Lecture W14Revsine 8e Chap17

Intercorporate
Investments
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17
Copyright © 2021 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Learning Objectives
After studying this chapter, you will understand:
1. How to account for investments in debt securities.

2. How an investor’s degree of influence over an investee company
determines the accounting treatment of equity investments and why.
3. How fair value accounting is applied to equity securities.
4. How to apply the equity method and the fair value option.
5. What consolidated financial statements are, how they are prepared
under the acquisition method, and how noncontrolling interests are
measured and reported.
6. How goodwill arises and when it is considered impaired and written
down.
7. How business combinations were previously accounted for under the
purchase and pooling of interests methods and how the method used to
record an acquisition in the past affects financial analysis, even today.
Copyright © 2021 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill 17-2
Learning Objectives, concluded
After studying this chapter, you will understand:
8. What variable interest entities (VIEs) are and when they must be
consolidated.
Accounting for Investments in Debt
Securities
 Investments in debt securities are classified as held-to-maturity,
trading securities, or available-for-sale securities.
 Held-to-maturity securities are those that the firm has both the intent and
the ability to hold until the maturity date.
 Trading securities are investments that are part of an actively managed
investment portfolio designed to achieve trading gains.
 Available-for-sale securities are investments that do not qualify for either
of the above.
Accounting for Held-to-Maturity
Securities
 Debt securities (e.g., bonds and notes) that a firm intends to hold to
maturity are generally accounted for at amortized cost.
 The investment account is adjusted for the amortization of premium or
discount in each period.
 Interest income is recognized following the effective interest method.
 No adjustment is made for a change in the fair value of debt
securities in the held-to-maturity portfolio.
Principal Financial purchases a five-year $100,000 bond from Baker Company with a 7%
coupon interest rate for $108,659 on January 1, 20X1. The effective yield on this bond
investment is 5%, meaning the discount rate that equates the $108,659 purchase price
with the present value of the promised cash flows is 5%. The bond matures on December
31, 20X5, and a $7,000 coupon payment is due at the end of each year.
Accounting for Held-to-Maturity
Securities, continued
 Entry on January 1, 20X1, to record the acquisition of the bond:
 Entry on December 31, 20X1, to record interest income and

amortization of the bond premium:
 Firms may elect to account for held-to-maturity investments using use fair
value accounting.
Available-for-Sale Securities
 Available-for-Sale Securities
 Investments in debt securities classified as available for sale are
presented in the balance sheet at fair value, requiring an
adjustment at each balance sheet date.
 The investor applies the effective interest method just as it would
for a held-to-maturity investment, and adjusts the amortized cost
at each balance sheet date to the fair value.
 The fair value adjustment is reported as part of other comprehensive
income.
 Suppose Principal Financial had classified its investment as available
for sale. At December 31, 20X1, the bonds had an amortized cost of
$107,092, but a fair value of $107,500. The following entry would be
made:
 If an available for sale security is sold, the full holding period gain or
loss is recognized in the income statement and the balance in AOCI
is “recycled.”
Trading Securities
 Trading Securities
The accounting for trading securities is similar to available-for-

sale securities, except that the fair value adjustments are

recognized in net income rather than in OCI.
 Suppose Principal Financial had classified its investment as trading:
The gain is recognized in

net income for trading
securities.
Recording Credit Losses
 Effective for fiscal years beginning after December 15, 2019, SEC
registrants are subject to the Current Expected Credit Loss (CECL)
rules for investments in debt securities.
 Firms must accrue a loss currently when there is the expectation that not
all of the promised principal or interest payments will be received.
 The amount of the loss accrued is generally the difference between the
present value of the expected cash flows and the amortized cost of the
investment.
 The rules are generally not applicable to trading securities, which are
already reported at fair value with unrealized gains and losses reported in
net income.
Soon-to-Be Superseded Guidance:
Other-Than-Temporary Impairments
 Until firms adopt the CECL rules, they might incur an other-than-
temporary impairment.
 For available-for-sale debt securities:
 If a firm intends or it is likely that the firm will be required to sell the
security, the entire amount of impairment is recognized in earnings.
 If a firm does not intend to sell the security and it is unlikely that the firm
will be required to sell the security before recovery of its amortized cost
basis less any current-period credit loss, then the other-than-temporary
impairment is separated into the amounts:
 Representing the credit loss, which is recognized in earnings.
 Related to all other factors, which is recognized in other comprehensive
earnings.
 For held-to-maturity securities, the analysis is simpler:
 If the fair value of the security is less than amortized cost and the firm
does not expect to recover the entire amortized cost basis, OTTI is
recognized.
 The OTTI is split between credit loss recognized in net income and
losses related to other factors recognized in OCI.
Types of Equity Investments
Under GAAP, the method of accounting for equity investments depends

on the degree to which the investor company is able to influence the
operating decisions of the investee.
Minority Passive Investments: Fair
Value Accounting
 In general, all minority passive equity investments are accounted for at
fair value, with changes in fair value accounted for in net income.
 One exception is for investments where fair value is not readily
determinable.
 For those securities, firms may opt to report at fair value or to report at
cost, adjusted for changes in observable prices minus impairment.
Example:
• Principal Financial purchased two securities in 20X1 and two in 20X2.
• It sold its Company B preferred stock in 20X4.
Value Accounting
To record the purchase of shares on January 1, 20X1:
The total fair value of all minority-passive investments is compared to the total cost of the securities.
The fair value is $1,000 less than the cost so a fair value adjustment is required:
Value Accounting
To record the purchase of shares on July 1, 20X2:
At year-end 20X2, the portfolio’s value is $97,000 versus a $100,000 cost, so a $3,000 credit is the
required balance in the fair value adjustment account. It currently has a $1,000 credit so the
following is required:
Value Accounting
When minority passive investments are sold, a realized gain or loss is recorded.
Minority Passive Investments: Income
Tax Effects
 Fair value adjustments have income tax consequences but, because
under income tax law gains and losses are not recognized until a
security is sold, the tax effects are deferred.
 Principal recorded a $1000 loss in 20X1. That loss reduced the
company’s pre-tax income but had no effect on 20X1 taxable income,
resulting in a temporary difference.
 Assume a 21% marginal tax rate:
Minority Active Investments
When an investor has the ability to exert significant influence over an investee’s
decisions, the investor has an active investment.
 Unless there is evidence that the investor is unable to influence the investee,
there is a presumption that an investor holding 20% to 50% is able to exert
significant influence over the investee.
Minority Active Investments:
Equity Method
Minority active investments are accounted for using the equity
method.
 The investor records its initial investment in the investee at
cost.
 Subsequently, the Investment account is increased for the
investor’s pro rata share of the investee’s net income, and
there is a corresponding credit to the Investment income
account.
 In the case of a loss, the investor’s Investment account decreases
and there’s a corresponding debit to the Investment loss account.
 Dividends from the investee reduce the Investment account.
 The net increase in the investment account is the amount by
which the investor’s share of the investee’s earnings exceed its
share of the investee’s dividends declared.
Minority Active Investments:
Equity Method Illustration
Planet Burbank’s dividend

declaration and subsequent
payment, has no effect on Willis’
income.
When Cost and Book Value Differ
 Investors rarely buy shares at a price exactly equal to the book
value of those shares. Why?
 The investee’s books are prepared under GAAP, and reflect most
balance sheet items at historical cost rather than at current value.
Sellers of the investee’s stock presumable know what the net assets of
the investee are worth.
 An informed buyer would knowingly pay a premium to acquire an
investment in another company.
 Goodwill exists because thriving, successful companies are
generally worth more than the sum of their individual net assets.
 When the cost of the shares acquired exceeds the underlying book
value at the acquisition date, the investor is required to amortize any
excess that is attributable to separately identifiable assets and liabilities
not having an indefinite life.
 Amortization is recorded as a reduction (debit) to Investment income
and a reduction (credit) to the Investment account.
Illustration of Equity Investment with
Goodwill
On January 1, 20X1, Willis Company purchases 30% of the outstanding common shares of Planet
Burbank Inc. for $9 million. The book value and fair value of Planet Burbank’s net assets (assets minus
liabilities) is $30 million. Initially, we assumed that Willis pays book value for its investment in Planet
Burbank (30% × $30 million = $9 million). Now, we assume Willis paid $24 million for its 30% stake, which
is $15 million more than the related book value of $9 million).
The difference between fair

value and book value of
inventories and fixed assets
explains only $12 million of the
disparity, leaving $3 million
unexplained.
Illustration of Equity Investment with
Goodwill, continued
On January 1, 20X1, Willis Company
purchases 30% of the outstanding
common shares of Planet Burbank Inc.
for $9 million. The book value and fair
value of Planet Burbank’s net assets
(assets minus liabilities) is $30 million.
Initially, we assumed that Willis pays
book value for its investment in Planet
Burbank (30% × $30 million = $9
million). Now, we assume Willis paid
$24 million for its 30% stake, which is
$15 million more than the related book
value of $9 million).
• The cost of the shares

acquired exceeds the
underlying book value at the
acquisition date.
• The investor is required to
amortize any excess that is
attributable to separately
identifiable assets and
liabilities not having an
indefinite life.
Fair Value Option for Equity Method
Investments
Firms may elect the fair value option for investments that would otherwise
be accounted for under the equity method; this election is irrevocable.
 A firm is allowed to elect the fair value option on an election date,
which is when one of the following events occurs:
 The firm first acquires an investment that is eligible for equity method
treatment
 The investment becomes subject to the equity method of accounting
 The investor ceases to consolidate a subsidiary
The investor firm does not

Unrealized gains and Assets and liabilities
report its proportionate
losses from changes measured at fair value
share of the investee
in fair value must be reported on the
profits and losses in
are reported in the balance sheet separately
earnings.
investor’s income from investments
Dividends received flow
statement not reported at fair value
directly to earnings.
Controlling (Majority) Interest:
Acquisition Method and Consolidation
 An entity that gains a controlling financial interest in another
entity is referred to as the parent company.
 Controlling financial interest is generally deemed to occur when one
entity, directly or indirectly, owns more than 50 percent of the
outstanding voting shares of another entity, called a subsidiary.
 The financial statements of the subsidiary are combined—line by
line—with those of the parent using a process called
consolidation.
 Consolidated financial statements portray the economic activities of
the parent and the subsidiary as if they were one entity.
Acquisition Method and Preparation of
Consolidated Statements (100%
Acquisition)
Alphonse Corporation paid $10 million cash to buy all of the outstanding shares of Gaston Corporation.
The balance sheet of Alphonse Corporation immediately before the acquisition:
After the transaction is recorded, Alphonse’s current assets will be $10 million
lower due to the payment of cash, and an investment account of $10 million will
exist.
Adjustments for Consolidating the
Balance Sheet
Step 1 [entry (A)]

Eliminate the
Investment in Gaston
account against
Gaston’s equity
Step 2 [entry (B)]
Reclassify the
remainder of the
account
• The process described here is solely for the purpose of preparing consolidated
statements.
• The adjustments are not recorded on the books of the acquirer (parent
company).
Acquisition with Noncontrolling Interests
(Less Than 100% Acquisition)
 A controlled company must be consolidated as a whole regardless of the
parent’s level of ownership.
 The parent must measure and recognize the subsidiary as a whole at
business fair value.
 Under the acquisition method, the parent company includes in its
consolidated financial statements 100% of the subsidiary’s individual
assets acquired and liabilities assumed at their full fair values
determined as of the acquisition date, even when the parent owns less
than 100% of the controlled subsidiary.
 Measuring the controlling interest fair value is relatively straightforward.
 For the vast majority of cases, the value of the consideration transferred
provides the best evidence of the controlling interest fair value.
 Measuring the noncontrolling interest fair value is more difficult because
the noncontrolling shareholders are not parties to the transaction.
Acquisition Method with Noncontrolling
Interests: Consolidated Balance Sheet
Entry A: Eliminates the
account against
stockholders’ equity
accounts and sets up
noncontrolling interest
in Gaston
Entry B: Reclassifies
the remainder of the
investment account by
writing up net assets to
fair value and recording
goodwill attributed to
the controlling interest
Entry C: Recognizes
the noncontrolling
interest in the total
business fair value of
Gaston
Here, Alphonse pays $9 million to acquire 80% (rather than 100%) of Gaston’s
outstanding shares.
Acquisition Method with Noncontrolling
Interests: Consolidated Income
Statement
A subsidiary’s income is consolidated into its parents from the date of acquisition.
• We must amortize the

portion of the excess
acquisition value
attributed to fixed
assets of $1,500,000
over 20 years (which
is the remaining
useful life of those
fixed assets), resulting
in $75,000 of
amortization per year.
• The Alphonse income
statement is prepared
under the equity
method so it reflects
an income accrual for
Alphonse’s share of
Gaston’s income.
Finally, we must subtract that portion of Gaston’s earnings assigned to the 20% noncontrolling interests to
arrive at net income attributable to the Alphonse shareholders.
Additional Consolidation Issues
 Intercompany Receivables and Payables are eliminated against each

other in consolidating the balance sheet because when the firm is viewed as
a single entity, it cannot owe itself money.
 Adjustments are required for Intercompany Sales. These adjustments are
addressed in advanced accounting courses focusing on consolidations.
 Goodwill must be assessed annually to determine if an impairment is
necessary.
Additional Consolidation Issues:
Variable Interest Entities
 A variable interest entities (VIE) is a corporation, partnership, trust, or
any other legal structure used for business purposes that either:
a) does not have equity investors with voting rights or
b) has equity investors that do not provide sufficient financial
resources for the entity to support its activities.
 VIEs are often formed to engage in what are called structured
financing arrangements.
 GAAP requires the VIE to be consolidated if that company has a
controlling financial interest in the VIE and is the VIE’s primary
beneficiary.
 A company has a controlling interest in a VIE if it has both of the following
characteristics:
 The power to direct the activities of a VIE that most significantly
impact the VIE’s economic performance.

 The obligation to absorb losses of the VIE that could be potentially be
significant to the VIE.
Previous Approaches to Consolidated
Statements
• The only acquisition
method permitted for
merger and acquisition
transactions entered
into today is the
acquisition method.
• Transactions originally
accounted for under
either of the following
two methods continue
to be accounted for
under those methods.
• Pooling of interests
• Purchase
To determine which method was (and should continue to be) used for a given
transaction, determine the date that the parent acquired the subsidiary.
Pooling of Interests Method
 The pooling of interests method was permitted for transactions that

met certain criteria, including:
 Acquiring more than 90% of the voting common stock
 Consummation of the transaction through an exchange of stock
 The transaction was treated as if the two companies joined
together to become a new entity, rather than that one of the
companies acquired the other.
 The financial statements were restated retroactively as if the two
companies had always been one.
 There is no resetting of asset values to fair value or any recognition of
goodwill.
 Amid concerns that many transactions were structured to qualify as
poolings of interests even though they were clearly acquisitions, the
FASB banned poolings effective July 1, 2001.
Purchase Method
 Beginning July 1, 2001, only the purchase method was permitted.
 This method treated the transaction as an acquisition of one company
by another, regardless of whether the consideration paid was in cash or
stock.
 If the consideration was in stock, the purchase price was deemed to be the
fair value of the stock given up in the transaction.
 Any excess paid above book value for the acquired company was
attributed to specific assets and liabilities as well as to goodwill.
 The step-up in values and recognition of goodwill only occurred on the
portion of the assets acquired.
 Through 2001, goodwill was amortized over not more than 40 years.
 Since 2002, goodwill is not amortized; rather, it is subject to an annual review for
impairment.
 Effective in 2009, the purchase method was replaced with the
acquisition method.
Presentation of Noncontrolling Interests
 Beginning in 2009, consolidated net income is defined to include
all earnings of a parent and its consolidated subsidiaries, even if
the consolidated subsidiaries are not wholly owned.
 That net income is then attributed to the parent company
shareholders and the noncontrolling interests (i.e., the minority
shareholders of the subsidiary’s stock).
 When the noncontrolling interests are subtracted from consolidated
net income, the resulting amount is called consolidated net income
attributable to parent company shareholders.
Financial Analysis Issues
 Trend analysis is difficult because U.S. GAAP comparative
financial statements are not retroactively adjusted to include data
for the acquired company for periods prior to the acquisition.
Parent Company Subsidiary Company
Results Included Results Included
Year prior to Full Year No portion
acquisition
Year of acquisition Full Year Fraction of year
owned by the parent
Year after acquisition Full Year Full Year
 This can lead to distortions in year-to-year growth rates in

revenue and profits that statement users should be aware of.
Summary
 The accounting for investments in debt securities depends on the
security’s classification. Held-to-maturity securities are reported at
amortized cost. Trading securities are reported at fair value with gains
and losses reported in the income statement. Available-for-sale securities
are reported at fair value with gains and losses reported in other
comprehensive income.
 Financial reporting for intercorporate equity investments depends on the
degree to which the investor is able to influence the investee’s operating
decisions. Proportionate share size is a presumptive factor in assessing
an investor’s influence over an investee.
 Minority-passive equity investments are reported at fair value with
unrealized gains and losses reported in the income statement.
 For minority active investments, the equity method is used, whereby the
investor records its proportionate share of the investee’s profits and
losses, net of any excess cost amortization. However, using the fair value
option, firms may instead elect to report these investments at fair value.
Summary, continued
 When one entity controls another, consolidation is required.
 Currently, acquisitions are accounted for under the acquisition method,
but two other methods—pooling of interests and the purchase method—
were permitted previously. Acquisitions are not restated, so transactions
previously recorded as poolings or purchases continue to be reported on
that basis.
 Goodwill is typically recorded in business combinations other than those
that were treated as poolings of interest. Goodwill is subject to an annual
impairment test.
 Under current accounting for mergers and acquisitions, income of an
acquired company is included in the parent’s income statement from date
of acquisition, which greatly complicates trend analysis.
 Certain entities must be consolidated even if they are not majority owned.
When a company is the primary beneficiary of an entity that does not
have equity investors with voting rights or whose equity investors do not
provide sufficient financial resources to the entity’s activities, it must
consolidate the entity, which is called a variable interest entity, or VIE.

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Intercorporate

1. How to account for investments in debt securities.

 Entry on January 1, 20X1, to record the acquisition of the bond:

 Entry on December 31, 20X1, to record interest income and

sale securities, except that the fair value adjustments are

The gain is recognized in

Under GAAP, the method of accounting for equity investments depends

To record the purchase of shares on January 1, 20X1:

To record the purchase of shares on July 1, 20X2:

Planet Burbank’s dividend

The difference between fair

• The cost of the shares

The investor firm does not

The balance sheet of Alphonse Corporation immediately before the acquisition:

Step 1 [entry (A)]

• We must amortize the

 Intercompany Receivables and Payables are eliminated against each

impact the VIE’s economic performance.

significant to the VIE.

 The pooling of interests method was permitted for transactions that

 This can lead to distortions in year-to-year growth rates in

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