Motivations for Intercorporate Investments

1. Motivations for Intercorporate Investments • As a temporary investment of excess cash • As part of a long-term risk-adjusted portfolio • Expectations of dividends and gains • As a strategic investment • To develop relationships with suppliers and customers • To gain access to new product or geographic markets • To facilitate activity along a supply chain

2. Investments on the Balance Sheet Coca-Cola Company reported the following investments at December 31, 2007 and 2008 (in millions):

3. Note Disclosure of Investments Coca-Cola Company reported the following in Footnote 10 of its 2008 annual report:

4. Coca-Cola’s Investments • Marketable securities • Includes trading, available-for-sale, and cost method investments • Equity method investments • Investments for which Coca-Cola intends to exert significant influence over operations • Coca-Cola’s equity method investments • 35% interest in Coca-Cola Enterprises Inc. • 23% interest in Coca-Cola Hellenic • 32% interest in Coca-Cola FEMSA • 30% interest in Coca-Cola Amatil

5. Coca-Cola’s Investments • Joint ventures • Investments for which Coca-Cola and at least one other company share ownership interest and jointly control a separate entity • Controlling interest • Investments for which Coca-Cola has a controlling interest in another company for strategic reasons • 2007-2008 acquisitions by Coca-Cola • 18 German bottling and distribution operations • Energy Brands Inc.

6. Types of Investments for Reporting Purposes

7. Fair Value Option • SFAS 159 allows companies to elect ‘fair value option’ for eligible intercorporate investments • Investments reported at fair value • Value changes reported as part of income • Excludes controlling equity investments The discussion on marketable investments and equity method investments in this chapter assumes the company did NOT elect the fair value option for these investments.

8. Investments Under SFAS 115 • Must have readily determinable market value • Must have no significant influence over the investee • Three categories Trading Investments Available-for-Sale Investments Held-to-Maturity Securities

9. Trading Investments • Debt or equity securities • Reported as current assets at fair value • Income statement reporting Income Statement Other Income/losses: Unrealized gains/losses on trading investments…………$ xx Realized gains/losses on trading investments……………..xx Investment income…………………………………………… xx

10. Accounting for Trading Investments Securities owned by Zinc, Inc. are: Exhibit 1.2 To record purchase of investments costing $800,000:

11. Accounting for Trading Investments To record the sale of trading security C for $214,000: To record the unrealized value change for securities A and B: Net unrealized gain = $10,000

12. Accounting for Trading Investments To record the sale of trading securities A and B: Exhibit 1.2 $616,000 $610,000 Net realized gain = $6,000

13. Available-for-Sale Investments • Debt or equity securities • Balance sheet • Reported as current or noncurrent assets at fair value • Unrealized gains/losses reported in accumulated other comprehensive income • Income statement reporting • Realized gains/losses on available-for-sale investments • Investment income • Other comprehensive income • Unrealized gains/losses on available-for-sale investments

14. Journal Entries for Available-for-Sale Investments Securities owned by Zinc, Inc. are: Exhibit 1.2 To record the purchase of investments costing $800,000:

15. Journal Entries for Available-for-Sale Investments continued To record the sale of AFS security C for $214,000: To record the unrealized value change for securities A and B: Net unrealized gain = $10,000

16. Journal Entries for Available-for-Sale Investments continued $616,000 $610,000 Net unrealized gain = $6,000 To record the sale of AFS securities A and B: To reclassify unrealized gains of AFS securities from AOCI to income:

17. Held-to-Maturity Investments • Debt securities only • Reported as noncurrent assets at amortized cost • Discount or premium amortized over time • Moved to current assets during year of maturity • No gains or losses unless sold prior to maturity • Early sale requires extreme circumstances Income Statement Other Income/losses: Interest income…………………………………………………… $xx

18. Journal Entries for HTM Investments A company invested in a $1 million, 5% face value corporate bond on January 1, 2010 for $965,349, yielding 6%. Interest is paid annually on December 31. Maturity is December 31, 2013. To record the purchase of HTM securities: To record the receipt of interest income for 2010: $1,000,000 × 5% $50,000 – $57,921 $965,349 × 6%

19. Journal Entries for HTM Investments $1 million, 5% face value corporate bond for $965,349, yielding 6%. Carrying value at December 31, 2010: $965,349 + $7,921 = $973,270 $1,000,000 × 5% To record the receipt of interest income for 2011: $50,000 – $58,396 $973,270 × 6% Carrying value at December 31, 2011: $973,270 + $8,396 = $981,666 $1,000,000 × 5% To record the receipt of interest income for 2012: $50,000 – $58,900 $981,666 × 6%

20. Journal Entries for HTM Investments $1 million, 5% face value corporate bond for $965,349, yielding 6%. Carrying value at December 31, 2012: $981,666 + $8,900 = $990,566 To record the receipt of interest income for 2013: $1,000,000 × 5% $50,000 – $59,434 $990,566 × 6% Carrying value at December 31, 2013: $990,566 + $9,434 = $1,000,000 To record receipt of face value of bonds at maturity:

21. Impairment Test for HTM Investments • HTM investments must be evaluated for impairment • Two criteria • Fair value declines below amortized cost, and • Decline is judged to be ‘other than temporary’ • If judged to be impaired • Write down the security to fair value • Report the decline as an impairment loss on the income statement • Ignore subsequent increases in fair value

22. Recording an Impairment Loss Example: An investor owns an HTM security with a current amortized cost of $981,666. During 2011, the investor has determined that it is probable that all amounts due according to the contractual terms of a debt security will not be collected. The current market value is $200,000. To record the impairment:

23. Investments with Significant Influence • Two accounting options exist • Elect to use the SFAS 159 fair value option, or • Apply the equity method • Investor must exert significant influence over operating and financing decisions of the investee

24. When is Significant Influence Present? • Assumed to be present if the investment allows the investor to exercise significant influence over the financial and operating decisions of the investee • Generally 20 to 50% ownership required • Less than 20% ownership exceptions • Representation on the investee’s board • Involvement in investee operating and financial policies • Significant transactions between investor and investee

25. Accounting Under the Equity Method Investment performance should parallel the investee’s performance Increases Decreases Changes in proportion to the investee’s retained earnings account

26. Equity Method Example Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December 2. To record the purchase of equity investment: To record dividends declared: $0.50 × 300,000

27. Equity Method Example continued Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December 2. To record dividends received: To accrue earnings of the investee: 30% × $2,000,000

28. Equity Method Example continued Coca-Cola acquires 300,000 voting shares of Rocky Mountain Bottlers for $12 million cash to obtain a 30% ownership with significant influence over the investee. Rocky Mountain reports net income of $2 million and declares a cash dividend of $0.50 per share on November 1, and pays the dividend on December 2. Balance Sheet as long-term asset Income Statement

29. Equity in Net Income • Adjustments to reported net income may be required • If investment cost differs from investee’s book value • Adjustment required: Must amortize investment cost in excess of book value acquired • If investor and investee transact business with each other • Adjustment required: Remove gross margin that is not yet earned

30. Adjustments to Equity in Net Income Adjustments should be made for • Depreciation and amortization on revaluations of • Tangible assets, and • Limited life intangible assets Exceptions No adjustments for goodwill impairment (SFAS 142) and other indefinite life intangibles (EITF Issue 08-06)

31. Additional Investment Cost Valuation Rocky Mountain reports total assets of $80 million and total liabilities of $50 million, for a net book value of $30 million. The original cost paid by Coca-Cola was $12 million. Analysis indicates that Rocky Mountain has unreported technology valued at $5 million and its plant and equipment is undervalued by $1 million. Plant and equipment has a remaining life of 10 years as of January 2, 2011 and uses straight-line depreciation. The previously unreported technology is a limited life intangible asset with a 5-year life.

32. Inventory Sales Between Investee and Investor Upstream Sales Investee sells inventory to investor Downstream Sales Investor sells inventory to investee Both companies record sales as if selling to outside customers Both report gross margin as part of income Results in If inventory not sold to unrelated outside party at year-end, gross margin is not yet earned Investor must remove when calculating equity in net income of investee

33. Adjustments for Unconfirmed Inventory Profits Example Suppose Rocky Mountain sells canned beverages to Coca-Cola upstream for $800,000 at a 20% markup on cost. Coca-Cola holds $210,000 of this inventory at year-end. Coca-Cola sells finished products to Rocky Mountain downstream for $500,000 at a 25% markup on cost. Rocky Mountain holds $100,000 of this inventory at year-end. How much is unconfirmed profit?

34. Recognition of Adjusted Equity Income $300,000 ÷ 10 $1,500,000 ÷ 5 30% × $20,000 30% × $35,000

35. Other Comprehensive Income and the Equity Method • Investor must adjust its investment and other comprehensive income for its share of the investee’s yearly OCI • Such as investor’s recognition of unrealized gain on AFS securities Suppose Rocky Mountain reported $200,000 in unrealized gains on AFS securities. 30% × $200,000 = $60,000

36. Impairment Testing • Impairment testing required under APBO 18 for equity method investments • Criteria • If fair value of the investment declines below its carrying value, and • The decline is judged to be other than temporary • Accounting requirements • Investment is written down and a loss is recognized on the investor’s income statement • Subsequent increases ignored

37. Joint Venture • An entity formed by a small group of individuals or firms that contribute resources and jointly share in managing and controlling the venture • Often established for a short-term, single business transaction or activity • Enables expertise, special technology, capital, market access to be combined • Corporate joint venture • Exists when the venture is organized as a corporation U.S. companies use the equity method for joint ventures.

38. Controlling Investments • Give the investor control over the operating and financial decisions of the investee • Three forms • Statutory merger, statutory consolidation, or asset acquisition • Stock acquisition • Variable interest entity • General rule: assets, liabilities, revenues, and expenses are combined with those of the investor for financial statement reporting

39. Statutory Mergers, Statutory Consolidations, and Asset Acquisitions • An investor directly acquires the assets and liabilities of the investee • Assets and liabilities recorded directly on investor’s balance sheet at fair value Statutory Merger Occurs when the investor acquires the investee and becomes the remaining legal entity Statutory Consolidation Occurs when a new entity is formed to acquire both the investor and the investee Asset Acquisition Occurs when an investor acquires a subset of the investee’s assets

40. Stock Acquisitions • Occurs when an investor obtains control over another company by investing in its voting stock • Investee remains a separate legal entity The separate financial records are consolidated at the end of each reporting period.

41. Stock Acquisition Example Assume Coca-Cola acquires and holds all of the voting stock of Rocky Mountain Bottlers, paying the former stockholders of Rocky Mountain $40 million cash. This is the entry Coke makes on its own books, but its annual report shows Coke and Rocky Mountain’s combined accounts as if Coke recorded the acquisition as a statutory merger.