Intercorporate Equity Investments Analysis

  1. INTRODUCTION

This article focuses on a company’s accounting for investments in the common stock of other corporations.  However, the same concepts described in this article also apply to investments in debt securities and preferred shares.

The primary difference between the accounting for investments in debt securities and investments in equity securities is that, in addition to the classifications of investments described in this article, debt securities may be classified as held-to-maturity.  With held-to-maturity securities, the company records the debt instrument at cost.  The company recognizes any discount or premium on the securities through an amortization which increases or decreases the carrying value of the securities accordingly.  An important feature of the held-to-maturity classification is that no recognition of mark-to-market (unrealized) gains or losses are made on the securities.  The company will only recognize interest income and gains or losses on the securities when the securities are sold and the gains or losses are realized.  Because the held-to-maturity classification differs from the conventional accounting treatment for financial securities, accounting rules (both U.S. GAAP and IFRS) apply stringent conditions on when this classification may be used.

Under U.S. GAAP, the accounting treatment for equity investments depends on the extent of influence the company has over the investee.  A company may have either no influence on the investee, significant influence on the investee, or full control over the investee.

  1. PASSIVE MINORITY INVESTMENTS

Companies must consider various factors when deciding the extent of control over an investee, and thus the accounting treatment of the investment.  Generally, however, a company which owns less than 20% of the outstanding shares of the investee is considered a passive investor with insignificant influence over the investee.  Passive equity investments may be considered trading or available-for-sale securities[1].

2.1.  Trading Securities

An equity investment is considered a trading security if management purchases the security as part of an actively managed portfolio, intended to produce trading profits.  A company records the purchase at cost and then subsequently adjusts the security to fair value (market value) at subsequent financial reporting dates.  Trading securities are recognized as current assets.

The company recognizes the changes in the security’s fair value using a fair value adjustment account which increases or decreases the carrying value of the security.  When the price of a trading security increases, the company debits the fair value adjustment account, thus increasing the carrying value of the security.  When the price of the security decreases, the company credits the fair value adjustment account, thus decreasing the carrying value of the security.  The offsetting credit or debit to the fair value adjustment account are made to an income account.  Thus, for trading securities fair-value changes are recognized in the income statement.

When a trading security is sold, the company recognizes a realized gain or loss.  The amount of the realized gain or loss is the security’s sale price minus the fair value of the security on the last balance sheet date.

2.2.  Available-for-Sale Securities

Equity securities which are purchases with the intent of longer-term investment, rather than short-term speculation, are classified as available-for-sale.  The accounting treatment for available-for-sale securities is similar to that of trading securities in that the company recognizes fair value changes in a security’s price on the balance sheet.  However, the unrealized gains or losses for available-for-sale securities are recognized in shareholder’s equity (other comprehensive income).

If a price decline is considered “other than temporary”, the company must recognize the impairment in income.  The determination of an “other than temporary” impairment is highly subjective, however.

2.3.  Income Tax Effects of Passive Investments

For financial reporting purposes, companies recognize unrealized gains or losses (as of each financial reporting date) on passive equity investments through either income or other comprehensive income.  For tax purposes, however, gains or losses are not recognized until the security is sold.  Thus, an unrealized gain creates a deferred tax liability and an unrealized loss creates a deferred tax asset.

  1. ACTIVE MINORITY INVESTMENTS

Companies must utilize specialized accounting when the company exerts significant influence over the investee.  It is important to note that significant influence is not the same as direct control, which requires consolidation (discussed later in this article).

A company must consider various factors when determining the degree of influence over the investee.  Generally, however, a company has significant influence over an investee when the company owns between 20% and 50% of the investee’s outstanding shares.

3.1.  Equity Method

The most common method of accounting for active minority investment is the equity method[2].  With this method, the company generally recognizes the investment at cost and adjusts the carrying value of the investment for its proportional share of the investee’s earnings.  Particularly, the company increases the carrying amount of the investment, with a corresponding recognition in the investment income account, when the investee has a profit.  Likewise, the company decreases the carrying amount of the investment, with a corresponding recognition in the investment loss account, when the investee shows a loss.  To avoid double-counting of income, the company recognizes any dividends received as a reduction in the carrying value of the investment.

A complicating factor in equity method accounting arises when the investor company pays a price for the shares in excess of the proportional book value of the investee.  When this occurs, the company must first allocate the excess purchase price to any separately identifiable tangible and intangible assets, based on estimated fair values of those assets.  The company would depreciate or amortize the excess amounts as they would any other asset.  Any portion of the purchase price beyond the pro-rate book value of the investee and the excess amounts allocated to identifiable assets is considered unamortizable (either goodwill or land) and implicitly accounted for in the carrying amount of the investment.  The entire investment is tested periodically for impairment and thus these unamortizable amounts would be implicitly tested for impairment at that time.

The equity method is the most commonly used method of accounting for investments in joint ventures.  With a joint venture, a company shares the operating responsibilities and financial benefits of a project with another venture.

3.2.  Fair Value Method

A company may elect to account for active minority investments at fair value when certain conditions are met.  If a company decides to use fair value accounting, it must do so at the time the investment is initially recognized.  Also, the choice to use fair value accounting cannot be later revoked.

Under fair value accounting, the company initially records the investment at cost and then recognizes any unrealized gains or losses on the investment in the income statement.  The company would recognize any dividends in income, but would not recognize the proportional profit or loss of the investee (as they would under the equity method).

  1. BUSINESS COMBINATIONS

Companies which exert full control over the operations of an investee, even at levels of ownership of less than 100%, must fully consolidate the financial statements of the investee.  The company must consider various factors when determining the extend of control.  Generally, however, the company will have control with 50% or greater of the outstanding shares of the investee.

The accounting for control investments has changed dramatically over the last several decades.  Prior to July 2001, companies had two choices for accounting for control investments: the purchase method or the pooling of interests method.

The pooling of interests method was allowed when certain conditions existed.  This method required a company to record the acquired assets and liabilities at book value.  In other words, the company would present its financial statements as if the two companies had always been one entity[3].  The pooling of interests method was disallowed after July 2001.  However, companies were not required to restate acquisitions made prior to this date.  Thus, the financial statements of some companies will still be influenced by the prior use of this method.

Under the purchase method, the acquirer company would record the identifiable assets of the acquired company at fair value and recognize the difference between the acquisition cost and the assets as goodwill.  With this method, goodwill was amortized on a straight-line basis for 40 years.  The purchase method, thus, led to higher depreciation (due to the higher asset carrying values) and amortization charges and lower earnings.  Companies, therefore, had an incentive to structure acquisitions in a way that would qualify for pooling-of-interest treatment (prior to July 2001).  The purchase method was disallowed for all periods after January 2009.

4.1.  The Acquisition Method

Current accounting guidance mandates the use of the acquisition method in accounting for all control investments[4].  This method recognizes a control investment as a subsidiary-parent relationship and requires the acquiring company to fully consolidate the investee’s accounts with its own.

The acquisition method requires the acquirer company to recognize all separately identifiable assets (both tangible and intangible) and liabilities at fair value as of the acquisition date, regardless of whether the asset or liability was recognized on the investee’s books prior to the acquisition.  The acquirer company would recognize any difference between the acquisition price and the total fair value of the identifiable assets as goodwill.  The acquirer company must also eliminate any intercompany transactions with the subsidiary to avoid double-counting the transactions.  Should the acquirer company use stock in the transaction, the stock must be recorded at fair value (market price) at the time of the acquisition.

One issue that arises with consolidation rules is in relation to “push-down” accounting.  Specifically, since the acquirer company must establish fair values for the subsidiaries assets (tangible and intangible), the subsidiary has a basis for revaluation of its assets.  If the subsidiary remains a separate, publicly traded entity (the parent has not fully acquired the subsidiary), current accounting guidance requires the subsidiary’s financial statements to reflect the revaluation.  Thus, the parent’s accounting treatment is “pushed-down” to the subsidiary.

Another accounting issue arises when a portion of the purchase price is not fully specified at the time of acquisition, but rather dependent upon the outcome of future events.  Specifically, the buyer may have to provide the seller additional consideration based on the future earnings or other financial performance goals of the subsidiary.  These potential additional considerations are known as contingent liabilities[5].  Under current U.S. GAAP, a contingent liability arising from an acquisition is recorded on the parent’s books as part of the acquisition cost when the liability is probable and can be reliably measured.

A company may acquire another at a bargain price, meaning the acquisition price is less than the fair value of the investee’s assets.  This may occur, for example, when a company (the investee) is in distress.  When an acquisition is considered a bargain acquisition, the parent company must recognize the difference between the price and the fair value of the assets as a gain in the income statement.

4.2.  Noncontrolling Interests

A noncontrolling interest arises when a company acquires less than 100% of the outstanding shares of a subsidiary.  Under the acquisition method, an acquiring company must fully combine the assets, liabilities, revenue, and expenses of the subsidiary with its own.  The noncontrolling interest thus represents the claim that outsiders have on the earnings and net worth of the subsidiary company.

The parent company recognizes the noncontrolling interest as a separate line in the shareholder’s equity section.  The noncontrolling interest must be valued independently of the acquisition price.  Because companies often pay a “control premium” in an acquisition, the fair value of the minority interest will represent a lower per-share amount than the acquisition price.

The parent company will also show the portion of earnings (or loss) attributed to the noncontrolling interests as a separate line item in the income statement.

4.3.  Variable Interest Entities

Often a company will establish a separate legal entity to facilitate certain business transactions.  These entities are referred to as special purpose entities (SPEs) and they are often structured to allow the company access to financing terms which they would not otherwise have access to.

Prior to current GAAP, these entities were generally not consolidated with the parent and therefore represented a significant source of “off-balance sheet” debt.  Enron, for example, used SPEs to hide massive amount of debt from investors.  In 2009, the Financial Accounting Standards Board issued revised guidance for such entities.  Under the new standards, which utilize the broader term “variable interest entity (VIE)”, an entity must be consolidated on the parent’s financial statements when the parent (a) has a controlling financial interest in the VIE and (b) is the VIE’s primary beneficiary[6].

  1. ACCOUNTING FOR INTERCORPORATE EQUITY INVESTMENTS UNDER IFRS

5.1.  Passive Minority Investments

In the aftermath of the global financial crisis, the IASB began a multi-phase process of modifying the accounting for financial instruments[7].  Companies are mandated to comply with the new standards for all reporting periods after January 2018, but many companies have already begun implementation.

Under current IFRS guidance for passive investments, companies recognize changes in fair value based on the asset’s classification[8].  Companies utilize the same classifications for passive minority investments as those found under U.S. GAAP: held-to-maturity, trading, and available-for-sale.  There are several differences between current IFRS and current U.S. GAAP in the treatment of passive investments, but the two standards are mostly similar.  One difference, for example, is that IFRS has a lower threshold for the recognition of impairment than under U.S. GAAP; however, the impairment issue has been addressed in the new IFRS standards.

The updated IFRS standards will dramatically change the way firms account for passive minority investments.  The most significant change is in the recognition of impairment.  Firms must now record the asset net of an allowance for expected future losses.  Prior to the updated treatment, firms would only recognize a loss when the loss was realized.  Also, prior to the new guidance, firms recognized impairment differently depending on the classification of the asset.  Under the new guidance, firms will employ the same procedure for impairment regardless of the asset’s classification.

5.2.  Active Minority Investments

IFRS is similar to U.S. GAAP in it treatment of active passive investments, i.e., those investments in which the company has significant influence but not full control.  Under both standards, the investor company accounts for the investment using the equity method.  The equity method under IFRS, however, differs from U.S. GAAP in two material respects: (1) IFRS allows the investor company to use fair value accounting on long-term assets when calculating the book value of the investee, and (2) IFRS is more restricted in allowing investor firms to utilize the fair value accounting in lieu of the equity method.

The new IFRS standard eliminates previous classifications and introduces the following three classifications for financial assets: (1) fair value through profit or loss (FVPL), (2) fair value through other comprehensive income (FVOCI), or (3) amortized cost.  For passive minority equity investments, a company must determine if the equity shares are held for trading, in which case the fair value changes are recognized in the income statement.  If the equity shares are not designated as held for trading, the company can recognize the fair value changes in either the income statement or in other comprehensive income; however, the decision is irrevocable.  For debt investments, the company must classify the investments based on a “business model” approach.  Particularly, an instrument will be measured at amortized cost when both of two conditions are present: (1) the instrument is part of a business model whose objective is to receive the instrument’s contractual cash flows (as opposed to holding the instrument for speculative purposes), and (2) the instrument’s contractual cash flows are exclusively from principal and interest[9].  When these conditions are not both met, the instrument must be recognized at fair value, with any fair value changes recognized in the income statement.

5.3.  Control Investments

The acquisition method of accounting for investments in which the company has control is the result of a joint effort between the IASB and the FASB.  Thus, the current IFRS standards for consolidation differs little from the corresponding standards under U.S. GAAP[10].  However, an investor should note several differences.

Under IFRS, companies may recognize partial goodwill when an acquisition is for less than 100% of the subsidiaries outstanding shares.  With the partial goodwill method, the parent company recognizes only its proportionate share of goodwill.  For example, suppose company A acquirers 80% of the outstanding shares of company B for €1,000,000.  The fair value of company B’s assets is €700,000 and the fair value of its liabilities is €200,000.  Thus, the fair value of company B’s net assets is €500,000.  The €1,000,000 company A paid for the 80% interest in company B implicitly values the entire company B at €1,250,000 (€1,000,000 ÷ .80).  Under the full goodwill method (which is mandatory under U.S. GAAP, but optional under IFRS), company A recognizes goodwill as the difference between the fair value of company B minus the fair value of company B’s net assets, or €750,000 (€1,250,000 – €500,000).  Under the partial goodwill method, however, company A would recognize goodwill as the difference between the purchase price and its share (80%) of company B’s identifiable net assets, or €600,000 [€1,000,000 – (€500,000 x .8)].

A corollary to the partial goodwill method is in the recognition of noncontrolling interest.  Recall that a noncontrolling interest is the “claim” or ownership of the subsidiary by outsiders.  A company choosing the partial goodwill method would recognize noncontrolling interest (on the balance sheet) equal to the noncontrolling interest’s percentage share of the fair value of the subsidiaries net assets.  In the above example, company A would recognize noncontrolling interest of €100,000 (€500,000 x .2).

 

SOURCES

Lloyd, Sue.  “IFRS 9: A Complete Package for Investors”.  Investor Perspectives (July 2014).

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.  Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

[1] ASC Topic 320

[2] ASC 323

[3] The pooling of interests method was used for stock-based transactions and allowed the acquiring company to record the stock issue at par value, which substantially understated the true cost of acquisitions

[4] ASC 805

[5] A company may also recognize a contingent asset if the company is entitled to a refund of a portion of the acquisition cost should certain post-acquisition criteria be met.

[6] ASC Topic 810

[7] IFRS 9

[8] Current guidance is found in IAS 39, which is being replaced by IFRS 9

[9] A company may use fair value accounting for an instrument meeting these criteria if the debt instrument has a corresponding liability which is accounted for using fair value.  This allows management to eliminate a potential accounting mismatch between the asset and the corresponding liability.

[10] IFRS standards are found in IFRS 10

 

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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