APPENDIX D
Investments in Other Corporations
Have you ever wondered how big companies become big? The answer, for many companies, is by investing in other companies. One such business is Rogers Communications, best known for being Canada’s largest wireless phone carrier. However, Rogers Communications does much more than that. It owns television stations, magazine and trade publications, sports television networks, radio sta- tions, and the Toronto Blue Jays Major League baseball team. The company has achieved its diversity in part by investing in the shares of other companies and has spent considerable amounts of money purchasing other companies. For example, in 2013, it acquired Score Media Inc., Mountain Cablevi- sion Ltd., Blackiron Data ULC, and Pivot Data Centres. According to its 2013 annual report, Rogers purchased Score Media Inc. for a cash consideration of $167 million and later rebranded it as Sportsnet 360. In addition, the company’s investment portfolio consisted of more than $1,487 million worth of shares of other companies. In this appendix, you will see how to account for three different types of invest- ments using ASPE. To understand these investments and the reasons why they are accounted for in certain ways, you first need to answer the question: Why do companies invest in other companies?
An Overview
REASONS COMPANIES INVEST Many factors motivate managers to invest in securities. Some do so because the very nature of their business requires it. For example, pension funds, insurance companies, and mutual funds receive large sums of cash from their clients. To gen- erate earnings—an important source of revenue in these companies—they invest the cash in the securities of other companies. Investments are significant assets to these companies. Other managers invest in securities to even out seasonal fluctuations in cash. A manager whose company has extra cash at the end of a busy season may want to earn a return on the idle funds until they are needed for other purposes, such as repaying loans, purchasing property and equipment, or paying dividends. Excess cash can be invested in the shares and bonds of other companies, either long or short term. Managers may also invest excess cash to provide a cushion against future downturns in the economy or unanticipated emergencies. Such investments in securities are referred to as passive investments because the investors are not interested in influencing or controlling the companies that issued the securities.
Investments in Other Corporations APPENDIX D D- Sometimes managers want to expand their company’s presence in a related industry or market. They do so by investing in another company with the purpose of influencing, but not controlling, the company’s policies and activities. Finally, managers may want to control another company, either by purchasing it directly or by becoming the majority shareholder. In this case, the two companies combine their financial reports into consolidated financial statements, as Rogers Communications has done. In the notes to its 2013 annual report, Rogers reported $809 million invested in publicly traded companies, $103 million invested in pri- vate companies, and $575 million in investments that were accounted for using the equity method. As we discuss below, this means that Rogers had significant influ- ence over these companies.
IDENTIFYING INVESTMENT TYPES AND ACCOUNTING METHODS The accounting methods used to record investments are directly related to the purpose of the investment. Passive Investments in Debt and Equity Securities Passive investments: Are Investors make passive investments to earn a high rate of return on funds that purchased with excess funds may be needed in the future for either short- or long-term purposes. This category with the intent of earning a includes investments in both debt securities (bonds and notes) and equity securi- return. ties (shares): • Investments in equity securities are presumed to be passive if the investing company owns less than 20 percent of the other company’s outstanding vot- ing shares or any amount of nonvoting shares. The cost method or fair value through net income (FV–NI) method can be used to measure and report these investments. • Investments in debt securities are always considered to be passive. If they are meant to be sold before maturity, they are treated as equity securities and reported using the market value method (also called fair market value method). If the company intends and has the ability to hold them until the maturity date, however, the company measures and reports them at amor- tized cost. Investments in Shares for Signifi cant Infl uence Active investments are those in which a company owns enough shares in another business to influence or control that business. An investor or company that owns enough voting shares of another company to have an important impact on its operat- ing and financing policies is said to have significant influence. Significant influence is presumed to exist if the investing company owns from 20 to 50 percent of the out- standing voting shares. However, other factors may also indicate significant influence, including membership on the board of directors of the other company, participation in its policy-making processes, evidence of material transactions between the two companies, an interchange of managerial personnel, and technological dependency. The equity method is used to measure and report this type of investment. Investments in Shares for Control Control is the ability to determine the operating and financial policies of another company through ownership of its voting shares. For all practical purposes, control is presumed when the investing company owns more than 50 percent of the out- standing voting shares. These investments are accounted for by combining the two companies’ financial records, using the consolidated statement method. The three investment types and the appropriate measuring and reporting methods for each can be summarized as shown in Exhibit D.1.
D- APPENDIX D Investments in Other Corporations EXHIBIT D Accounting for Investments in Other Corporations’ Shares
Level of Involvement in Decision Making Reason for the Method of (Percentage of Ownership) Investment Accounting How It Works
Control (more than 50%) Take over the Consolidation Combine the financial statements of parent company and subsidiaries
Significant Influence Influence the Equity Method Record investment at cost, add percentage share of (20–50%) company net income, deduct percentage share of dividends
Passive (less than 20%) Invest excess cash to Cost or FV-NI Record investment at cost but adjust this cost earn greater return Method basis to market value at period-end if these investments are traded in an active market; report dividends and gains/losses as investment income on the income statement
Let’s look more closely at the accounting and reporting rules for each of these investment types.
Accounting for Passive Investments
DEBT INVESTMENTS HELD TO MATURITY AMORTIZED COST METHOD When management plans to hold a bond investment until the maturity date (when the principal is due), it is reported in the financial account appropriately named Investments Held to Maturity. Bonds should be classified as investments held to maturity if management has both the intent and the ability to hold them until the maturity date. These bonds are reported at amortized cost—that is, at cost adjusted for the amortization of any bond discount or premium. We illustrate how to account for these investments from their purchase date through the maturity date. Bond Purchases On the date of purchase, a bond may be acquired at face value, for less than face value (at a discount), or for more than face value (at a premium). Following the cost prin- ciple, the bond’s total cost is debited to the Investments Held to Maturity account. To illustrate, assume that on October 1, 2013, Horizon Telemedia Inc. paid the face value of $100 million for 8 percent bonds due to mature on October 1, 2018. The 8 percent interest is paid each September 30. Management plans and has the ability to hold the bonds for five years until their maturity date. The purchase of the bonds on October 1, 2013, would be accounted for as follows (amounts in millions):
Analyze Assets = Liabilities + Shareholders’ Equity Investments Held to Maturity +100 Cash −100
Record dr Investments Held to Maturity (+A) ...... 100 cr Cash (−A) ...... 100
Investments in Other Corporations APPENDIX D D- Interest Earned In this illustration, the company purchased the bonds at face value. Because there is no premium or discount to amortize, the book value remains constant over the life of the investment. In such situations, the revenue earned on the investment each period is measured as the amount of interest collected in cash or accrued at year-end. The following accrual of $2 million in interest would be required on December 31 [$100 million face value × 0.08 (or 8%) × 3/12 of a year (since the October 1 purchase)]:
Analyze Assets = Liabilities + Shareholders’ Equity Interest Receivable +2 Interest Revenue (+R) +2
Record dr Interest Receivable (+A) ...... 2 cr Interest Revenue (+R, +SE) ...... 2
On September 30, 2014, when the investor receives a full year of interest ($2 million each quarter × 4 quarters = $8 million), the following effects are recorded:
Analyze Assets = Liabilities + Shareholders’ Equity Cash +8 Interest Revenue (+R) +6 Interest Receivable −2
Record dr Cash (+A) ...... 8 cr Interest Receivable (−A) ...... 2 cr Interest Revenue (+R, +SE) ...... 6
Succeeding interest payments would be accounted for in the same way. On the income statement, Interest Revenue is reported in the Other Items section. Principal at Maturity When the bonds mature on October 1, 2018, the journal entry to record receipt of the $100 million face value payment will be
Analyze Assets = Liabilities + Shareholders’ Equity Cash +100 Investments Held to Maturity −100
Record dr Cash (+A) ...... 100 cr Investments Held to Maturity (−A) ...... 100
D- APPENDIX D Investments in Other Corporations Note the following: • If the bond investment is sold before maturity, any difference between the market value (the proceeds from the sale) and the net book value (the unam- ortized cost) is reported in the income statement as a gain or loss on the sale. • If management intends to sell the bonds before (or is unable to hold them until) the maturity date, they should be treated in the same way as passive investments, which we discuss in the next section.
PASSIVE INVESTMENTS COST OR FV–NI METHOD When the investing company owns less than 20 percent of the outstanding vot- ing shares in another company or any level of nonvoting shares, its investment in equity securities is considered passive. Among the assets and liabilities shown on the balance sheet, only passive investments in marketable securities (i.e., shares and debt that are not held to maturity) are reported using either the cost method or the fair value through net income (FV–NI) method. Classifying Passive Investments Passive investments can be traded actively with the objective of generating short- term profits on changes in the price of securities. This approach is similar to the one taken by many mutual funds whose portfolio managers actively buy and sell securities. On the balance sheet, these investments are classified as current assets. Most companies do not actively trade the securities of other companies. Instead they invest in them to earn a return on funds they may need in the near future for operating purposes. These investments are classified as either current or noncur- rent assets, depending on whether management intends to sell them within the next year. We will focus on analyzing passive investing activities for a fictional company in the next section. Recording and Reporting Passive Investments Exhibit D.2 shows the fictional balance sheet for Horizon Telemedia Inc. (HTI), where its Investments in Marketable Securities account is reported at $357 million for the year 2014.
EXHIBIT D Horizon Telemedia Inc.’s Balance Sheet
HORIZON TELEMEDIA INC Control Consolidated Balance Sheet December Dollars in millions ASSETS LIABILITIES & SHAREHOLDERS’ EQUITY Current Assets Current Liabilities Cash and Cash Equivalents Accounts Payable Passive Investments in Marketable Securities Other Current Liabilities summarized Other Current Assets summarized Total Current Liabilities Total Current Assets Long-Term Debt Significant Investments in Affiliates Other Liabilities Influence Plant Property and Equipment Net Shareholders’ Equity Goodwill Common Shares Other Assets summarized Retained Earnings Total Assets Total Liabilities and Shareholders’ Equity
Investments in Other Corporations APPENDIX D D- The notes to HTI’s 2014 annual report contain the following information concern- ing this investment portfolio:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Investments in Marketable Equity Securities. The Company’s investments in marketable equity securities are recorded at cost in the consolidated financial statements. Marketable equity securities the Company expects to hold long term are classified as noncurrent assets. If the marketable equity security has a fair market value available and this market value declines below the cost basis of this investment and the decline is considered to be other than temporary, the Company will record a write-down, which is included in earnings.
Here is how the cost method is applied: • Assume that Horizon Telemedia Inc. invests in equity securities, acquiring a passive interest in the shares of other companies. These assets are reported on the balance sheet (Exhibit D.2) as Investments in Marketable Securities on HTI’s balance sheet. • At the end of each reporting period, the company is required to assess whether there are any indications that the value of the investment in the other company’s shares may be impaired. When there is an indication of impairment, the carrying amount of the investment should be reduced. Accountants use a special account, a valuation allowance, to show the change in the value below acquisition cost. If the value of the investment has decreased, the valuation allowance is subtracted from the cost of the invest- ment. If the value of the investment increases, then the valuation allowance is reversed only by the original amount set up in the allowance account for that investment. Hence, the carrying amount of the investment can never be greater than the original cost of the investment. • Because a journal entry must affect at least two accounts, the other half of the adjusting entry is made to another account called Impairment Loss, which is reported on the income statement and affects the calculation of net income. This process may sound complicated, so let’s simplify it a little. Let’s assume that HTI had no passive investments at the end of 2011. In the following example, we apply the cost method to a sample securities purchase.
Purchase of Shares Assume that on January 2, 2012, HTI purchased 1,000,000 common shares of Internet Financial News (IFN) for $60 per share, paying $60,000,000. On that date, 10,000,000 shares were outstanding, so HTI owned 10 percent of IFN (1,000,000 ÷ 10,000,000). This investment would be treated as a passive investment that is recorded initially (on January 2, 2012) at cost:
Analyze Assets = Liabilities + Shareholders’ Equity Investment in IFN +60 Cash −60
Record dr Investment in IFN (+A) ...... 60 cr Cash (−A) ...... 60
D- APPENDIX D Investments in Other Corporations Dividends Earned Investments in equity securities earn a return from two sources: (1) price increases and (2) dividend income. Price increases (or decreases) are analyzed both at year-end and when a security is sold. On the income statement, dividends earned are reported as Investment Income (or Dividend Revenue) and included in the computation of net income for the period. Let’s assume that on December 15, 2012, HTI received a $1 per share cash dividend from IFN totalling $1,000,000 ($1 × 1,000,000 shares). The dividend received (in millions of dollars) is accounted for as follows:
Analyze Assets = Liabilities + Shareholders’ Equity Cash +1 Investment Income (+R) +1
Record dr Cash (+A) ...... 1 cr Investment Income (+R, +SE) ...... 1
Year-End Valuation At the end of the accounting period, HTI needs to assess the value of the investment. Some investments may not be traded in an active market, in which case, the company must keep the investment recorded at cost and take into account any adverse changes that have occurred that will impact the future cash flows of the investment. This impairment requires adjusting the account to the impaired value at the end of each period, using the valuation account Impairment Allowance. The offset to the Impairment Allowance is the Impairment Loss on Investments account. If the Impairment Allowance account has a debit balance, it is added to the Investment account. If it has a credit balance, it is subtracted from the Investment account The Impairment Loss on Investment account is then reported in the income statement. This impacts net income, which eventually will be closed to Retained Earnings. Thus, the accounting equation remains in balance. Investments that are traded in an active market must be “marked to market” or in other words, be recorded at the market value. For example, let’s assume that IFN had a $58 per share market value at the end of the year. That is, the investment lost value ($60 − $58 = $2 per share). The following chart shows the computation of any gain or loss in the passive investments portfolio. The amounts are given in millions of dollars:
In Year: 2012 millions Investment in IFN Market value $ 58 ($58 per share × 1 million shares) − Cost − 60 ($60 per share × 1 million shares) 02/01/12 60 Amount for adjusting entry to mark this 2 AJE ($ 2) investment to market 12/31/12 58
On December 31, 2012, HTI would mark its investment to market as follows:
Analyze Assets = Liabilities + Shareholders’ Equity Investment in IFN −2 Gain (Loss) on Investments −2
Investments in Other Corporations APPENDIX D D- Record dr Gain (Loss) on Investments (−SE) ...... 2 cr Investment in IFN (−A) ...... 2
On the 2012 balance sheet under Investments in Marketable Securities, HTI would report its investment in IFN at a fair value of $58 million. The company also would report on the income statement an impairment loss of $2 million. One other item that would be reported on the income statement for 2012 would be invest- ment income of $1 million (from dividends received), classified under Other Items. Now let’s assume that HTI held the IFN securities through the year 2013. At the end of 2013, the shares had a market value of $61 per share. The adjustment for 2013 is computed as follows:
Year: 2013 In millions
Market value $ 61 ($61 per share × 1 million shares) − Current recorded book value − 58 ($58 per share × 1 million shares) Investment in IFN $ 3 12/31/12 58 AJE 3 12/31/13 61
On December 31, 2013, the investment is marked to market as follows:
Analyze Assets = Liabilities + Shareholders’ Equity Investment in IFN +3 Gain (Loss) on Investments +3
Record dr Investment in IFN (+A) ...... 3 cr Gain (Loss) on Investments (+SE) ...... 3
On the 2013 balance sheet under Investments in Marketable Securities, HTI would report its Investment in IFN at a fair value of $61 million. The company would also report on the income statement for 2013 a gain of $3 million. The balance sheet account would be reported as shown below at December 31, 2013.
On the Balance Sheet: (in millions) Assets Investments in Marketable Securities $61
Sale of Shares Let’s assume that on March 17, 2014, Horizon Telemedia Inc. sold all of its investment in IFN for $64 per share. The company received $64 mil- lion in cash ($64 × 1,000,000 shares) for shares purchased at $60 million in 2012 ($60 × 1,000,000 shares). On that date, accountants record a $3 million realized gain on the sale and then eliminate the Investment in IFN account. You may be wondering why the gain is for only $3 million and not $4 million, which is the dif- ference between the amount of cash received from the sale of the investment and the cost of the investment ($64 million − $60 million). The difference is due to the fact that this investment had a readily available market price and was therefore marked to market every period. When this investment was adjusted to market value
D- APPENDIX D Investments in Other Corporations over the previous two years, the journal entries recorded a net gain of $1 million ($2 million loss in 2012 and a $3 million gain in 2013). Therefore, $1 million of the total $4 million gain has already been recognized, and the gain to record at the time of sale is for $3 million, as shown below.
Analyze Assets = Liabilities + Shareholders’ Equity Cash +64 Gain on Sale Investment in IFN −61 of Investments (+R) +3
Record dr Cash (+A) ...... 64 cr Investment in IFN (−A) ...... 61 cr Gain on Sale of Investments (+R, +SE) ...... 3
S P OTLIGHT ON Financial Reporting
Passive Investments and the Fair Value Requirement International Financial Reporting Standards (IFRS) require companies to account for passive investments at fair value. Fair value is the price the seller would receive if the assets were sold.
Accounting for Infl uential Investments
INVESTMENTS FOR SIGNIFICANT INFLUENCE EQUITY METHOD For a variety of reasons, an investor may want to exert significant influence (by owning 20 to 50 percent of a company’s outstanding voting shares) without becom- ing the controlling shareholder (by acquiring over 50 percent of the voting shares). For example, • A retailer might want to influence a manufacturer to ensure obtaining cer- tain products designed to its specifications. • A manufacturer might want to influence a computer consulting firm to incor- porate the firm’s cutting-edge technology into its manufacturing processes. • A manufacturer might recognize that a parts supplier lacks experienced management and could prosper with additional managerial support. When an investor can exert significant influence over an investee (the com- pany it partially owns), accountants must use the equity method to value the investment. As you have seen, when Horizon Telemedia Inc. invests in securities as a passive investor, the company reports those investments on the balance sheet as Investments in Marketable Securities. However, when HTI owns 20 to 50 percent of the outstanding voting shares, the company is presumed to be taking a more active role as an investor. On the balance sheet, Horizon Telemedia reports these long-term investments for significant influence as Investments in Affiliates (see Exhibit D.2).
Investments in Other Corporations APPENDIX D D- Recording Investments under the Equity Method With a passive investment (less than 20 percent share ownership), an investor usually cannot influence the investee’s operating and financing activities—for example, by compelling the investee to pay dividends. So, the investor reports any dividends received from the investee as dividend revenue. Under the equity method, however, the investor’s 20 to 50 percent ownership in a company presumes significant influence over the investee’s operating and financing policies. Often the investee’s board of directors may include a representa- tive of the investor who influences the investee’s board to declare dividends among other decisions. Because of this influence, the investment is accounted for as if the two companies were one. That is, the net income the investee earned increases the investee’s net assets (assets − liabilities). Likewise, the investor should report a portion of the investee’s net income as its income and an increase in the invest- ment account. Dividends paid by the investee decrease the investee’s net assets. Similarly, the receipt of dividends by the investor is treated as a reduction of the investment account, not revenue. A summary follows:
Net Income of Investee. When the investee reports net income for the year, the investor records investment income equal to its percentage share of the investee’s net income and increases the asset account Investments in Affiliates. (If the investee reports a net loss, the investor records the opposite effect.)
Dividends Paid by Investee. If the investee declares and pays dividends to the investor during the year (a financing decision), the investor reduces the investment account and increases cash.
+ Investments in Affiliates (A) − Beginning balance Purchases of shares in affiliated Sales of shares in affiliated companies companies Investor’s percentage share of Investor’s percentage share of investee’s net income (also credit investee’s net loss (also debit Equity in Equity in Investee Earnings) Investee Losses) Investor’s percentage share of investee’s dividends declared for the period (also debit Cash) Ending balance
Purchase of Shares For simplicity, let’s assume that at the end of 2011, Horizon Telemedia had no long-term investments in companies over which it exerted sig- nificant influence. On January 2, 2012, Horizon Telemedia purchased 4 million shares of the outstanding voting shares of IFN for $240 million cash. Because IFN had 10 million shares of common shares outstanding, HTI acquired a 40 percent interest (4 million ÷ 10 million shares) and was presumed to have significant influ- ence over the investee. Therefore, HTI must use the equity method to account for the investment. The purchase of the asset would be recorded on January 2, 2012, at cost in Investments in Affiliates.
Analyze Assets = Liabilities + Shareholders’ Equity Investments in Affiliates +240 Cash −240
D- APPENDIX D Investments in Other Corporations Record dr Investments in Affiliates (+A) ...... 240 cr Cash (−A) ...... 240
Investee Earnings Because the investor can influence the investee’s income- earning process, the investor bases its investment income on the investee’s earnings rather than on the dividends paid. In 2012, IFN reported net income of $50 million. Horizon Telemedia’s percentage share of that income, $20 million (40% × $50 million), would be recorded on December 31, 2012, as follows:
Analyze Assets = Liabilities + Shareholders’ Equity Investments in Affiliates +20 Equity in Investee Earnings (+R) +20
Record dr Investments in Affiliates (+A) ...... 20 cr Equity in Investee Earnings (+R, +SE) ...... 20
If reporting a net loss, the investor records its share of the loss by decreasing the investment account and recording the loss under Equity in Investee Losses. Equity in Investee Earnings (or Losses) is reported in the Other Items section of the income statement, along with interest revenue and interest expense.
Dividends Received Because Horizon Telemedia can influence the dividend policies of its investees, the company should not record any dividends it receives as investment income. Instead, dividends reduce its investment account. On December 1, 2012, IFN declared and paid a cash dividend of $2 per share to share- holders. HTI received $8 million in cash ($2 per share × 4 million shares) from IFN, and recorded this on December 1, 2012, as follows:
Analyze Assets = Liabilities + Shareholders’ Equity Investments in Affiliates −8 Cash +8
Record dr Cash (+A) ...... 8 cr Investments in Affiliates (−A) ...... 8
The cumulative effects of the IFN purchase, earnings, and dividends for 2012 are reflected in the following T-accounts (in millions of dollars):
Summarize
Investments in Affiliates (A) Equity in Investee Earnings (R) 1/1/12 0 0 1/1/12 Purchases 240 Share of investee Share of investee Share of investee net earnings 20 8 dividends 20 net earnings 12/31/12 252 20 12/31/12
Investments in Other Corporations APPENDIX D D- Sale of Shares Companies record any sale of shares in affiliated companies in COACH’S TIP the same way as sales of other assets. Investment in Affiliates is reduced by the Because Horizon Telemedia percentage of shares sold, Cash is debited, and the difference is recorded as either a owned percent of IFN prior Gain (or Loss) on Sale of Investments. to the sale million of the Let’s assume that on January 2, 2013, Horizon Telemedia decided to sell million shares outstanding 1,000,000 of the 4,000,000 shares it owned in IFN for $70 million. That represents it will then own percent 25 percent of Horizon Telemedia’s Investment in Affiliates. One-fourth of the bal- million of million shares ance in the account is equal to $63 million ($252 million × ¼), so the accounting a er the sale Thus it must still effects on January 2, 2013, are the following: apply the equity method
Analyze Assets = Liabilities + Shareholders’ Equity Cash +70 Gain on Sale of Investments in Affiliates −63 Investments (+R) +7
Record dr Cash (+A) ...... 70 cr Investments in Affiliates (−A) ...... 63 cr Gain on Sale of Investments (+R, +SE) ...... 7
Reporting Investments under the Equity Method On the balance sheet, Investments in Affiliates is reported as a long-term asset. However, as the year-end entries show, the investment account does not reflect either cost or market value. Instead, the following occurs: • The investment account increases with the cost of the purchased shares and the proportional share of the investee’s income. • The investment account decreases with the dividends received from the investee, the proportional share of any investee losses, and any sale of shares in the investee. At the end of the accounting period, accountants do not adjust the investment account to reflect changes in the market value of securities accounted for under the equity method. When the securities are sold, accountants record the difference between the cash received and the book value of the investment as a Gain (Loss) on Sale of Invest- ments and report the amount on the income statement in the Other Items section.
S P OTLIGHT ON ETHICS
Improper Infl uence A key assumption in accounting is that all transactions occur at “arm’s length.” That is, each party to the transac- tion is acting in his or her own self-interest. But when one company exerts signifi cant infl uence over another (i.e., when it owns to percent of the voting common shares), it is unreasonable to assume that transactions between the two companies are carried out at arm’s length. Consider what might happen if an investor company could aff ect the investee’s dividend policy If the inves- tor reported dividends paid by the investee as dividend income the investor could manipulate its own income by infl uencing the other company’s dividend policy In a bad year the investor might request large dividend payments to bolster its income In a good year it might try to cut dividend payments to build up the investee’s retained earnings which would support large dividends in the future The equity method prevents this type of manipulation Instead of recognizing dividends as income this method bases income from the investment on a percentage of the affi liated company’s reported net income
D- APPENDIX D Investments in Other Corporations INVESTMENTS WITH CONTROLLING INTERESTS CONSOLIDATED STATEMENTS Why Control Other Companies? Before we discuss financial reporting of investments that involve ownership of more than 50 percent of another company’s outstanding voting shares, we should consider the reasons for acquiring this level of ownership. Following are some of these reasons: Vertical integration. In this type of acquisition, one company acquires another company that operates on a different level in the distribution channel. Horizontal growth. Horizontal acquisitions involve companies that operate on the same level of the distribution channel. Synergy. Two companies operating together may be more profitable than two companies operating separately. Rogers Communications has created or purchased a number of broadcast and Internet services. Merging these companies and sharing news content may create more profits than operat- ing separate entities could. Understanding why one company has acquired control over other companies is a key factor in understanding that company’s business strategy. What Are Consolidated Statements? Any corporate acquisition involves two companies. A merger occurs when one company purchases all assets and liabilities of another company and the acquired company goes out of existence. When the acquired company remains in business, the company that gains control over it by acquiring all or a majority of the voting shares is the parent company. The subsidiary company is the company that the Parent company: The parent acquired.1 Following is a list of three corporations and some of the well- entity that controls another known companies they own: company. Subsidiary company: The Gap Inc. YUM! Brands, Inc. The Walt Disney Company entity that is controlled by Gap Pizza Hut ABC Television Network the parent. Old Navy KFC ESPN Banana Republic Taco Bell Disneyland Forth & Towne WingStreet Walt Disney World BR Factory Stores Little Sheep Pixar Animation Studios Piperlime Banh Shop Touchstone Pictures
When one company acquires another, the results of their operations must be Consolidated fi nancial reported together in consolidated statements. Consolidated financial statements statements: The fi nancial combine the operations of two or more companies into a single set of statements, statements of parent and usually identified by the word consolidated in the statement titles. For example, the subsidiary companies title of the statement in Exhibit D.2 is Consolidated Balance Sheet. Consolidated combined into a single set statements can be thought of as adding together the financial statements for two of fi nancial statements. or more companies so that they appear to be a single company. Thus, the cash accounts for the companies are summed, along with the inventory accounts, the land accounts, and all other accounts. Combining all financial information into one set of consolidated statements gives users better information on the size and COACH’S TIP scope of operations in companies controlled by the parent corporation. When consolidated statements are prepared, intercompany items such as loans Because a single set of fi nancial statements covers from the parent company to the subsidiaries must be eliminated. Remember that both the parent company and consolidated statements imply that a single company exists when in fact there its subsidiaries external users are two or more separate legal entities. Intercompany items do not exist in a sin- such as shareholders and banks gle corporation. For example, a debt that the parent owes to its subsidiary is not and you will not be able to reported on a consolidated statement because a company cannot owe money to obtain fi nancial statements for itself. Accounting for business acquisitions and preparing consolidated financial individual subsidiaries statements are discussed in detail in advanced accounting courses.
Investments in Other Corporations APPENDIX D D- DEMONSTRATION CASE A PASSIVE INVESTMENTS Cascon Equipment Corporation sells and services a major line of farm equipment. Both sales and service operations have been profitable. The following transactions affected the company during 2014: a. Jan. 1 Purchased 2,000 common shares in Dear Company at $40 per share. Purchase represented 1 percent of the shares outstanding. Management intends to trade these shares actively. b. Dec. 28 Received $4,000 cash dividend on Dear Company shares. c. Dec. 31 Determined that the current market price of Dear shares was $39.
Required 1. Prepare the journal entry for each of these transactions. 2. What accounts and amounts will be reported on the balance sheet at the end of 2014 and on the income statement for 2014? Suggested Solution 1. a. dr Investment in Dear Company (+A) ...... 80,000 cr Cash (−A) (2,000 shares × $40) ...... 80,000 b. dr Cash (+A) ...... 4,000 cr Investment Income (+R, +SE) ...... 4,000 c. dr Loss on Investments (+E, −SE) ...... 2,000 cr Investment in Dear Company (−A) ...... 2,000
Year:
Market value per share shares Cost per share shares Adjustment needed to record investment at A realized loss to income market value
2. On the balance sheet On the income statement
Current Assets Other Items
Investment in Dear Company Investment Income Loss on investment
DEMONSTRATION CASE B EQUITY METHOD On January 1, 2014, Connaught Company purchased 40 percent of the outstanding voting shares of London Company on the open market for $85,000 cash. London declared $10,000 in cash dividends on December 1, 2014, and reported net income of $60,000 for the year on December 31, 2014.
Required 1. Prepare the journal entries for 2014. 2. What accounts and amounts were reported on Connaught’s balance sheet at the end of 2014 and on Connaught’s income statement for 2014?
D- APPENDIX D Investments in Other Corporations Suggested Solution 1. Jan. 1 dr Investments in Affiliates (+A) ...... 85,000 cr Cash (−A) ...... 85,000 Dec. 1 dr Cash (+A) (40% × $10,000) ...... 4,000 cr Investments in Affiliates (−A) ...... 4,000 Dec. 31 dr Investments in Affiliates (+A) (40% × $60,000) ...... 24,000 cr Equity in Investee Earnings (+R, +SE) ...... 24,000 2. On the balance sheet On the income statement
Noncurrent Assets Other Items
Investments in Affi liates Equity in Investee Earnings cost dividends percentage of investee’s net income balance in Investments account
KEY TERMS Consolidated Financial Statements Passive Investments Parent Company Subsidiary Company
See complete definitions in the glossary in the back of the text.
Practice Material
QUESTIONS
1. When is it appropriate to use consolidation, equity, and 4. What are consolidated financial statements and what market value methods for an investment in another do they attempt to accomplish? corporation? 5. Under the equity method, dividends received from 2. What are the differences between the accounting the investee company are not recorded as revenue. methods used for passive investments and those used Recording dividends as revenue would involve double for investments involving a significant influence? counting. Explain. 3. What are the differences between the accounting 6. What are the two sources of return for passive methods used for investments involving a significant investments? influence and those used for investments involving control? Multiple-choice questions and corresponding answers can be found on Connect.
MINI-EXERCISES
MD- Recording Equity Method Securities Transactions On January 2, 2014, Ubuy.com paid $100,000 to acquire 25 percent (10,000 shares) of the common shares of E-Net Enterprises. The accounting period for both companies ends December 31. Give the journal entries for the purchase on January 2 and for each of the fol- lowing transactions that occurred during 2014: July 2 E-Net declared and paid a cash dividend of $3 per share. Dec. 31 E-Net reported net income of $200,000.
Investments in Other Corporations APPENDIX D D- MD- Determining Financial Statement Eff ects of Equity Method Securities Using the following categories, indicate the effects (direction and amount) of the transac- tions listed in ME-1. Use + for increase and − for decrease.
Balance Sheet Income Statement Shareholders’ Net Transaction Assets Liabilities Equity Revenues Expenses Income
MD- Recording Passive Investment Transactions During 2014, Princeton Company acquired some of the 50,000 outstanding common shares of Cox Corporation as trading securities. The accounting period for both companies ends December 31. Give the journal entries for each of the following transactions that occurred during 2014: July 2 Purchased 8,000 shares of Cox common shares at $28 per share. Dec. 15 Cox Corporation declared and paid a cash dividend of $2 per share. 31 Determined the current market price of Cox shares to be $29 per share.
MD- Determining Financial Statement Eff ects of Passive Investment Transactions Using the following categories, indicate the effects (direction and amount) of the transac- tions listed in ME-3. Use + for increase and − for decrease.
Balance Sheet Income Statement Shareholders’ Net Transaction Assets Liabilities Equity Revenues Expenses Income
MD- Recording the Purchase and Sale of a Passive Investment Rocktown Corporation bought 600 shares of General Esterdies on March 20, 2014, for its trading securities portfolio at $29 per share. Rocktown sold the shares at $33 per share on June 23, 2014. Prepare the journal entries to record the transactions on each of these dates, assuming that the investment had not yet been adjusted to market value (i.e., the invest- ment was still recorded at cost at the time of sale).
EXERCISES
ED- Recording and Reporting an Equity Method Security Felicia Company acquired 21,000 of the 60,000 outstanding common shares of Nurces Corporation during 2014 as a long-term investment. The annual accounting period for both companies ends December 31. The following transactions occurred during 2014: Jan. 10 Purchased 21,000 common shares of Nurces at $12 per share. Dec. 31 Nurces Corporation reported net income of $90,000. Dec. 31 Nurces Corporation declared and paid a cash dividend of $0.60 per share. Dec. 31 Determined the market price of Nurces shares to be $11 per share.
Required 1. What accounting method should the company use? Why? 2. Give the journal entries for each of these transactions. If no entry is required, explain why. 3. Show how the long-term investment and the related revenue should be reported on the 2014 financial statements of Felicia Company.
D- APPENDIX D Investments in Other Corporations ED- Recording Gains for Passive Investments On June 30, 2013, MetroMedia Unlimited purchased 10,000 shares of Mitekii for $20 per share. The following information pertains to the price per share of Mitekii shares:
Price
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Required 1. Assume that the shares are traded on an open market. Prepare the journal entries required on each date given. 2. Show how the investment and gains would be reported at the end of 2014 and 2013 on the classified balance sheet and income statement.
ED- Recording Losses for Passive Investments On March 10, 2013, Gesalt Solutions Inc. purchased 5,000 shares of Sperior Technologies for $50 per share. The following information pertains to the price per share of Sperior Technologies shares:
Price
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Required 1. Assume that the shares are traded on an open market. Prepare the journal entries required on each date given. 2. Show how the investment and losses would be reported at each year-end on the classified balance sheet and income statement.
COACHED PROBLEMS
CPD- Recording Passive Investments and Investments for Signifi cant Infl uence On August 4, 2012, Cappio Corporation purchased 1,000 shares of Maxweller Company for $45,000. The following information applies to the shares price of Maxweller Company:
Price
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Maxweller Company declares and pays cash dividends of $2 per share on June 1 of each year.
Required 1. Prepare journal entries to record the facts in the case, assuming that Maxweller shares are traded on an open market. 2. Prepare journal entries to record the facts in the case, assuming that Cappio uses the equity method to account for the investment. Cappio owns 30 percent of Maxweller, and Maxweller reported $50,000 of net income each year.
Investments in Other Corporations APPENDIX D D- CPD- Comparing Methods to Account for Various Levels of Ownership of Voting Shares Bart Company had 30,000 outstanding common shares for $10 per share. On January 1, 2014, Homer Company purchased some of these shares at $25 per share, with the intent of holding them for a long time. At the end of 2014, Bart Company reported the following: net income, $50,000, and cash dividends declared and paid during the year, $25,500. The market value of Bart Company shares at the end of 2014 was $22 per share.
Required 1. This problem involves two separate cases. For each case (shown in the table below), identify the method of accounting that Homer Company should use. Explain why. TIP: Divide the number of shares purchased by the number outstanding to determine the percentage of ownership. 2. Give the journal entries for Homer Company at the dates indicated for each of the two independent cases. If no entry is required, explain why. Use the following format:
Case A: Case B: Shares Shares Purchased Purchased
Journal entries made by Homer Company a To record the acquisition of Bart Company at January b To recognize the income reported by Bart Company for c To recognize the dividends declared and paid by Bart Company d Entry to recognize the market value eff ect at end of
3. Complete the following schedule to show the separate amounts that should be reported on the 2014 financial statements of Homer Company:
Dollar Amounts CaseA CaseB
Balancesheet Investments Incomestatement Investment Income Gain on Investments Equity in Investee Earnings
4. Explain why assets and investment income for the two cases are different.
GROUP A PROBLEMS ®
PAD- Recording Passive Investments and Investments Practise and learn online with Connect. for Signifi cant Infl uence On July 12, 2012, Rossow Corporation purchased 1,000 shares of Reimer Company for $30,000. The following information applies to the share price of Reimer Company:
Price
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Reimer Company declares and pays cash dividends of $2 per share on May 1 of each year.
D- APPENDIX D Investments in Other Corporations Required 1. Prepare journal entries to record the facts of the case, assuming that Reimer shares are traded on an open market. 2. Prepare journal entries to record the facts of the case, assuming that Rossow uses the equity method to account for the investment. Rossow owns 30 percent of Reimer, and Reimer reported $50,000 of net income each year.
PAD- Comparing the Market Value and Equity Methods Lisa Company had 100,000 outstanding common shares. On January 10, 2014, Marg Company purchased a block of these shares in the open market at $20 per share, with the intent of holding the shares for a long time. At the end of 2014, Lisa reported net income of $300,000 and cash dividends of $0.60 per share. At December 31, 2014, Lisa Company shares were selling at $18 per share.
Required 1. This problem involves two separate cases. For each case (shown in the table below), identify the method of accounting that Marg Company should use. Explain why. 2. Give the journal entries for Marg Company at the dates indicated for each of the two independent cases. If no entry is required, explain why. Use the following format:
Case A: Case B: Shares Shares Purchased Purchased
Journal entries made by Marg Company a To record the acquisition of Lisa Company on January b To recognize the income reported by Lisa Company for c To recognize the dividends declared and paid by Lisa Company d Entry to recognize the market value eff ect at end of
3. Complete the following schedule to show the separate amounts that should be reported on the 2014 financial statements of Marg Company:
Dollar Amounts CaseA CaseB
Balancesheet Investments Incomestatement Investment Income Loss on Investments Equity in Investee Earnings
4. Explain why assets and investment income for the two cases are different.
Endnotes
1. The discussion assumes acquisition of 100 percent of another company. Any acquisition of 51 to 99 percent of another company creates a minority interest that is discussed in advanced accounting courses.
Investments in Other Corporations APPENDIX D D-