Reading 9: Intercorporate Investments

Question 1

Amortized Cost

Answer 1

• Balance sheet: amortized cost

- Interest (including amortization), Realized G/L

Question 2

Fair Value Through Profit or Loss

Answer 2

• Balance Sheet: Fair Value

- Income Statement: Interest, Dividends, G/L

Question 3

Fair Value Through OCI

Answer 3

• Balance Sheet: Fair value, with G/L recognized in equity

- Income Statement: Interest, dividends

Question 4

Reclassification Under IFRS 9

Answer 4

• Not permitted for FVPL or FVOCI

- Debt security reclassification is permitted only if the business model has changed.

Question 5

Investment in Associates

Answer 5

• equity method
• investment recorded at cost and reported on the balance sheet as a non current asset
• earnings increases it, dividends decreases

Question 6

Fair Value of Option

Answer 6

• GAAP allows equity method investments to ne recorded at fair value.
• IFRS: the fair value option is only available to venture capital firms, mutual funds and similar entities.
• Irrevocable

Question 7

Calculating year-end investment w/ equity method

Answer 7

% acquired x (book value of net assets at the beginning of year + net income - dividends) + unamortized excess purchase price

Question 8

Impairments of Investment in Associates

Answer 8

• Must be tested for impairment
• GAAP: if FV < carrying value and decline is considered other-than-temporary, the investment is written-down to fair value and loss is recognized on income statement.
• IFRS: impairment needs to be evidenced by one or more loss events.

-No recovery in value in the future, assets cannot be written up.

Question 9

Upstream

Answer 9

• investee to investor
• investee has recognized all of the profit in IS
• Investor must eliminate its proportionate share of profit that is unconfirmed (goods have not been used or sold by the investor).
• Ex: Investor owns 30% of investee. During year, Investee sold goods to Investor and recognized $15,000 profit from the sale. Half good remain.

($15,000 total profit x 50% unconfirmed) x 30% ownership interest) = $2,250 of equity income will be recognized.

Question 10

Downstream

Answer 10

-investor to investee
-investor has recognized all of the profit in IS
-Investor must eliminate its proportionate share of profit that is unconfirmed (goods have not been used or sold).
-Ex: Investor owns 30% of investee. During year, Investor sold goods to Investee of
$40,000 for $50,000. Investee sols 90% of goods by year-end.

($10,000 total profit x 10% unconfirmed) x 30% ownership interest) = $300 of equity income will be recognized.

Question 11

Business Combinations

Answer 11

• Merger: A + B = A
• Acquisition: A + B = A b
• Consolidation: A + B = C

Question 12

Historic Accounting Measures

Answer 12

1) Purchase Method
2) Pooling-of-interests method

*Pooling has been eliminated by GAAP and IFRS. Acquisition method replaced purchase method.

Question 13

Acquisition Method

Answer 13

-Minority interest is accounted for in IS and BS (accounted for in stockholders equity)

Question 14

Goodwill

Answer 14

• Under acquisition method, the purchase price is allocated to identifiable A + L on the basis of fair value.
• Any remainder is reported to Goodwill (unidentifiable asset).

Full Goodwill (required under U.S. GAPP; allowed under IFRS):
-full goodwill = (fair value of equity of whole subsidiary) - (fair value of net identifiable assets of the subsidiary)
Partial goodwill (only allowed under IFRS):
-parital goodwill = purchase price - (% owned x FV of net identifiable asset of subsidiary)
or partial goodwill = % owned x full goodwill

**Goodwill always lower using the partial method.

Question 15

Noncontrolling Interest and Goodwill

Answer 15

• The value of noncontrolling interest depends on which method is used.
• If the full goodwill method is used, noncontrolling interest is based on the acquired company’s fair value.
• If partial goodwill method is used, noncontrolling interest is based on the fair value of the acquired company’s identifiable net assets.

Question 16

Ratio concerns with Goodwill

Answer 16

• Full goodwill results in higher total assets and higher total equity than the partial goodwill method.
• Thus, return on assets and return on equity will be lower if the full goodwill method is used.

Question 17

Goodwill Impairment

Answer 17

• Goodwill is not amortized, it is tested for impairment annually.
• IFRS (1-step): Carrying value of cash generating unit > exceeds recoverable amount. Impairment loss recognized.
• GAAP (2-step):
  1) Carrying value of reporting unit > fair value….impairment exists
  2) Loss is measured as difference between carrying value of goodwill and implied fair value of goodwill.
• **impairment loss is recognized in income statements as part of continuing operations.

Question 18

Bargain Purchase

Answer 18

• Acquisition price < fair value of net assets
• Both IFRS and GAAP require that the difference b/w fair value of net assets and purchase price be recognized as a gain in the income statement.

Question 19

Joint Venture

Answer 19

• Control is shared by two or more investors.
• Equity method required for GAAP & IFRS (rarely proportionate consolidation is allowed (no minority interest needed in proportionate consolidation))

Question 20

Special Purpose Entity

Answer 20

• Typical motivation is to reduce risk and lower cost of financing.
• Sponsor company usually has control over the SPE’s finances or operating activities while third parties have controlling interest in equity.

Question 21

Variable Interest Entity (VIE)

Answer 21

• Has one or both of the following characteristics:
  1) At-risk equity that is insufficient to finance the entity’s activities w/o additional financial support.
  2) Equity investors that lack any one of the following:
• Decision making rights
• The obligation to absorb expected losses
• The right to receive expected residual returns

***VIEs must be consolidated

Question 22

Contingent Assets and Liabilities

Answer 22

-IFRS: only contingent liabilities whose fair values can be measure reliably are recognized at the time of acquisition. Contingent assets are never recognized. Subsequently, CLs are REMEASURED at the higher of the value initially recognized, or the best estimate of the amount needed to settle the liabilities.

• GAAP: divides contingent assets and liabilities into contractual and noncontractual.
• Contractual: CAs and CLs are recorded at their fair values on acquisition date.
• Noncontractual CAs and CLs are also recorded if “more likely than not” they meet the definition of A or L.
• Subsequently, REMEASUREMENT of liabilities is similar under IFRS, while assets are REMEASURED at the lower of initial value and the best estimate of the future settlement amount.

Question 23

Contingent Consideration

Answer 23

• CC = specific amount is payable to the former shareholders of the subsidiary if certain earnings or revenue targets are met.
• Recognized at fair value under both IFRS and GAAP as an asset, liability or equity. Subsequent changes in value are recognized in IS.

Question 24

In-process R&D

Answer 24

• Capitalized as an intangible asset and included as an asset under GAAP and IFRS
• Subsequently amortized if successful or impaired if unsuccessful

Question 25

Restructuring Costs

Answer 25

-Expensed when incurred (not capitalized)

Question 26

BS & IS Effects based on method (equity, proportionate consolidation, acquisition)

Answer 26

1) All three methods report the same net income.
2) Equity method and proportionate consolidation (PC) report the same equity. Acquisition method equity will be higher by the amount of minority interest.
3) Assets and liabilities are highest under the acquisition method and lowest under the equity method; PC is in-between.
4) Revenues and expenses are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in-between.

Question 27

Ratio Effects based on method (equity, proportionate consolidation, acquisition)

Answer 27

• Net profit margin (net income/revenue): EM Higher (sales lower, NI the same), PC in-between, Acq Lower
• ROE (net income/total equity): EM Higher (equity lower, NI the same), PC same as equity, Acq Lower
• ROA (net income/total assets): EM Higher (NI the same, assets lower), PC in-between Acq Lower