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.

Terminology

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:

1. We live in a flat globalized world with a complex intertwined web of global corporations…
2. This knowledge can be applied immediately with the recent pickup in M&A activity and IPOs
3. 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:

1. Investments in financial assets
2. Investments in associates
3. Joint Ventures
4. Business Combinations
5. Special Purpose Entities alphabet soup (SPV, SIV, VIE, etc).

Investments in financial assets:

1. Held-for-trading (e.g. proprietary trading, parking cash in short-term liquid investments like treasuries, ABCP, etc)
2. Available-for-Sale
3. Held-to-maturity

 

Accounting treatment of investments in financial assets where investor does not have significant influence for both IFRS & US GAAP

 

• 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.

 

Quick summary (via Schweser) of accounting treatment based on % ownership… for both IFRS & US GAAP

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:

1. Requires the investor to recognize proportionate share of income as earned on I/S.
2. Carried at cost, plus its share of post-acquisition income (after adjustments) net of dividends.
3. Reported as a single line item on the balance sheet and on the income statement.
4. 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

1. Merger: Acquirer + Acquired = Acquirer
2. Acquisition: Acquirer + Acquired = Acquirer + Acquired (subsidiary of Acquirer)
3. Consolidation: Acquirer + Acquired = New Company

IFRS does not make such distinctions

Acquisition Method

1. All assets, liabilities, revenues & expenses of a subsidiary are combined on a line-by-line basis with the parent.
2. 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)

1. 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)

1. IFRS requires sponsor of SPE to consolidate if sponsor controls SPE
2. US GAAP requires primary beneficiary of Variable Interest Entities (VIE) to consolidate VIE
3. 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…