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Chapter 18:

Chapter 18: . Intercorporate Equity Investments. ASSETS. LIABILITIES. STOCKHOLDERS’ EQUITY. Lecture . Relevant circumstances Consolidation Pooling of interests Purchase method New entity approach Pro rata Equity method Fair value method Defining the Reporting Entity

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Chapter 18:

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  1. Chapter 18: Intercorporate Equity Investments

  2. ASSETS LIABILITIES STOCKHOLDERS’ EQUITY Lecture • Relevant circumstances • Consolidation • Pooling of interests • Purchase method • New entity approach • Pro rata • Equity method • Fair value method • Defining the Reporting Entity • Translation of Foreign Operations • IFRS • Improving Accounting Standards • SPE, VIE, and the downfall of Enron

  3. Reporting on Intercorporate Equity Investments • Consolidated reporting as if the two separate legal entities are one accounting entity using either the purchase or pooling method (as appropriate) • Nonconsolidation using the equity method of accounting • Nonconsolidation using the fair (market) value approaches

  4. Finite Uniformity for Intercorporate Investmentst Ownership of Voting Stock Accounting Method >50% Consolidate per ARB 51 (SFAS No. 94) SFAS No. 141 and 142 20% to 50% Equity Accounting per APB Opinion No. 18 >20% Fair (market) value for both trading securities and available-for-sale securities...

  5. Relevant Circumstances The relevant circumstances that justify differential accounting for intercorporate equity investments depend on the level of influence held by the investor

  6. Three Levels of Control • Majority owned company: owner has effective control • Majority owned company: control is only temporary or the majority owner does not have effective control • Less-than-majority-owned companies: relevant circumstance is whether the investor can exercise significant influence over operating and financial policies

  7. Consolidation • A technique in which two or more entities are reported as if they are one common accounting entity • Also called a business combination

  8. Consolidation Terms • Combined enterprise • Constituent companies • Combinor • Combinee

  9. Consolidation • Central accounting issue is the valuation of the assets and liabilities of the separate entities being combined for reporting purposes • FASB (1976) outlined three possible methods of accounting • pooling of interests accounting • purchase accounting • new entity approach

  10. Divestitures • Sell-off • Spin-off • Split-off • Split-up

  11. Pooling of Interests • Based on the premise that no substantive transaction occurs between the constituent companies • Is argued to be simply the formal unification of two previously separate ownership groups • Desirability of pooling is to avoid certain ramifications of purchase accounting

  12. Purchase Method • Assumption is that the combinor is a parent company that purchases the combinee (subsidiary) and must account for the purchase as it would for the acquisition of any asset • The asset, investment in the combinee company, is recorded by the combinor at the latter’s cost determined as of the date the combination is consummated

  13. New Entity Approach • Regard the combined enterprise as an entirely new entity • Results in the use of current values for the assets and liabilities of all the separate entities as of the date the combination is consummated

  14. Pro Rata Consolidation ( 4th method) • Consolidation of assets and liabilities occurs only to the extent of the stock acquired by the parent • An arbitrary distinction at the 50 % point where control is assumed does not exist

  15. Equity Method • Used whenever the investor has the ability to exercise significant influence over the investee • A one-line consolidation takes place • The investment account simply mirrors the net change in investee book value

  16. Fair Value Method • Market value applies where no significant influence exists and market values are readily determinable for investments of approximately 20 percent or less • Increases or decreases in market value may or may not go through income depending upon management’s intention to sell them in the near term

  17. Defining the Reporting Entity SFAS No. 94 asserts, rather than demonstrates, that consolidated reporting (and the fictional accounting entity thus created) is more relevant to investors than are separate entity statements in which the reporting entity is the legal entity.

  18. Translation of Foreign Operations • CAP issued two ARBs on the subject • 4 • 43 • APB issued APB Opinion No. 6 • FASB has issued three SFASs • No. 1 • No. 8 • No. 52

  19. Exchange Rate Between Currencies of Different Countries • Assumed to be the result of two factors: • different nominal interest rates arising from differences in expected inflation rates occurring in different countries • the ratio of the relative prices of a common “market basket” of goods and services • Instability in foreign exchange rates that has the potential to create large translation gains and losses

  20. U.S. dollar orientation Foreign currency orientation Approaches to Translation

  21. SFAS No. 8 • Consistent with the U.S. $ orientation • Temporal method of translation was required: all balance sheet items that were carried at current or future exchange prices • Foreign currency exposure • Accounting exposure • Economic exposure

  22. SFAS No. 52 • May 1978, FASB requested comments from constituents regarding the first twelve SFASs • 88% of the comments received requested that the board reconsider SFAS No. 8 • primary complaints about SFAS No. 8: exchange gains and losses are reported, when from an economic viewpoint the reverse had occurred • Adopts a functional currency orientation rather than a U.S. dollar orientation

  23. SFAS No. 52 • Net income is measured in the foreign currency and then restated into dollars at the average exchange rate for the period • Balance sheet items are translated at the current exchange rate at the end of the period • Objective is to avoid reporting • accounting exchange gains and losses when an economic gain or loss has not occurred • foreign-currency-denominated operations as if they had occurred in U.S. dollars

  24. Functional Currency Determination • Cash flow indicators • Sales price indicators • Sales market indicators • Expense indicators • Financing indicators • Intercompany transactions and arrangements indicators

  25. IFRS • IFRS 3 is similar to SFAS Nos. 141 and 142, however, • being more principles-based than FASB standards, it does not have quantitative measures for consolidation. • it requires "obtaining control" of the combinee. • Pooling, as in the United Stated States, is no longer allowed.

  26. IFRS • IFRS 3 requires that accounting policies of the subsidiary must conform with that of the parent with disclosures made if this is not the case. FASB is more lenient, not having this policy. • IFRS 3 requires that minority interests be included in owners' equity whereas under US GAAP, minority interests can appear in either liabilities or equity.

  27. Improving Accounting Standards • The new entity approach might be used with the present order of finite uniformity. • If it is not, proportionate consolidation should be carefully considered, because it gives a generally useful rigid uniformity solution to the FASB awkward finite uniformity approach to consolidation. • A lower cutoff point, such as 10%, could also be instituted for marketable security investments that are not consolidated.

  28. SPE, VIE, and the downfall of Enron

  29. Special Purpose Entity (SPE) • A joint venture between a sponsoring company and a group of outside investors • SPE is limited by its charter to certain permitted activities. Hence, the term “special purpose” comes from the limited scope of the SPE. • Most common uses an SPE are • financing arrangements, • leasing arrangements, • and sales/transfers of illiquid or poor performing assets

  30. Enron • Enron sold poorly performing assets to LJM • enabled Enron to move debt off its books and • to show inflated earnings and cash flow from the sale of assets to the SPEs which were controlled and run by Enron employees. • Enron’s aggressive accounting and the use of SPEs broke new ground to the extent in which structured finance arrangements can be used to manipulate reported financial reporting

  31. The Response to Enron’s Downfall • Sarbanes-Oxley Act of 2002 • Eliminate the SPE by changing its name • Change the criteria for consolidation of the SPE/VIE

  32. Variable Interest Entities (VIE) • The abuse of SPEs by firms such as Enron left a very bad taste in the public’s mouth. The first thing the FASB did was to change the name of the arrangement • from SPE (Special Purpose Entity) • to VIE (Variable Interest Entity). • Previously as little as a 3% equity interest by an outside investor allowed the controlling enterprise to avoid consolidation. The minimum investment to avoid consolidation has been raised to 10%.

  33. ASSETS LIABILITIES STOCKHOLDERS’ EQUITY Lecture • Relevant circumstances • Consolidation • Pooling of interests • Purchase method • New entity approach • Pro rata • Equity method • Fair value method • Defining the Reporting Entity • Translation of Foreign Operations • IFRS • Improving Accounting Standards • SPE, VIE, and the downfall of Enron

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