How to Account for Intercorporate Investments (joint ventures, subsidiaries, mergers, acquisitions)
CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 23 in 2011 textbook/Reading 21 in 2010 textbook.
I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows
I find this basic M&A accounting read very interesting because:
- We live in a flat globalized world with a complex intertwined web of global corporations…
- This knowledge can be applied immediately with the recent pickup in M&A activity and IPOs
- You can check yourself if you lost money as a tax payer in US Treasury’s investment in Citigroup, BOA!
Investments in other corporations for accounting can take the form of:
- Investments in financial assets
- Investments in associates
- Joint Ventures
- Business Combinations
- Special Purpose Entities alphabet soup (SPV, SIV, VIE, etc).
Investments in financial assets:
- Held-for-trading (e.g. proprietary trading, parking cash in short-term liquid investments like treasuries, ABCP, etc)
- US GAAP: All unrealized gains and losses on Available-for-sale securities are reported in other comprehensive income (OCI) in the equity section of B/S.
- IFRS: Unrealized Foreign Exchange G/L on Available-for-sale securities are recognized on I/S and non-FX unrealized G/L as OCI on B/S
Reclassification of Investments in Financial Assets:
- IFRS does not allow reclassification
- US GAAP allows reclassifying Available-for-Sale securities as Held-to-Maturity and vice versa.
According to US GAAP, what matters is the degree of influence… even if % ownership is less than 20% but if an investor exerts significant influence, then equity method is used.
Equity Method Investment:
- Requires the investor to recognize proportionate share of income as earned on I/S.
- Carried at cost, plus its share of post-acquisition income (after adjustments) net of dividends.
- Reported as a single line item on the balance sheet and on the income statement.
- Dividends received are not recognized on investor’s I/S but instead reduce the Investment account on B/S.
US GAAP classifies Business Combinations as
- Merger: Acquirer + Acquired = Acquirer
- Acquisition: Acquirer + Acquired = Acquirer + Acquired (subsidiary of Acquirer)
- Consolidation: Acquirer + Acquired = New Company
IFRS does not make such distinctions
- All assets, liabilities, revenues & expenses of a subsidiary are combined on a line-by-line basis with the parent.
- If the parent owns less than 100% of the subsidiary, a proportionate share of subsidiary’s net assets on B/S and net income on I/S is included as a minority/non-controlling interest account.
Proportionate Consolidation Method (Joint Ventures, IFRS only)
- Similar to Acquisition method except, investor includes only proportionate share of assets, liabilities, revenues & expenses on a line-by-line basis
Special Purpose Entity (SPE)
- IFRS requires sponsor of SPE to consolidate if sponsor controls SPE
- US GAAP requires primary beneficiary of Variable Interest Entities (VIE) to consolidate VIE
- In other words, if an entity receives the majority of expected returns, losses or residual benefits of an SPE/VIE, then the entity has to consolidate the SPE/VIE.
Comparison of Methods
I will leave Goodwill for another post…