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Intercorporate Investments
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17
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Learning Objectives After studying this chapter, you will understand: 1
How to account for investments in debt securities.
How an investor’s degree of influence over an investee company determines the accounting treatment of equity investments and why.
How fair value accounting is applied to equity securities.
How to apply the equity method and the fair value option.
What consolidated financial statements are, how they are prepared under the acquisition method, and how noncontrolling interests are measured and reported.
How goodwill arises and when it is considered impaired and written down.
How business combinations were previously accounted for under the purchase and pooling of interests methods and how the method used to record an acquisition in the past affects financial analysis, even today.
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Learning Objectives After studying this chapter, you will understand: 2
What variable interest entities (VIEs) are and when they must be consolidated.
The major differences between IFRS and U.S. GAAP related to accounting for financial assets, consolidations, special purpose entities (SPEs) or VIEs, and joint ventures.
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Accounting for Investments in Debt Securities
Investments in debt securities are classified as held-to-maturity, trading securities, or available-for-sale securities.
Held-to-maturity securities are those that the firm has both the intent and the ability to hold until the maturity date.
Trading securities are investments that are part of an actively managed investment portfolio designed to achieve trading gains.
Available-for-sale securities are investments that do not qualify for either of the above.
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Accounting for Held-to-Maturity Securities 1
Debt securities (e.g., bonds and notes) that a firm intends to hold to maturity are generally accounted for at amortized cost.
The investment account is adjusted for the amortization of premium or discount in each period.
Interest income is recognized following the effective interest method.
No adjustment is made for a change in the fair value of debt securities in the held-to-maturity portfolio.
Principal Financial purchases a five-year $100,000 bond from Baker Company with a 7% coupon interest rate for $108,659 on January 1, 20X1. The effective yield on this bond investment is 5%, meaning the discount rate that equates the $108,659 purchase price with the present value of the promised cash flows is 5%. The bond matures on December 31, 20X5, and a $7,000 coupon payment is due at the end of each year.
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Accounting for Held-to-Maturity Securities 2
| Year-End | Interest Income | Premium Amortization | Amortized Cost | Fair Value |
| Jan. 1 | – | – | $108,659 | $108,659 |
| 20X1 | $ 5,433 | $ (1,567) | 107,092 | 107,500 |
| 20X2 | 5,355 | (1,645) | 105,447 | 105,000 |
| 20X3 | 5,272 | (1,728) | 103,719 | 103,000 |
| 20X4 | 5,186 | (1,814) | 101,905 | 102,000 |
| 20X5 | 5,095 | (1,905) | 100,000* | 100,000 |
*Before payment of principal on December 31, 20X5.
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Accounting for Held-to-Maturity Securities 3
| Year-End | Interest Income | Premium Amortization | Amortized Cost | Fair Value |
| Jan. 1 | – | – | $108,659 | $108,659 |
| 20X1 | $ 5,433 | $ (1,567) | 107,092 | 107,500 |
| 20X2 | 5,355 | (1,645) | 105,447 | 105,000 |
| 20X3 | 5,272 | (1,728) | 103,719 | 103,000 |
| 20X4 | 5,186 | (1,814) | 101,905 | 102,000 |
| 20X5 | 5,095 | (1,905) | 100,000* | 100,000 |
*Before payment of principal on December 31, 20X5.
Entry on January 1, 20X1, to record the acquisition of the bond:
| DR Investment in bonds | $108,659 | |
| CR Cash | $108,659 |
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Accounting for Held-to-Maturity Securities 4
Entry on December 31, 20X1, to record interest income and amortization of the bond premium:
| DR Cash | $7,000* | |
| CR Interest Income | $5,433† | |
| CR Investment in Bonds | 1,567‡ |
*$100,000 × 7%
†$108,659 × 5%
‡$7,000 − $5,433
Firms may elect to account for held-to-maturity investments using use fair value accounting.
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Available-for-Sale Securities 1
Available-for-Sale Securities
Investments in debt securities classified as available for sale are presented in the balance sheet at fair value, requiring an adjustment at each balance sheet date.
The investor applies the effective interest method just as it would for a held-to-maturity investment, and adjusts the amortized cost at each balance sheet date to the fair value.
The fair value adjustment is reported as part of other comprehensive income.
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Available-for-Sale Securities 2
Suppose Principal Financial had classified its investment as available for sale. At December 31, 20X1, the bonds had an amortized cost of $107,092, but a fair value of $107,500. The following entry would be made:
| DR Fair value adjustment—available-for-sale securities | $408 | |
| CR OCI—unrealized gain or loss in fair value of available-for-sale securities | $408 |
If an available for sale security is sold, the full holding period gain or loss is recognized in the income statement and the balance in AOCI is “recycled.”
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Trading Securities
Trading Securities
The accounting for trading securities is similar to available-for-sale securities, except that the fair value adjustments are recognized in net income rather than in OCI.
Suppose Principal Financial had classified its investment as trading:
20X1:
| DR Cash | $ 7,000 | |
| CR Interest income | $ 5,433 | |
| CR Investment in bonds | 1,567 | |
| DR Fair value adjustment—trading securities | $ 408 | |
| CR Gain on trading securities | $ 408 |
The gain is recognized in net income for trading securities.
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Recording Credit Losses
Effective for fiscal years beginning after December 15, 2019, SEC registrants are subject to the Current Expected Credit Loss (CECL) rules for investments in debt securities.
Firms must accrue a loss currently when there is the expectation that not all of the promised principal or interest payments will be received.
The amount of the loss accrued is generally the difference between the present value of the expected cash flows and the amortized cost of the investment.
The rules are generally not applicable to trading securities, which are already reported at fair value with unrealized gains and losses reported in net income.
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Soon-to-Be Superseded Guidance: Other-Than-Temporary Impairments
Until firms adopt the CECL rules, they might incur an other-than-temporary impairment.
For available-for-sale debt securities:
If a firm intends or it is likely that the firm will be required to sell the security, the entire amount of impairment is recognized in earnings.
If a firm does not intend to sell the security and it is unlikely that the firm will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, then the other-than-temporary impairment is separated into the amounts:
Representing the credit loss, which is recognized in earnings.
Related to all other factors, which is recognized in other comprehensive earnings.
For held-to-maturity securities, the analysis is simpler:
If the fair value of the security is less than amortized cost and the firm does not expect to recover the entire amortized cost basis, OTTI is recognized.
The OTTI is split between credit loss recognized in net income and losses related to other factors recognized in OCI.
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Types of Equity Investments
Under GAAP, the method of accounting for equity investments depends on the degree to which the investor company is able to influence the operating decisions of the investee.
EXHIBIT 17.1 Financial Reporting Alternatives for Intercorporate Equity Investments
| Type of Investment: | Minority Passive | Minority Active | Controlling |
| Level of influence: | No substantial influence | Substantial influence | Effective control |
| Level of ownership: | Less than 20%* | 20%–50%* | More than 50% |
| Accounting: | Fair value measurement with unrealized gains and losses reported in income statement | Equity method | Full consolidation |
| Fair value option permitted | Transactions completed 2009 or later: Acquisition Method | ||
| Transactions completed July 1, 2001 through 2008: Purchase Method | |||
| Transactions completed prior to July 1, 2001: Purchase Method or Pooling of Interests† |
* Presumptive ownership level. May be rebutted by evidence indicating level of influence is substantial even though ownership is below 20% or that level of influence is not substantial even though ownership exceeds 20%.
†For qualifying transactions completed through an exchange of shares.
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Minority Passive Investments: Fair Value Accounting 1
In general, all minority passive equity investments are accounted for at fair value, with changes in fair value accounted for in net income.
One exception is for investments where fair value is not readily determinable.
For those securities, firms may opt to report at fair value or to report at cost, adjusted for changes in observable prices minus impairment.
Example:
Principal Financial purchased two securities in 20X1 and two in 20X2.
It sold its Company B preferred stock in 20X4.
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Minority Passive Investments: Fair Value Accounting 2
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $(1,000) | $ (3,000) | $ 2,000 | $(4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 3
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $(1,000) | $ (3,000) | $ 2,000 | $ (4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 4
To record the purchase of shares on January 1, 20X1:
| DR Investment in Company A common | $ 10,000 | |
| DR Investment in Company B preferred | 20,000 | |
| CR Cash | $ 30,000 |
The total fair value of all minority-passive investments is compared to the total cost of the securities. The fair value is $1,000 less than the cost so a fair value adjustment is required:
| DR Unrealized holding loss on minority-passive investments (income statement) | $ 1,000 | |
| CR Fair value adjustment—minority-passive investments | $ 1,000 |
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Minority Passive Investments: Fair Value Accounting 5
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $ (1,000) | $ (3,000) | $ 2,000 | $ (4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 6
To record the purchase of shares on July 1, 20X2:
| DR Investment in Company C common | $ 30,000 | |
| DR Investment in Company D common | 40,000 | |
| CR Cash | $ 70,000 |
At year-end 20X2, the portfolio’s value is $97,000 versus a $100,000 cost, so a $3,000 credit is the required balance in the fair value adjustment account. It currently has a $1,000 credit so the following is required:
| DR Unrealized holding loss on minority-passive investments (income statement) | $ 2,000 | |
| CR Fair value adjustment—minority-passive investments | $ 2,000 |
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Minority Passive Investments: Fair Value Accounting 7
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost |