of purchase

B shares price over FMV of net
identifiable assets is assigned to
goodwill.
 Surviving
shareholders are  Goodwill is not amortized, but is
those of A. subject to impairment testing.

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 Key Aspects of Purchase Method
 Investment is recorded at the purchase price.
 Assets and liabilities of S, but only S, are restated to their current market
value at the time of acquisition but not thereafter.
 The difference between the purchase price and the market value of the
subsidiary’s net assets (assets minus liabilities) at the date of acquisition
is recorded as goodwill.
 Income of the merged entity is recognized from the date of the purchase.
 Goodwill and other indefinitely long-lived intangibles are not amortized
but must be evaluated for impairment.
 Portion of subsidiary’s net assets NOT OWNED by P is reported as
Minority Interest on P’s balance sheet between liability and equity.
 Portion of subsidiary’s income NOT belonging to P is reported as
Minority Interest on P’s income statement.
 Preparing Consolidated Financial Statements
1. Elimination of any inter-company payables / receivables.
 Any receivables/payables on the books of P that are due from/to S are removed
from the combined books.
2. Elimination of inter-company sales/expenses.
 Any transactions between P and S are eliminated in consolidation.
3. Elimination of inter-company investment (i.e. Parent Investment in
Subsidiary)
 P records the Investment in S using the equity method on its own books. When the
consolidated books are prepared, this investment (and all transactions related to it),
are removed. The Investment is replaced with the assets and liabilities of S.
4. Presentation of Minority Interest in Net Assets (i.e. Owners’
Equity) and Minority Interest in Net Income.
 If P does not own 100% of S, the portion of the combined Owners’ Equity NOT
OWNED by P and Net Income NOT EARNED by P must be shown separately.
 Majority ownership:
Intercompany transactions—loans

 Suppose that, prior to the acquisition, Gaston had borrowed

$300,000 from Alphonse.
$300,000
cash loan

Alphonse’s Gaston’s
receivable payable

 The adjusting entry made to eliminate this “internal”

transaction is:
Loan payable –Gaston (on Alphonse’s books) -$300,000
Loan receivable –Alphonse (on Gaston’s books) -$300,000

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 Majority ownership:
Intercompany transactions—sales

 Suppose that Alphonse sold goods to Gaston as follows:

 Two things must happen to eliminate this intercompany sale:

Alphonse’s
revenue

Gaston’s No change to
COGS gross margin
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