CFA Level II Financial Reporting and Analysis

Intercorporate Investments
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Contents and Introduction

1. Introduction

2. Basic Corporate Investment Categories

3. Investments in Financial Assets (IAS 39)

4. Investment in Financial Assets (IFRS 9)

5. Investments in Associates and Joint Ventures

6. Business Combinations

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2. Basic Corporate Investment Categories

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3. Investment in Financial Assets: IAS 39

Investor can not exert significant influence or control over the operations of the
investees
Four categories:
1. Held-to-maturity
2. Fair value through profit or loss
3. Available-for-sale
4. Loans and receivables
Reclassification of Investments
Impairments
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Financial Assets: Four Categories

Held-to-Maturity

Fair Value through Profit or Loss

Available-for-Sale

Investments in financial assets with

fixed or determinable payments;
positive intent and ability to hold to
maturity

Two sub-categories:
Held for trading: intent to sell in
the near term
Designated at fair value

Investments not categorized as

HTM or FVPL

Initially report at fair value and

subsequently at amortized cost

Shown at fair value on balance

sheet

Shown at fair value on balance

sheet

Interest income and realized

gains/losses shown on Income
Statement

Interest income, realized

gains/losses and unrealized
gains/losses shown on Income
Statement

Interest income and realized

gains/losses shown on Income
Statement

Unrealized gain/loss is ignored

Unrealized gain/loss shown as part

of OCI

Loans and receivables are broadly defined as non-derivative financial assets with fixed
or determinable payments.
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Reclassifications and Impairments

Reclassification of Investments
Allowed but with restrictions
Example: HTM AFS if there is a change in intent or change in ability to hold to maturity

Impairments
Financial asset is impaired whenever its carrying amount is expected to permanently exceed its
recoverable amount
IFRS: at the end of each reporting period, financial assets not carried at fair value need to be
reviewed for any objective evidence that the assets are impaired; for HTM securities, loss =
difference between carrying value and PV of cash flows
U.S. GAAP: For AFS or HTM securities, determine whether decrease in value is temporary. If not
temporary, the cost base is written down and loss recognized in the income statement

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Example 1
How would this investment be reported on the
balance sheet, income statement, and statement of
shareholders equity at 31 December 2011, under
either IFRS or U.S. GAAP (accounting is essentially the
same in this case), if Baxter designated the
investment as 1) held-to-maturity, 2) held for trading,
3) available-for-sale, or 4) designated at fair value?
How would the gain be recognized if the debt
securities were sold on 1 January 2012 for 352,000?
How would this investment appear on the balance
sheet at 31 December 2012?

How would the classification and reporting differ if

Baxter had invested in Cartels equity securities
instead of its debt securities?

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Working for Example 1

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4. Investments in Financial Assets: IFRS 9

IFRS 9 will take effect by 2015 and will replace IAS 39
Significant convergence between IFRS and U.S. GAAP.
New approach considers the contractual characteristic of cash flows as well as the
management of the financial assets. The portfolio approach of the current standard
(i.e., designation of held for trading, available-for-sale, and held-to-maturity) is no
longer appropriate and the terms available-for-sale and held- to-maturity no longer
appear in IFRS 9.

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Financial Assets Classification and Measurement Model

Reclassification of equity instruments is not
permitted because the initial classification of
FVPL and FVOCI is irrevocable.
Reclassification of debt instruments from
FVPL to amortized cost (or vice versa) is only
permitted if the business model for the
financial assets (objective for holding the
financial assets) has changed in a way that
significantly affects operations. Changes to
the business model will require judgment and
are expected to be very infrequent.

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5. Investments in Associates and Joint Ventures

An investment is considered an Associate Company when the investor has (or can exercise)
significant influence, but not control, over the investees business activities. Significant influence may
be evidenced by:
representation on the board of directors
participation in the policy-making process
material transactions between the investor and the investee
interchange of managerial personnel
technological dependency
Characteristics of joint ventures: 1) A contractual arrangement exists between two or more venturers,
and 2) the contractual arrangement establishes joint control
Equity method of accounting is required for investment in associates and joint venture

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5.1 Equity Method of Accounting: Basic Principles

Investment is initially recorded at cost
Share of income (not dividends) recorded in investors I/S
Investment account reflected as single line item on B/S
Value of investment = beginning value + share of profit
share of dividends
Investment classified as noncurrent asset on B/S
One line consolidation

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Example 2 Equity Method: Balance in Investment Account

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5.2 Investment Costs That Exceed the Book Value of the Investee
Value of investment (in proportion to investors stake) consists of:
Reported net asset value of investee (on investees B/S)
Fair value surplus/deficit relating to investees identifiable
assets/liabilities
Surplus is amortized over time

Goodwill = difference between purchase price and acquirers share of

fair value of investees net assets

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Example 3 Equity Method Investment in Excess of Book Value

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5.3 Amortization of Excess Purchase Price

Excess amounts allocated to identifiable assets/liabilities of investee must be amortized on investors I/S
Example 4
The plant and equipment are depreciated on
a straight-line basis and have 10 years of
remaining life. Prince reports net income for
2011 of 100,000 and pays dividends of
50,000. Calculate the following:
1. Goodwill included in the purchase price.
2. Investment in associate (Prince) at the
end of 2011.

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Working for Example 4

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5.4 Fair Value Option & 5.5 Impairment

Both IFRS and U.S. GAAP give the investor the option to account for their equity
method investment at fair value. Under U.S. GAAP, this option is available to all
entities; however, under IFRS, its use is restricted to venture capital organizations,
mutual funds, unit trusts, and similar entities, including investment-linked
insurance funds.

Both IFRS and U.S. GAAP require periodic reviews of equity method investments for
impairment. If the fair value of the investment is below its carrying value and this
decline is deemed to be other than temporary, an impairment loss must be
recognized.

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5.6 Transactions with Associates

Because an investor company can influence the terms
and timings of transactions with associates, profits
from such transactions cannot be realized until
confirmed through use of third party sale.
Investor companys share of any unrealized profit
must be deferred by reducing the amount recorded
under the equity method. This deferred profit is
added back to the equity income when confirmed.
Transactions may be upstream or downstream
Upstream (associate to investor) profit recorded in
investees I/S.
Downstream (investor to associate) profit included in
investors I/S.

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Example 5

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Example 6

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5.7 Disclosure & 5.8 Issues for Analysts

Companies must disclose assets, liabilities and results of
equity method investments
Is the equity method appropriate?
Investor may hold < 20% of investee but exercise significant influence
Investor may hold > 25 of investee but may not have significant
influence

Equity method is effectively one-line consolidation

Net margin may be overstated but debt ratios understated

Quality of equity method earnings

Assumes that a dollar earned by investee is a dollar received by the
investor company

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6. Business Combinations
Involve the combination of two or more organizations into a larger economic entity
IFRS: No distinction among business combinations; one party identified as acquirer
US GAAP: Four types of business combinations

Merger
Acquisition
Consolidation
Variable interest (special purpose) entity

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Accounting for Business Combinations

Historically, two methods have been used:
Pooling of Interest
Purchase Method

Pooling of interest method has been discontinued:

US GAAP discontinued it in June 2001
IFRS discontinued it in 2004

Both U.S. GAAP and IFRS require use of acquisition method (replaces the purchase
method)

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6.1 Pooling of Interests and Purchase Methods

Pooling of Interests
Combined companies portrayed as if they had always existed as one
Assets and liabilities of combined companies recorded at book values and pre-combination
retained earnings are included in the balance sheet of the combined companies

Purchase Method
Net assets were recorded at fair values
For the same level of revenue, the purchase method results in lower reported income than the
pooling of interests method

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6.2 Acquisition Method

Recognition and measurement of identifiable assets and liabilities

Recognition and measurement of contingent liabilities

Recognition and measurement of indemnification assets
Recognition and measurement of financial assets and liabilities
Recognition and measurement of goodwill
Recognition and measurement acquisition price is less than fair value

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Example 7 Recognition and Measurement of Goodwill

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6.3 Impact of the Acquisition on Financial

Statements and Post-Acquisition
Example 8
Jefferson has no identifiable
intangible assets. Show the
balances in the postcombination balance sheet
using the acquisition method.

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Working for Example 8

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6.4 The Consolidation Process

Combine assets, liabilities, revenues and expenses of subsidiary with parent

Intercompany transactions are eliminated

For business combination with less than 100% acquisition show non-controlling
(minority) interests on balance sheet
Difference between IFRS and U.S. GAAP in terms of how minority interest is
measured
U.S. GAAP says use Full Goodwill method
IFRS says either Full Goodwill or Partial Goodwill methods can be used

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Example 9 Non-controlling Asset Valuation

1. Calculate the value of PP&E (net) on the
consolidated balance sheet under both
IFRS and U.S. GAAP.
2. Calculate the value of goodwill and the
value of the non-controlling interest at
the acquisition date under the full
goodwill method.
3. Calculate the value of goodwill and the
value of the non-controlling interest at
the acquisition date under the partial
goodwill method.

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Example 9 - Working

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Income Statement Impact

Non-controlling (minority) interests are presented as a line item reflecting the allocation of profit or
loss for the period. Intercompany transactions, if any, are eliminated in full.

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Goodwill Impairment
Goodwill is not amortized, it must be tested for impairment at least annually. Once written down,
goodwill cannot be restored.
IFRS
Goodwill is allocated to acquirers cash generating units
Goodwill impairment testing is done using a one-step approach
Impairment loss is based on difference between carrying value and recoverable amount
U.S. GAAP
Goodwill is allocated to acquirers reporting units
Goodwill impairment testing is done using a two-step approach
1. Identify impairment possibility by comparing carrying value and fair value
2. Determine implied fair value of goodwill: fair value of reporting unit fair value of net assets

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Examples 10 and 11 Goodwill Impairment

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6.5 Financial Statement Presentation Subsequent to the

Business Combination

IFRS and U.S. GAAP have similar formats for consolidated income statements.
Each line item (e.g., turnover [sales], cost of sales, etc.) includes 100% of the
parent and the subsidiary transactions after eliminating any upstream (subsidiary
sells to parent) or downstream (parent sells to subsidiary) intercompany
transactions. The portion of income accruing to non-controlling shareholders is
presented as a separate line item on the consolidated income statement.
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6.6 Variable Interest and Special Purpose Entities

Special purpose entities (SPEs) are created to accommodate specific needs of the sponsoring entity.
The sponsoring entity frequently transfers assets to the SPE, obtains the right to use assets held by the
SPE, or performs services for the SPE, while other parties provide funding to the SPE. SPEs can be a
legitimate financing mechanism for a company to segregate certain activities and thereby reduce risk.
SPEs may take the form of a limited liability company (corporation), trust, partnership, or
unincorporated entity.

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Variable Interest Entity

VIE is a U.S. GAAP concept and refers to an entity that is financially controlled
by one or more parties that do not hold a majority voting interest.
A SPE is a VIE if:
1. Total equity at risk is insufficient to finance activities without financial
support from other parties
2. Equity investors lack any one of the following:
a. the ability to make decisions
b. the obligation to absorb losses
c. the right to receive returns
The primary beneficiary of a VIE must consolidate it as its subsidiary regardless
of how much of an equity investment it has in the VIE.

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Example 12 Receivables Securitization

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Example 12 - Working

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6.7 Additional Issues in Business Combinations That

Impair Comparability
Contingent Assets and Liabilities
Contingent Considerations

In-Process R&D
Restructuring Costs

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Summary
Investments in Financial
Assets

Investment in
Associates

Joint Ventures

Business
Combinations

Description

No significant influence

Significant influence

Shared control

Control

Accounting

HTM, FVPL, AFS

Equity

Equity

Acquisition Method

Assets
Liabilities
Equity
Revenue
Net Income
Leverage
NPM
ROE

ROA

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Conclusion
Read the summary
Review learning objectives
Examples
Practice problems
Practice questions from other sources

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