1 Introduction to Accounting for Inter-corporate Investments 1.1 Introduction Corporations often invest in equity and debt securities of other corporations. This chapter focuses on the accounting for and financial reporting of investments in equity securities, and in particular, investments in ordinary shares that grant the investor voting rights in the investee. Depending on how many securities are acquired, the investor may have little or no influence over the investee, significant influence over the investee, and even control of the investee. The accounting methods discussed here reflect the level of influence the investor has over the investee (no significant influence, significant influence, or control). The level of influence an investor has over an investee is often determined by the ownership level. The rebuttable presumption is that ownership of less than 20% of the voting rights gives the investor no significant influence over the investee. Ownership of between 20% and 50% of the voting rights means that the investor has significant influence over the investee, and an ownership of more than 50% of the voting rights constitutes control over the investee. Ownership of more than 50% of the voting rights is not the only way to achieve control. Control over an investee can be achieved by other means; for instance, by convertible securities (e.g., options, convertible preferred shares, convertible bonds), or contractual arrangements. Furthermore, ownership of more than 50% of the voting rights does not automatically grant control over an investee. For example, involvement of a company in bankruptcy procedures, government regulations, or restrictions on cross-border dividend payments, may prevent an investor from effectively exercising control. For investments without significant influence (ownership of up to 20% of the voting rights), the accounting method is Fair Value Accounting, if fair value Electronic supplementary material The online version of this chapter (https://doi.org/10.1007/9783-030-61769-1_1) contains supplementary material, which is available to authorized users. © The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 E. Amir and M. Ghitti, Financial Analysis of Mergers and Acquisitions, https://doi.org/10.1007/978-3-030-61769-1_1 3 4 1 Introduction to Accounting for Inter-corporate Investments can be determined reliably. If fair value cannot be determined reliable, the Cost method should be used. Normally, an investment in equity securities of publicly listed companies is recognized on the investor’s balance sheet at fair value and investments in private corporations will most likely be presented on the investor’s balance sheet at cost. For investments with significant influence (20%–50% of the voting rights), the accounting method is the Equity method, which is discussed later in Sect. 1.3. For controlled investments (above 50% of the voting rights), the accounting method is full consolidation under the Purchase Method of Accounting, which is discussed in Sect. 1.4. There are two additional accounting methods for investments in equity. The first one is the Proportionate Consolidation, which was applied in cases where more than one entity jointly control another entity. The second one is the Pooling of Interests method, which was applied in certain mergers. To date, both methods are not normally applied in practice. We will describe these methods to highlight certain features of accounting for consolidations in Sects. 1.5 and 1.6. Next, we will briefly discuss each method, by describing the balance sheet recognition and the recognition of gains and losses in the income statement (profit and loss account). We will also briefly discuss investments in debt securities. 1.2 Passive Investments in Equity and Debt Securities—Fair Value Accounting When an investor holds less than 20% of an investee’s voting shares, the presumption is that there is no significant influence over the investee’s operating, investing, and financing activities (“passive investment”). By their nature, investments in debt securities do not provide the investor with significant influence over the investee, hence these are also passive investments. Both International Financial Reporting Standards (IFRS) and US GAAP provide detailed guidance for investments in financial assets (IFRS 9 and ASC 320 / ASC 321). Under IFRS 9, financial assets can be measured either at: • amortized cost (for debt securities only); • fair value through other comprehensive income (FVOCI); • fair value through profit or loss (FVPL). The measurement varies according to both: • the investor’s business model for each category of financial assets (hold to collect versus hold to collect and sell); and • the contractual cash flows originated by each category of financial assets (solely payments of principal and interest on the principal amount outstanding, or else). 1.2 Passive Investments in Equity and Debt Securities—Fair Value Accounting 5 Under IFRS, the presumption is that passive investments in equity securities are held for trading. That is, the investor holds these shares primarily for price appreciation and/or dividend income. The accounting rule for these investments is to present them on the balance sheet at fair value and to recognize unrealized gains and losses (that is, changes in the value of the investment) in the income statements (fair value through profit and loss—FVPL). In addition, all realized gains and losses, as well as dividend income, are recognized in the income statement. In some cases, though, the investor holds equity securities for purposes other than trading. For example, a company may be required to hold a stake in the investee to gain access to certain markets or because of regulatory requirements. In these cases, recognition of unrealized gains and losses in the income statement may distort the company’s reported profitability because management has no intention to trade the investment. These investments may be classified as nontrading investment in equity securities (or, available for sale securities), and unrealized gains and losses would then be recognized in other comprehensive income (OCI), which is part of shareholders’ equity (fair value through other comprehensive income—FVOCI). Essentially, these unrealized gains and losses bypass the income statement and are recognized directly in shareholders’ equity. According to US GAAP, the required accounting method for investments in publicly listed equity securities is to recognize unrealized gains/losses in the income statement (trading securities). That is, under US GAAP, investments in publicly listed equity securities may not be classified as available for sale securities, although investments in debt securities may. Classification of investments in publicly listed equity securities as FVPL is also the default accounting treatment under IFRS; nonetheless, the reporting entity can use the alternative classification as FVOCI, if it actively classifies the investment as non-trading. Irrespective of the classification as trading (FVPL) or non-trading (FVOCI) securities, disposal of these investments will normally result in recognition of gains or losses on the income statement.1 As for investments in debt securities, there are three alternative methods. These investments may be presented at FVPL, FVOCI, or Held-to-Maturity (Amortized Cost method). To be classified as Held-to-Maturity, the investor must have a positive intent and ability to hold the investment in the debt security until its maturity. Example starts Tal Company Ltd. was founded on January 1, 2019. At that time, the company had £100,000 in cash and £100,000 of ordinary shareholders’ equity. The company 1Under US GAAP, the accounting rules for trading securities are substantially the same as those described for IFRS. Notwithstanding, in case of equity securities with easily determinable market values, they must be classified at FVPL. 6 1 Introduction to Accounting for Inter-corporate Investments presents financial statements for December 31 of each year. Assume the tax rate is 25%. On January 2, 2019, the company made the following investments: (a) (b) (c) (d) no. 1,000 ordinary shares of Red Company for £20 a share; no. 600, 5% preferred shares, £50 par, of Green Company for £25,000; £30,000 par value of 10% convertible bonds of Blue Company for £30,000; no. 2,500 ordinary shares of Gray Company for £10 a share. During 2019, the company received, in cash, interest on convertible bonds of Blue Company, and dividends on preferred stock of Green Company. Realized gains (interest and dividends) are taxable at 25% while taxation on unrealized gains and losses is deferred until the security is effectively sold. There is no other investment income. The market values of the investments and their accounting classifications as of December 31, 2019 are as follows: Investment Cost Market value Red Company £20,000 £24,000 Trading equity security Green Company £25,000 £30,000 Trading equity security Blue Company £30,000 £28,000 Held-to-Maturity debt security Gray Company £25,000 £22,000 Non-trading equity security Accounting classification Required: Present the income statement and balance sheet for Tal Company as of December 31, 2019. Solution: Income statement £ Comments Dividend income on preferred shares 1,500 600 × £50 × 0.05 Interest income on bonds 3,000 £30,000 × 0.10 9,000 (24,000 + 30,000) − (20,000 + 25,000)b Unrealized gains on trading securitiesa Income before tax Income tax expense Net income Other comprehensive income Unrealized loss on non-trading security Tax benefit (deferred) Net unrealized loss aNote bRed 13,500 3,375 10,125 £ Comments (3,000) Gray Company 750 (2,250) that for Held-to-Maturity security, unrealized gain and losses are not recognized and Green Company 1.2 Passive Investments in Equity and Debt Securities—Fair Value Accounting Balance sheet Cash £ 4,500 7 Comments Dividend and interest income Investment in trading securities 76,000 Market value of equity securities Investment in bonds held-to-maturity 30,000 Bonds at amortized cost Deferred tax asset on unrealized loss Total assets 750 £3,000 × 0.25 111,250 Tax payable on dividends and interests 1,125 4,500 × 0.25 Deferred taxes on unrealized gains 2,250 (4,000 + 5,000) × 0.25 Total liabilities 3,375 Common shares 100,000 Retained earnings 10,125 Other comprehensive losses (2,250) Total shareholders’ equity 107,875 Total liabilities and equity 111,250 Example ends 1.3 Investments with Significant Influence—The Equity Method Companies often acquire a significant, but not controlling, interest in the equity of another company (the investee). Companies may also, at times, sell a controlled subsidiary, but retain a significant investment in it. These investments may be in the form of common stocks, preferred stocks, or other in-substance equity interests. The investor should apply the equity method of accounting (IAS 28/ASC 323) if the equity investment provides the investor with significant influence over the investee. This is often the case when an investor holds 20% of the voting common stocks (or equivalent) of an investee, but does not have a controlling financial interest. However, ownership levels of as little as 3%–5% may also require application of the equity method in certain circumstances, such as with investments in limited partnerships. An investor should also apply the equity method to an investment in a joint venture that the investor jointly controls with other investors. “Joint Venture” is a term that is loosely used in practice, but is defined in both IFRS (see IFRS 11) and US GAAP (see ASC 323). The definition of a joint venture (and Joint Arrangement) may have important accounting consequences. Equity method investments are recorded initially at cost (including transaction costs). Any differences between the cost to the investor and the underlying equity in net assets of the investee at the date of investment (basis differences) should be identified and treated by the investor as in the case of consolidated subsidiaries. Notwithstanding, nothing will appear on the investor’s balance sheet other than a 8 1 Introduction to Accounting for Inter-corporate Investments single line item showing the carrying amount of the investment: this one-line item includes both the share of the investee’s net assets at fair value, as measured on initial recognition, and goodwill, if any. After the initial recognition, an equity method investment is adjusted to recognize the investor’s share of earnings, losses, and/or changes in equity of the investee after the acquisition date. When an investor provides other forms of financial support, such as loans, loan guarantees, or preferred stocks, investee’s losses may need to be recorded even after the common stocks investment has been reduced to zero. Anyway, when the investor’s share of losses of the investee equals or exceeds its interest in the investee, the investor will usually discontinue recognizing its share of further losses, unless the investor bears an unlimited liability. Dividends received from the investee generally reduce the carrying amount of the investment on the balance sheet and are not recognized on the investor’s income statement. Equity method investments are assessed for other-than-temporary impairment. The existence of basis differences will often result in adjustments to the investor’s share in the investee’s net income, including impairments. Disposal of equity method investments will normally result in recognition of gains and losses on the investor’s income statement. Example starts On January 1, 2019, Eli Ltd. acquired 30% of the ordinary shares of Amir Ltd. for £750,000. At that time, the fair values of Amir’s assets and liabilities were properly assessed. Tax rate is 30%. Both Eli and Amir issue financial statements as of December 31 of each year. Here are the details: Amir Ltd. (£) Fixed assets, net Patents Carrying amousnt Fair value 1,500,000 1,600,000 100,000 150,000 Inventory 400,000 400,000 Long-term receivables 320,000 320,000 Cash Total assets Bonds payable (6%) Contingent liability 300,000 300,000 2,620,000 2,770,000 600,000 600,000 – 50,000 Shareholders’ equity 2,020,000 2,120,000 Total liabilities and equity 2,620,000 2,770,000 During 2019, Amir reported net income of £200,000 and distributed dividends on ordinary shares of £100,000. The remaining useful life of fixed assets and patents is 5 and 10 years, respectively. Inventory is sold by the end of fiscal 2019. The contingent liability will not be settled prior to December 31, 2021. During 2019, Amir’s goodwill lost 10% of its value. Impairment of goodwill is not tax-deductible (i.e., it is treated as a permanent difference for accounting purposes). 1.3 Investments with Significant Influence … 9 Required: a. Calculate the amount of goodwill purchased. b. Calculate the amount of Eli’s share in Amir’s net income. c. Present a reconciliation of the “Investment in Amir” account during fiscal 2019. Solution: Part (a) Amir Ltd. (£) Carrying amount Fixed assets, net Fair value 1,500,000 Patents 100,000 1,600,000 100,000 30,000 6,000 15,000 1,500 50,000 (50,000) (15,000) – 400,000 400,000 Long term receivables 320,000 320,000 Total assets 300,000 300,000 2,620,000 2,770,000 600,000 600,000 Bonds payable (6%) Contingent liability – 30% of ∆ Amortization 50,000 150,000 Inventory Cash ∆ Shareholders’ equity 2,020,000 2,120,000 Total liabilities and equity 2,620,000 2,770,000 Asset write-up 30,000 Deferred taxes (9,000) Asset write-up, net of tax 21,000 valuea Share in book 606,000 Goodwill purchasedb 123,000 Total payment 750,000 a£2,020,000 b£750,000 × 0.3 − £606,000 − £21,000 Part (b) Share in net income £ Share in reported income 60,000 Amortization of fixed assets (6,000) Amortization of patents (1,500) Deferred tax on amortization Reduction in goodwill Share in net income 2,250 (12,300) 42,450 10 1 Introduction to Accounting for Inter-corporate Investments Part (c) Investment account Investment January 1, 2019 Share in net income £ 750,000 42,450 Share in dividends (30,000) Investment December 31, 2019 762,450 Example ends 1.4 Consolidation—Controlling Interests When an investor holds a controlling interest in the investee, the investor will present consolidated financial statements.2 Several international accounting standards prescribe the rules for consolidations. IFRS 10 establishes principles for the presentation and preparation of consolidated financial statements, when an entity controls one or more other entities. The basic rule is that if you control another entity, you consolidate it; if you do not control that entity, you do not consolidate it. IFRS 10 is more specific in its definition of control, with the aim of ensuring that all entities that should be consolidated are indeed so. Consolidation techniques are detailed in IFRS 3. The disclosure requirements for interests in subsidiaries are specified in IFRS 12. IFRS 9 does not apply to interests in subsidiaries that are consolidated. When instruments containing potential voting rights (see further) give access to the returns associated with an ownership interest in a subsidiary, the instruments are not subject to the requirements of IFRS 9. When an investor controls an investee, the investor will normally present consolidated financial statements. An investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. The three elements of control thus are: • power over the investee; • exposure, or rights, to variable returns from involvement with the investee; • the ability to use power over the investee to affect the amount of the investor’s returns. IFRS 10 requires an investor to reassess whether it controls an investee if facts and circumstances indicate that there are changes to one, or more, of the three elements of control. Consolidation shall begin from the date the investor obtains control of the investee. It ceases when the investor loses control of the investee. When preparing 2See IFRS 10, IFRS 3, ASC 810, and ASC 805. 1.4 Consolidation—Controlling Interests 11 consolidated financial statements, the parent uses uniform accounting policies for both itself and its subsidiaries and it must make appropriate adjustments to achieve conformity. Consolidated financial statements: • combine like items of assets, liabilities, equity, income, expenses, and cash flows of the parent with those of its subsidiaries, after making uniform accounting standards and policies adopted by the entities falling within the consolidation area; • offset (eliminate) the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary (goodwill, if any, is accounted for according to IFRS 3); • eliminate in full intragroup assets and liabilities, equity, income, revenues, expenses, and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recorded in assets, such as inventory and fixed assets, are eliminated in full).3 IAS 12 applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. Revenues and expenses of the subsidiary are based on the amounts of the assets and liabilities recorded in the consolidated financial statements at the acquisition date. For example, depreciation expenses recorded in the consolidated income statement after the acquisition date are based on the fair values of the related depreciable assets recorded in the consolidated financial statements at the acquisition date. When consolidating, there are several aspects which need to be taken into consideration. Some of them are the following: • • • • • potential voting rights; reporting date; goodwill; non-controlling interests; loss of control. Potential voting rights: To assess control, an entity should consider potential voting rights. When potential voting rights (or derivatives containing potential voting rights) exist, profits, losses and changes in equity allocated to the parent and non-controlling interests in preparing consolidated financial statements are determined solely on the basis of existing ownership interests and do not reflect the possible exercise, or conversion, of potential voting rights and other derivatives. 3Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. 12 1 Introduction to Accounting for Inter-corporate Investments Example starts Many offshore companies are set up for a specific purpose, such as securitizations. For legal and tax purposes, local directors (such as lawyers and accountants) manage such companies. The onshore unit wishes to avoid being seen as managing the offshore unit. The onshore investing company may enter contracts with the offshore unit for specific services that the offshore unit provides. Such contracts virtually run the offshore unit and transactions are executed automatically. These transactions often include receiving funds from specific operators and remitting these funds to the onshore company. The role of the directors is to administer the contract. The ownership of the offshore unit is irrelevant, as the offshore unit is governed by the contract. Therefore, the onshore company should consolidate the offshore unit in its accounts. Example ends Reporting date: The financial statements of the parent and its subsidiaries shall have the same reporting date. Otherwise, the subsidiary prepares, for consolidation purposes, additional financial statements as of the same date as the financial statements of the parent. If it is impracticable for a particular subsidiary to prepare its financial statements as of the same date as its parent, the parent shall consolidate the financial information of the subsidiary using the most recent financial statements of the subsidiary, adjusted for the effects of significant transactions, or events occurring between the date of those financial statements and the date of the consolidated financial statements. The difference between the date of the subsidiary’s financial statements and that of the consolidated financial statements shall be no more than three months, and the length of the reporting periods and any difference between the dates of the financial statements shall be the same from period to period. Goodwill: Under the purchase method of accounting, the purchase price paid by the parent is allocated to the net identifiable assets of the subsidiary on a fair value basis (this process is known as Purchase Price Allocation). After completion of such process, any residual constitutes goodwill, which is reported as a non-current intangible asset on the consolidated balance sheet. Under IFRS, goodwill can be calculated in two alternative methods: • as the difference between the fair value of the whole subsidiary and the fair value of its net identifiable assets (Full Goodwill method); or • as the difference between the purchase price and the fair value of net assets acquired by the parent (the share of the subsidiary’s net identifiable assets acquired by the parent). This method is called the Partial Goodwill method. Under US GAAP, only the full goodwill method is allowed. Example starts On January 1, 2019, Parent acquires a 75% interest in the equity of Subsidiary by paying a cash consideration of $1,500. At that date, the fair value of Subsidiary’s net identifiable assets is estimated to be $1,000 and the fair value of the remaining 25% of Subsidiary is estimated to be $450. 1.4 Consolidation—Controlling Interests 13 Based on these details, under the full goodwill method, goodwill will be equal to ($1,500 + $450 − $1,000 =) $950. Under the partial goodwill method, goodwill will be equal to ($1,500 − 75% × $1,000 =) $750. The key difference between the two procedures is that: • under the full goodwill method, both the parent’s and the non-controlling interests’ share of goodwill will be recognized on the consolidated balance sheet; whereas, • under the partial goodwill method, only the parent’s share of goodwill will be recognized on the consolidated balance sheet. To see this, consider what Parent paid to get its share of Subsidiary’s net identifiable assets and what non-controlling interests “paid” to get their share of Subsidiary’s net identifiable assets: • Parent paid $1,500 to get 75% of $1,000 (Subsidiary’s net identifiable assets on a fair value basis), resulting in a goodwill of $750; • non-controlling interests “paid” $450 to get 25% of $1,000 (Subsidiary’s net identifiable assets on a fair value basis), resulting in a goodwill of $200. The sum of the two figures above ($750 + $200) represents the amount of goodwill recognized under the full goodwill method ($950). Example ends Non-controlling interests (NCIs): Whenever a parent gains control over an investee, it will have to report 100% of the investee’s assets, liabilities, revenues, expenses, and cash flows, irrespective of the actual level of ownership held. When a parent owns less than 100% of a subsidiary, therefore, it is necessary to recognize non-controlling interests (formerly known as “minority interests”) to account for the proportionate share of the investee’s (or, rather, subsidiary) net assets not owned by the parent. This non-controlling interests account is shown in the consolidated balance sheet within shareholders’ equity, separately from the equity of parent’s owners. These are external owners of shares in the subsidiaries of the parent company. The parent should attribute the net income and the components of other comprehensive income to the owners of the parent and to the non-controlling interests, even if this results in the non-controlling interests having a deficit balance. If a subsidiary has outstanding cumulative preferred shares classified as equity and they are held by non-controlling interests, the parent should compute its share of net income after adjusting for the dividends on such shares, whether or not such dividends have been declared. Purchases and sales of shares in subsidiaries between the parent and the noncontrolling interests increase, and decrease, their accounts in equity, while control is maintained. Profits, or losses, on these transactions are recorded in the equity of the parent, usually as additional paid-in capital but not in the income statement (see Chapter 3). 14 1 Introduction to Accounting for Inter-corporate Investments There are two alternative accounting methods for non-controlling interests: the full method and the partial method. These methods correspond to the two alternative methods for measuring goodwill. Consider the previous example: under the Full Method, non-controlling interests are $450, whereas under the Partial Method, they are equal to $200. Loss of control: If a parent loses control of a subsidiary, the parent should immediately: • derecognize the assets and liabilities of the former subsidiary from the consolidated balance sheet; • recognize any investment retained in the former subsidiary at its fair value when control is lost, and subsequently account for it in accordance with relevant accounting standards (passive investment, equity method, or a joint venture); • record the gain, or loss, associated with the loss of control attributable to the former controlling interest. Example starts On January 1, 2007, Entity A buys 100% of Entity T for €500,000, when Entity T’s fair value is €400,000. On acquisition, goodwill is thus €100,000 (€500,000 − €400,000). On December 31, 2019, Entity A sells 60% of Entity T for €675,000. At that date: • the fair value of the residual stake held by Entity A in Entity T (40%), including goodwill, is equal to €420,000; • Entity A’s book value of net assets is €800,000, while goodwill is €50,000. Following the transaction, Entity A loses control of Entity T, but retains an investment in an associate (40% of Entity T). The investment retained in Entity T will be recognized at fair value at the day of disposal and, subsequently, recorded using the equity method of accounting. The gain associated with the loss of control is computed as the: • • • • fair value of the consideration received; plus fair value of any investment retained in the former subsidiary; minus book value of the net assets (including goodwill) derecognized; plus book value of NCI, if any. The gain is thus equal to (€675,000 + €420,000 − €800,000 − €50,000 =) €245,000. At disposal, the journal entries on Entity A’s books will be the following: 1.4 Consolidation—Controlling Interests 15 Dr. € Cr. Consideration received 675,000 Investment in associate (including goodwill) 420,000 Net assets derecognized 800,000 Goodwill derecognized 50,000 Gain from disposal 245,000 Example ends Example starts Below are the balance sheets and income statements for Acquire and Target for the years ended on December 31, 2019 and December 31, 2018. Consider the following scenarios: 1. Acquire buys 100% of Target’s voting shares for £400 in cash on 31 December 2018; 2. Acquire buys 100% of Target’s voting shares for £500 in cash on 31 December 2018; 3. Acquire buys 60% of Target’s voting shares for £500 in cash on 31 December 2018. Balance sheet (£) Acquire Target 31/12/18 31/12/19 31/12/18 31/12/19 700 1,000 350 400 Cash 600 500 100 125 Other current assets 300 500 150 250 Tangible fixed assets Current liabilities (300) (400) (200) (250) Net assets 1,300 1,600 400 525 Share capital 100 100 50 50 Retained profits 1,200 1,500 350 475 Shareholders’ equity 1,300 1,600 400 525 Income statements (£) Acquire 31/12/18 Sales Target 31/12/19 31/12/18 31/12/19 600 900 250 400 Cost of sales (200) (300) (100) (150) Operating expenses (100) (200) (50) (100) 300 400 100 150 Dividends paid (100) (100) – (25) Retained profit 200 300 100 125 Retained profits beginning balance 1,000 1,200 250 350 Retained profits closing balance 1,200 1,500 350 475 Net income 16 1 Introduction to Accounting for Inter-corporate Investments The balance sheet for Acquire assumes no investment in Target even at December 31, 2019. So, you should consider cash effects deriving from the investment separately. Case 1: £400 cash for 100% of shares Balance sheet (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Tangible fixed assets 700 1,000 350 400 Investment in Target Equity Purchase Purchase 700 1,000 1,050 1,400 400 525 – – 300 250 Cash 600 500 100 125 200 125a Other current assets 300 500 150 250 300 500 450 750 Current liabilities (300) (400) (200) (250) (300) (400) (500) (650) Net assets 1,300 1,600 400 525 1,300 1,750 1,300 1,750 100 100 50 50 100 100 100 100 Retained profits 1,200 1,500 350 475 1,200 1,650 1,200 1,650 Shareholders’ equity 1,300 1,600 400 525 1,300 1,750 1,300 1,750 Share capital aAcquire’s cash balance at December 31, 2019 is computed as: beginning cash (£200), less dividends paid (£100), plus dividend received from Target (£25). For simplicity, we do not show the dividends paid by Target in the Acquire’s income statement, although in reality they would be there Income statement (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Sales Equity Purchase Purchase 600 900 250 400 600 900 600 1,300 Cost of sales (200) (300) (100) (150) (200) (300) (200) (450) Operating expenses (100) (200) (50) (100) (100) (200) (100) (300) – 150 – – Share of Target’s income Net income 300 400 100 150 300 550 300 550 Dividends paid (100) (100) – (25) (100) (100) (100) (100) Retained profit 200 300 100 125 200 450 200 450 Retained profits begin 1,000 1,200 250 350 1,000 1,200 1,000 1,200 Retained profits closing 1,200 1,500 350 475 1,200 1,650 1,200 1,650 1.4 17 Consolidation—Controlling Interests Case 2: £500 cash for 100% of shares Balance sheet (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Tangible fixed assets 700 1,000 350 400 Equity Purchase Purchase 700 1,000 1,050 1,400 100 100a 625 – – 150 Intangible fixed assets Investment in Target 500 Cash 600 500 100 125 100 25 200 Other current assets 300 500 150 250 300 500 450 750 Current liabilities (300) (400) (200) (250) (300) (400) (500) (650) Net assets 1,300 1,600 400 525 1,300 1,750 1,300 1,750 100 100 50 50 100 100 100 100 Retained profits 1,200 1,500 350 475 1,200 1,650 1,200 1,650 Shareholders’ equity 1,300 1,600 400 525 1,300 1,750 1,300 1,750 Share capital aSame as in 2018 because goodwill is not amortized Income statement (£) Acquire Target Acquire Equity Sales Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 600 900 250 400 Equity Purchase Purchase 600 900 600 1,300 Cost of sales (200) (300) (100) (150) (200) (300) (200) (450) Operating expenses (100) (200) (50) (100) (100) (200) (100) (300) – 150 – – Share of Target’s income Net income 100 150 300 550 300 550a (100) – (25) (100) (100) (100) (100) 300 100 125 200 450 200 450 300 400 Dividends paid (100) Retained profit 200 Retained profits begin 1,000 1,200 250 350 1,000 1,200 1,000 1,200 Retained profits closing 1,200 1,500 350 475 1,200 1,650 1,200 1,650 aSame as in Case 1 only because goodwill is not amortized Case 3: £500 cash for 60% of shares Balance sheet (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Tangible fixed assets Intangible fixed assets 700 1,000 350 400 700 Equity Purchase Purchase 1,000 1,050 1,400 260 260 18 1 Introduction to Accounting for Inter-corporate Investments Balance sheet (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Investment in Target Equity Purchase Purchase 500 575 – – Cash 600 500 100 125 100 15 200 140 Other current assets 300 500 150 250 300 500 450 750 Current liabilities (300) (400) (200) (250) (300) (400) (500) (650) Net assets 1,300 1,600 400 525 1,300 1,690 1,460 1,900 – – 160 210 Minority interests Share capital 100 100 50 50 100 100 100 100 Retained profits 1,200 1,500 350 475 1,200 1,590 1,200 1,590 Shareholders’ equity 1,300 1,600 400 525 1,300 1,690 1,460 1,900 Income statement (£) Acquire Target Acquire Acquire 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 31/12/18 31/12/19 Equity Sales Equity Purchase Purchase 600 900 250 400 600 900 600 Cost of sales (200) (300) (100) (150) (200) (300) (200) (450) Operating expenses (100) (200) (50) (100) (100) (200) (100) (300) 90 – – – – (60) Share of Target’s income Minority interests Net income 300 400 Dividends paid (100) Retained profit 200 Retained profits begin Retained profits closing 1,300 100 150 300 490 300 490 (100) – (25) (100) (100) (100) (100) 300 100 125 200 390 200 390 1,000 1,200 250 350 1,000 1,200 1,000 1,200 1,200 1,500 350 475 1,200 1,590 1,200 1,590 Example ends 1.5 Joint Control When two or more investors jointly control an investee, none of them has control on its own. Two or more investors jointly control an investee when they must act together to direct the investee’s relevant activities. As no investor can direct the activities without the co-operation of the other(s), no investor individually controls the investee; hence, no investor consolidates the investee. Each investor accounts for its interest in the investee in accordance with the relevant IFRS/US GAAP 1.6 Pooling of Interests 19 depending on the specific circumstances; for example, the equity method, or the fair value method. Normally, the investors will use the equity method in case of joint control. In rare cases (which will be discussed later on), the proportionate consolidation method may be applied under IFRS only, but not under US GAAP. Under proportionate consolidation, the parent recognizes on its balance sheet the share in the assets, liabilities, revenues, and expenses. The share in the assets and liabilities is based on fair values at the time of acquisition, including recognition of goodwill, intangibles, and other fair value adjustments. Note, however, that under proportionate consolidation there are no non-controlling interests. 1.6 Pooling of Interests While the pooling of interests method is not currently applied, it is important to understand the difference between consolidation under the purchase method and consolidation under pooling. The pooling of interests method was discontinued in the US in 2001, and under IFRS in 2004. The pooling method was used for merger and acquisition transactions under certain conditions. For example, the deal was based only on exchange of shares and the two merging companies were similar to each other in terms of size. The pooling method involves consolidating the balance sheets of the two companies based on book value and not on fair value as in the purchase method. This is followed by the restatement of historical financial statements as if the two companies were one for many years. Upon consolidation, this method excludes fair value adjustments such as intangible assets and goodwill unless they are already recognized on the balance sheet of one of the merging companies. As such, no goodwill is reported as a consequence of the acquisition or merger. Certain sectors preferred using the pooling method for business combinations before its discontinuation. The use of the method peaked during 1998, when it comprised 52% of all deal volume. In dollar terms, this equaled $852 billion. Large technology companies used the pooling method, because they were able to avoid recording the related acquisition costs. Earnings were higher because there were no amortization and impairment of goodwill and other fair value adjustments. Example starts Consider the balance sheets and income statements for Acquire and Target for the years ended on December 31, 2019 and 2018 as in the previous example. Consider the following scenarios: (i) Acquire buys 60% of Target for £500 in cash and uses the proportionate consolidation method; (ii) Acquire issues 75 shares (at par value) for 100% of the shares of Target and uses the pooling of interests method. Assume the investment is made on December 31, 2016. 20 1 Introduction to Accounting for Inter-corporate Investments Scenarios: (i) Proportionate consolidation for 60%; (ii) Pooling of interests assuming 100% for 75 shares Balance sheet (£) Acquire Target Acquire Acquire 31/12/16 31/12/17 31/12/16 31/12/17 31/12/16 31/12/17 31/12/16 31/12/17 Tangible fixed assets 700 1,000 350 400 Intangible fixed assets Cash Other current assets 600 500 100 125 Prop. Prop. Pooling Pooling 910 1,240 1,050 1,400 260 260 – – 160 90 700 650 300 500 150 250 390 650 450 750 Current liabilities (300) (400) (200) (250) (420) (550) (500) (650) Net assets 1,300 1,600 400 525 1,300 1,690 1,700 2,150 – – – – 100 100 50 50 100 100 175 175 Retained profits 1,200 1,500 350 475 1,200 1,590 1,525 1,975 Shareholders’ equity 1,300 1,600 400 525 1,300 1,690 1,700 2,150 Minority interests Share capital Income statement (£) Acquire Target Acquire Acquire 31/12/16 31/12/17 31/12/16 31/12/17 31/12/16 31/12/17 31/12/16 31/12/17 Prop. Prop. Pooling Pooling 600 900 250 400 600 1,140 850 1,300 Cost of sales (200) (300) (100) (150) (200) (390) (300) (450) Operating expenses (100) (200) (50) (100) (100) (260) (150) (300) – – – – Sales Minority interests Net income 300 400 100 150 300 490 400 550 Dividends paid (100) Retained profit 200 (100) – (25) (100) (100) (100) (100) 300 100 125 200 390 300 Retained profits begin 450 1,000 1,200 250 350 1,000 1,200 1,225 1,525 Retained profits closing 1,200 1,500 350 475 1,200 1,590 1,525 1,975 Example ends Example starts On January 1, 2019, Acquire Ltd. purchased 50% of Target Ltd. for £2,000. At that time, the fair values of Target were properly assessed. Tax rate is 40%. Here are the details: 1.6 Pooling of Interests (£) 21 Target fair value Acquire carrying amount Target carrying amount 5,000 1,750 2,000 Depreciable life 6 years 400 100 120 Depreciable life 6 years Inventory will be sold in 2019 Notes January 1, 2019 Fixed assets, net Patents Inventory Long-term receivables 1,250 400 450 450 200 200 Cash 2,760 500 500 Total assets 9,860 2,950 3,270 Bonds payable 3,750 400 420 Premium amortized over 10 years Unrecognized legal claim – – 50 Shareholders’ equity Contingent liability 6,110 2,550 2,800 Total liabilities & equity 9,860 2,950 3,270 22,000 4,500 (16,500) (2,400) 5,500 2,100 (2,350) (1,400) 3,150 700 (1,260) (280) 1,890 420 December 31, 2019 Revenues Cost of goods sold Gross profit Expenses Pretax income Income tax expenses Income before associates Equity in associates ? – Net income ? 420 750 300 Dividends paid Required: a. present the balance sheet of Acquire for January 1, 2019 (immediately following the investment, under proportionate consolidation; b. present the investment account in Target for the fiscal year ended on December 31, 2019 under the equity method; c. complete Acquire’s income statement for fiscal 2019 under the equity method. 22 1 Introduction to Accounting for Inter-corporate Investments Solution: (£) Target carrying amount Acquire carrying amount Target fair value Prop. Cons. January 1, 2019 Fixed assets, net Patents Goodwill 5,000 1,750 2,000 6,000 400 100 120 460 – – – 650 Investment in Target 2,000 – – – Inventory 1,250 400 450 1,475 450 200 200 550 Long-term receivables Cash (after investment) 760 500 500 1010 Total assets 9,860 2,950 3,270 10,145 Bonds payable 3,750 400 420 3,960 – – 50 25 Contingent liability Deferred Taxes – – – 50 Shareholders’ equity 6,110 2,550 2,800 6,110 Total liabilities and equity 9,860 2,950 3,270 10,145 Investment Account (50%) Share in Target’s equity Fixed assets write-up Patents write-up Inventory write-up Bonds valuation Contingent liability 1,275 125 10 25 (10) (25) 1,400 Deferred taxes (40% x w. ups) (50) Goodwill 650 2,000 Income in 2019 Share in Target’s net income 210 Amortization of fixed assets (20.833) Amortization of patents (6 y.) Cost of inventory sold Amortization of bonds (10 y.) (1.667) (25) 1 Contingent claim (not settled) – Amortization of goodwill – Deferred taxes 19 1.7 23 Summary (£) Acquire carrying amount Target carrying amount Target fair value Prop. Cons. 182 Dividends (150) Investment balance 31/12/2019 2,032 Acquire’s income statement 2019 Income before associates Equity in net income of associates Net income 1,890 182 2,072 Example ends 1.7 Summary In this chapter, we introduce the accounting methods used in inter-corporate investments, focusing on transactions where one company invests in the voting shares of another company. As described above, the accounting methods reflect the degree of influence the investor exerts over the investee. We start with the accounting method used to account for passive investments without significant influence. The two methods used to account for passive investments are either cost of fair value. The cost method, which is used primarily for investments in private shares, presents the cost of the investment on the balance sheet and recognizes dividends received in the income statement. The fair value method, which is used primarily for investments in listed shares, presents the fair value of the investment on the balance sheet; if the investment is classified as “fair value through profit and loss”, unrealized gains and losses are recognized in the income statement. However, if the investment is classified as “fair value through comprehensive income” (only under IFRS for equity instruments), unrealized gains and losses are recognized directly in equity. Note that realized gains and losses are always recognized in profit and loss. If the investor has significant influence over the investee, for example, if the investor holds between 20% and 50% of the investee’s voting shares, the equity method is used. Under this method, the investment is recorded initially at cost and it increases with the investor’s share in the investee’s profits and decreases with the share in the investee’s dividends. If the investor controls the investee, for example, if the investor holds more than 50% of the voting shares, the purchase method (also called acquisition method) must be used, and the investor presents consolidated financial statements. We also discussed the measurement of goodwill and non-controlling interests (NCI). Finally, we highlighted two additional methods for inter-corporate investments— the Pooling of Interests Method and Proportionate Consolidation; which are less frequently applied in practice. 24 1 Introduction to Accounting for Inter-corporate Investments References Financial Accounting Standards Board (FASB), ASC 320 Investments—Debt and Equity Securities, as updated lastly in 2018. Financial Accounting Standards Board (FASB), ASC 321 Investments—Equity Securities, as updated lastly in 2020. Financial Accounting Standards Board (FASB), ASC 323 Investments—Equity Method and Joint Ventures, as updated lastly in 2020. Financial Accounting Standards Board (FASB), ASC 805 Business Combinations, as updated lastly in 2019. Financial Accounting Standards Board (FASB), ASC 810 Consolidation, as updated lastly in 2018. International Accounting Standards Board (IASB), IAS 12 Income Taxes, as amended lastly in 2017. International Accounting Standards Board (IASB), IAS 28 Investment in Associates and Joint Ventures, as amended lastly in 2017. International Accounting Standards Board (IASB), IFRS 3 Business Combinations, as amended lastly in 2020. International Accounting Standards Board (IASB), IFRS 9 Financial Instruments, as amended lastly in 2020. International Accounting Standards Board (IASB), IFRS 10 Consolidated Financial Statements, as amended lastly in 2015. International Accounting Standards Board (IASB), IFRS 11 Joint Arrangements, as amended lastly in 2017. International Accounting Standards Board (IASB), IFRS 12 Disclosure of Interests in Other Entities, as amended lastly in 2016.