Lecture 06 Equity Investments

Question 1

What are equity investments?

Answer 1

Equity is a financial instrument (i.e., a contract) that gives a residual (ownership) interest in the net assets of an entity.

Broadly speaking, an equity investment can be made for one of two reasons. The investment is either

• passive, i.e., the investor acquires an insignificant ownership share and intends to benefit from appreciation in the value of the investee without actively influencing the investee’s decisions; or
• active, i.e., the investor acquires significant ownership rights or influence and takes an active role in shaping the investee’s decisions.

Question 2

What is the difference between the treatment of a passive investment and an active investment?

Answer 2

The accounting treatment differs between active and passive equity investments, mirroring the investor’s motives and intentions.

• Passive investments are carried at fair value, with changes recognized in income as unrealized gains and losses. Dividends are booked as income.
• Active investments are accounted for as if the investee were part of the investor’s own operations, with investment income recognized in proportion to the investee’s own income. Dividends reduce the balance.

Question 3

What is the criterion which is used to distinguish between active and passive investments?

Answer 3

The distinguishing criterion between active and passive investments is whether the investor has significant influence over the investee.

Any ownership share greater than 20 percent is automatically considered to give the investor significant influence.

But even at less than 20 percent, significant influence may obtain if, e.g.,
* the investor has representation on the investee’s board of directors or other central decision-making bodies; or
* there are economically significant contractual arrangements that bind the investee to the investor.

Question 4

What happens if the investor does not have significant influence in the equity investment?

Answer 4

Such passive investments are carried on the balance sheet at their fair market value (which, if not directly observable, may require estimation).

On the income statement, the investor recognizes

• changes in fair value, as unrealized gains and losses (IFRS also allows for recognition in OCI);
• realized gains and losses upon sale of the investment; and
• dividends, when declared and receivable.

Question 5

What happens if the investor has significant influence over the investee?

Answer 5

• If the investor has significant influence over the investee, the investment is instead accounted for by the so-called equity method.
• The equity method differs radically from the accounting for passive investments.
• Under the equity method, the investor’s accounting essentially tracks and mirrors the investee’s balance sheet and income statement.

Question 6

What are the basic rules for the equity method of treating equity investments with significant influence?

Answer 6

The initial carrying value of the investment is the acquisition price.

In each subsequent period, the investor recognizes its share of the investee’s GAAP income (or loss).

This income share is recognized as income from equity-method investees on the income statement and added to (or subtracted from) the investment account on the balance sheet.

Dividends are not treated as income but as a partial liquidation of the investment and are hence subtracted from the investment account.

The price paid for the investment is almost always higher than the corresponding share of the investee’s (net) balance sheet value. (Why?)

Since this excess value is not included in the investee’s accounting records, the investor must keep track of it separately.

In particular, if any of the excess value pertains to depreciable assets, the associated depreciation or amortization is subtracted from the investor’s share of the investee’s income and the investment balance each period.

Question 7

What is the method for purchase price allocation for an equity-method investment?

Answer 7

First, measure all items on the investee’s balance sheet at their respective fair values (which may differ from their book values).

Next, determine the fair value of all identifiable intangible assets not recognized on the investee’s balance sheet yet (brand value, technology, customer data, etc.).

Any amount of purchase price in excess of these fair values is goodwill.

If goodwill is negative the amount is recorded as an immediate gain in income.

Question 8

How are unrealized gains and losses treated in equity-method investments?

Answer 8

Under the equity method, unrealized gains and losses in fair value are not recorded, unlike in accounting for passive investment.

The only exception is when the investment’s fair value drops significantly and persistently (other-than-temporarily) below the carrying value.

In this case, an impairment is recorded, i.e., a loss that reduces the carrying value to its current fair value.

(Under IFRS, but not US GAAP, impairments may be reversed later.)

Question 9

How does one deal with transactions between the investor and the investee in equity-method investments?

Answer 9

Investor and investee might sell goods to each other. Given the parties’ close relationship, such transactions are generally not at arm’s length.

The value of the transferred goods thus includes a profit margin that was not determined under market conditions.

If the goods remain on the buyer’s balance sheet, these transfer profits must (with few exceptions) be eliminated, reducing the investor’s income.

The reduction is reversed when the goods are sold in a later period.

In an upstream transfer (investee sells to investor), the investor removes its share of the investee’s profit, reducing the investment balance.
(Sometimes a different asset, such as inventory, is reduced instead.)

In a downstream transfer (investor sells to investee), the investor

• removes, either in investment income or in revenues and expenses,
  a share of the profit corresponding to its ownership in the investee, if the sale is on arm’s-length terms; or
• the full profit, if the sale is not on arm’s-length terms;
  in any case reducing the investment balance.

Question 10

How are equity-method investments treated on an cash flow statement?

Answer 10

On an indirect-method cash flow statement,

• equity-method investment income is subtracted in operating activities;
• additional contributions and acquisitions (if paid in cash) are outflows in investing activities; and
• dividends from the investee are inflows in operating activities or, if exceeding the original contribution balance, in investing activities.