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Inter-corporate investments

Inter-corporate investments. Market value accounting (minority passive investments) Accounting Met Life mini-case Equity method accounting (significant influence) Accounting Coca Cola mini-case. The following is a general roadmap of the accounting for. marketable securities:.

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Inter-corporate investments

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  1. Inter-corporate investments • Market value accounting (minority passive investments) • Accounting • Met Life mini-case • Equity method accounting (significant influence) • Accounting • Coca Cola mini-case

  2. The following is a general roadmap of the accounting for marketable securities: Securities available for sale (Unrealized gains and losses to stockholder's equity) Passive - market method <20% Trading securities (Unrealized gains and losses to Income Statement ) Minority Significant Influence - <50% Equity method >20% Degree of Ownership >50% Majority Consolidate Purchase method

  3. Minority Passive Investments – Market Method • Investor owns < 20% of investee • Classify portfolio as “available-for-sale” or “trading.” This classification dictates the accounting treatment • Record dividends received as income • Mark investments to market at each statement date • A = L + E • ΔA  = L + ΔE  • Q: Is ΔE income? • A: AFS, no – record in OCI • Trading, yes – record in net income • Equity increases either way. The issue is whether profit is affected.

  4. Met Life mini-case

  5. Met Life B/S

  6. Met Life Income Statement

  7. Met Life’s Statement of Stockholders’ Equity

  8. Met Life’s Investment Footnote

  9. Significant influence – Equity Method • Investor owns > 20% and less than 50%. The key is the ability to exert “significant influence.” • Dividends treated as a return of investment (reduce investment balance) rather than income • Report income equal to percentage interest in investee profits • Investment recorded at cost + profit recognized – dividends received.

  10. Assume that HP acquires a 30% interest in Mitel Networks. On the date of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP purchases its 30% stake for $300 (at book value).

  11. Investment balance parallels SE of Investee Co. Investee Investor – 30% 300 1000 30 profit 6 div 20 div 100 profit 1080 324 (1080 * .3 = 324)

  12. Footnote Disclosures - SBC • $11,003 • 5,913 Notes / R • $ 5,090 Equity Inv.

  13. $3,300 + $22,226 - $3,187 - $13,855 = $8,484 x 60% = $5,090 $1,022 x 60% = $613

  14. Coca-Cola mini-case

  15. Analysis Implications of Equity Method Investments • Income does not equal Cash Flow • Regulations. Regulatory authorities can sometimes intervene in an investee company’s dividend policy. • International. An investee company may operate in a country where restrictions exist on remittance of earnings or where the value of currency can deteriorate rapidly. Political risks can further inhibit access to earnings. • Restrictions. Dividend restrictions in loan agreements can limit the ability of the investee company to make dividend payments from retained earnings. • Power. Presence of a stable or powerful minority interest can reduce the investor company’s ability to set dividend or other policies of the investee company.

  16. Analysis Implications of Equity Method Investments • Net operating profit margin (NOPM NOPAT/Sales). Most analysts include equity income inNOPAT since it relates to operating investments. The reported NOPM is, thus, overstated due to nonrecognition of investee sales and the recognition of investee income. • Net operating asset turnover (NOAT Sales/Average NOA). The equity investmentbalance is typically included in operating assets. This means that NOAT is understated due to nonrecognition of investee sales and overstated by nonrecognition of investee assets in excess of the investment balance. The net effect is, therefore, indeterminate (NOAT is overstated provided NOA exceeds sales, and understated otherwise.) • Financial leverage (FLEV Net financial obligations/Average equity). Financialleverage is understated due to nonrecognition of investee liabilities and the recognition of investee equity (the proportionate share of investee earnings is included in SBC’s income). • Although ROE components are affected, ROE is unaffected since income and equity are unaffected. • Book value does not equal market value. There can be significant unrealized gains in the equity method investment.

  17. Summary: exclusion of debt from B/S • Operating leases • Leased asset/liability not recorded on B/S • Equity method investments • Only record percentage of equity owned as an investment, not full or proportionate assets and liabilities • SPEs • A/R securitization / synthetic leases • Executory contracts (product financing agreements) • Transfer of manufacturing assets to a SPE or other party with purchase agreement for output

  18. Consolidation Accounting Preview • Equity accounting is used by the parent for any investment with “significant influence,” usually > 20% • Consolidation is required is investor has “control,” usually > 50% • The consolidation process replaces the equity investment with the balance sheet of the investee company. • Also, equity income is replaced with revenues and expenses to which it relates. • Balance sheets and Income Statements are added together • Total stockholders’ equity remains the same as does net income.

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