Investments in Equity Securities. The Internet research exercise examines Cisco System s strategy of growth through acquisitions.

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1 CHAPTER 8 Investments in Equity Securities SYNOPSIS In this chapter, the author discusses investments in equity securities. The discussion is divided into equity securities classified as current and long-term investments. The specific topics associated with investments in equity securities are (1) the criteria for equity investments to be classified as current; (2) accounting for investments in trading and available-for-sale securities, including the mark-to-market rule; and (3) selected economic and theoretical issues. The specific topics associated with long-term equity investments are (1) accounting for long-term equity investments under the cost method, the mark-to-market method, the equity method, consolidations, goodwill, special purpose entities, and (2) the economic consequences associated with the different methods. The author provides a discussion of the detailed accounting procedures for consolidating financial statements in Appendix 8A. The ethics vignette examines the liberal accounting rules for recognition and amortization of goodwill in countries outside the United States. It then considers whether it is ethical for the government or standard-setting body in a particular country to set accounting standards that are designed to provide international economic advantages enjoyed solely by the companies and capital markets in that country. The Internet research exercise examines Cisco System s strategy of growth through acquisitions. The following key points are emphasized in Chapter 8: 1. Criteria that must be met before a security can be listed in the current assets section of the balance sheet. 2. Trading and available-for-sale securities and how the mark-to-market rule is used to account for them. 3. Why companies make long-term investments in equity securities. 4. The mark-to-market method, the cost method, and the equity method of accounting for long-term equity investments, and the conditions under which each method is used. 5. Consolidated financial statements, when they are prepared, and how they differ from financial statements that account for equity investments using the equity method. LECTURE/TEXT OUTLINE Investments in equity securities. I. Equity investments are an investment in the equity securities of other companies. These investments are made (1) to earn investment income through dividends and stock appreciation, and (2) to exert influence or control over the board of directors and management of the investee company. II. Equity securities classified as current.

2 A. Short-term investments in equity securities are reported as current assets. B. Criteria to be classified as current. 1. The securities must be readily marketable. This criterion implies that the security can be sold and converted into cash at will. 2. Management must intend to convert the investment to cash within the time period of current assets. a) Management's incentives to "window dress" current assets through the classification of equity securities. b) Auditors can examine the company's past practices and the nature and size of the investment to determine management's intentions. 3. If neither criterion is met, the investment must be included in the long-term investment section. III. Trading and available-for-sale securities. A. Accounting for readily marketable equity securities is governed by SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." B. Investments in readily marketable equity securities are classified into one of two categories. 1. Trading securities securities bought and held principally for the purpose of selling them in the near future with the objective of generating profit on shortterm price changes. These securities are always listed in the current section of the balance sheet. 2. Available-for-sale securities those investments not classified as trading securities. These securities are listed on the balance sheet as current or longterm, depending on management s intention. C. Events related to accounting for trading and available-for-sale securities. 1. Purchase of securities. a) Equity securities are always recorded at cost when they are acquired. b) Cost includes any incidental acquisition costs such as brokerage commissions and taxes. 2. Declaration and receipt of cash dividends. a) On the date the dividend is declared, dividend income and the corresponding dividend receivable are recorded.

3 b) When the cash from the dividend is received, Cash is debited and Dividend Receivable is credited. Receiving the dividend is simply an exchange of assets. 3. Sale of securities. a) The balance sheet value of the securities is removed from the books. b) The difference between the balance sheet value of the securities and the proceeds of the sale is recognized as either a realized gain or a realized loss. 4. Price changes of securities. a) The FASB mandated in SFAS No. 115 that readily marketable equity securities be carried on the balance sheet at current market value. b) The mark-to-market rule gives rise to unrealized (or holding) gains or losses. c) End of period adjustments to reflect current market values differ for trading securities and available-for-sale securities. (1) For trading securities, holding gains or losses are considered temporary accounts. They appear in the income statement and are reflected in retained earnings. (2) For available-for-sale securities, the unrealized price changes are considered permanent accounts and are carried in the shareholders' equity section of the balance sheet. 5. Reclassifications and permanent market value declines. a) When management changes the classification of investments from trading to available-for-sale, or vice versa, unrealized holding gains or losses should be recognized immediately in the income statement. b) When permanent market value declines (i.e., the price declines and is not expected to recover) the security should be written down to its market value and a realized loss should be recognized immediately. 6. Mark-to-market accounting and comprehensive income. a) While unrealized price changes in available-for-sale securities are not reflected in net income, the FASB requires that such changes be reported on a statement of comprehensive income. b) No specific form is required, but the statement of comprehensive income must be displayed with the same prominence as the other financial statements.

4 c) Comprehensive income provides the statement user with an estimate of the overall change in a company's wealth during the period. 7. Practical and theoretical issues associated with the mark-to-market rule. a) Current market values provide more useful information about the wealth of the firm. b) Market value accounting, in general, is criticized because market values are subjective and can result in large fluctuations from period to period (which are not necessarily relevant). Mark-to-market accounting for investments in equity securities avoids these criticisms. (1) The rule applies only to readily marketable equity securities, i.e., those that have readily determinable and objective market prices. (2) Market value changes of only those securities that are intended to be sold in the very near future (trading securities) are reflected in current income. Unrealized price changes related to securities classified as available-for-sale are not included in the income statement. c) Management's subjective judgment may influence the reported dollar amount of net income because the classification of securities as trading or available-for-sale depends heavily on management's intention. IV. Long-term equity investments. A. The accounting treatment used for long-term equity investments depends upon the investor's potential to influence the investee company. 1. Mark to market or cost method: If the investor has little potential to influence the investee company (defined as owning less than 20 percent of the investee's outstanding stock), then the marketability of the investee's stock determines the appropriate accounting treatment. a) If the investee's stock is not readily marketable, then the cost method is used to account for the equity investment. (1) The investment is initially recorded at cost, which includes any incidental costs like brokerage fees. (2) Dividends declared by the investee are recognized as revenue. (3) The investment is carried on the books at cost until it is sold or until it suffers a permanent impairment in value. b) If the investee's stock is readily marketable, then the securities are classified as available-for-sale and the mark-to-market rule is applied. The investment is accounted for as outlined in [II. C.] above.

5 2. Equity method: If the investor can exert significant influence over the investee company (defined as owning between 20 percent and 50 percent of the investee's outstanding stock), then the investment, regardless of whether the investee's stock is marketable, should be accounted for using the equity method. a) The investment is initially recorded at cost, which includes any incidental costs like brokerage fees. b) The amount reported for the investment is adjusted for changes in the investor's proportionate share of the investee's net assets. (1) The carrying value of the investment is adjusted for the investor's proportionate share of the investee's net income or loss. (a) Net income increases the investment, and the investor's share of the investee's net income flows through to the investor's income statement. That is, the investment account is debited, and an investment income account is credited for the investor's proportionate share of the investee's net income. (b) Net loss decreases the investment, and the investor's share of the investee's net loss flows through to the investor's income statement. That is, the investment account is credited, and an investment loss account is debited for the investor's proportionate share of the investee's net loss. (2) The carrying value of the investment is adjusted for the investor's proportionate share of dividends declared by the investee. (a) Dividends declared by the investee decrease the investor's investment and do not flow through to the investor's income statement. That is, Cash is debited and the investment account is credited for the investor's proportionate share of dividends declared by the investee. (b) Dividends declared by the investee are simply an exchange of one asset (the investment) for another asset (cash). c) Some cautions to financial statement users about the equity method. 3. The fair market value option: disclosures are required relating to the basis for the market value estimate when market values are used. 4. Consolidated financial statements: used when more than 50% of an entity is controlled. The assets and liabilities of the acquired company (subsidiary) are added to those of the parent corporation. The acquired company s revenues and expenses are included in the income statement of the parent. See appendix 8A for further details. 5. Goodwill.

6 a) Asset on the balance sheet that arises when there is a business acquisition. b) Goodwill is not amortized but is subject to being written-off under the impairment test. (1) Highly subjective test. (2) Permits earnings management. (3) Difficult to audit. 6. The equity method or consolidated statements? a) The method used will effect financial statements (1) Under equity method the liabilities of the acquired company are not included in the financial statements of the acquirer. (2) Effects ratios, especially debt to equity. (3) Equity method is considered by some to be a method of off-balancesheet financing. b) Effect on financial statements may effect decision about what percentage interest should be acquired. 7. Special purpose entites (SPEs). a) A separate entity created (1) The SPE raises capital by issuing debt or equity to investors and purchases property. (2) Property is leased to the sponsor. (3) Should the SPE be consolidated into the financial statements of the sponsor? (a) Not if sponsor doesn t have control. (b) Can be difficult to determine who actually contols the SPE. b) Difficult and controversial area Enron fraud utilized SPEs. V. Consolidated financial statements. (Appendix 8A) A. If the investor controls the investee company (defined as the investor owning greater than 50 percent of the investee's outstanding stock), then consolidated financial statements are prepared.

7 1. The purpose of consolidated financial statements is to report the combined accounts of the investor and investee companies. 2. Two types of investments. a) Business acquisitions the investor and investee combine for accounting purposes, but continue as separate legal entities. b) Business combinations or mergers the investor and investee combine to form one legal entity. B. Business acquisitions and mergers are accounted for using the purchase method. 1. With the purchase method, the parent is assumed to be purchasing the subsidiary's assets and liabilities. The assets and liabilities should be valued at their fair market values. 2. Accounting for consolidations using the purchase method. a) Record the acquisition of the subsidiary at cost, which reflects the fair market value of the subsidiary's net assets by debiting the investment in subsidiary account. b) Eliminations and adjustments necessary to combine the balance sheets of the parent and subsidiary. (1) Eliminate the investment in subsidiary account. (2) Record subsidiary's assets and liabilities at their fair market values. (3) Record goodwill, if appropriate. Goodwill equals the excess paid over the parent's share of the fair market value of the subsidiary's net assets. Goodwill is no longer amortized. (4) Record minority interest, if appropriate. Minority interest arises when the parent purchases less than 100 percent of the subsidiary's outstanding voting stock. Minority interest represents the claims of the minority shareholders (i.e., shareholders other than the parent) on the fair market value of the subsidiary's net assets. Minority interest is calculated by multiplying the fair market value of the subsidiary's net assets by the percentage of outstanding voting stock owned by minority shareholders. Minority interest is usually reported on the balance sheet between long-term liabilities and shareholders' equity. (5) Eliminate intercompany receivables and payables, if appropriate. (6) Eliminate the investee's shareholders' equity. c) Eliminations and adjustments necessary to combine the income statements of the parent and subsidiary.

8 VI. International perspective. VII. Review problems 1 and 2. VIII. Ethics in the real world. IX. Internet research exercise. LECTURE TIPS (1) The consolidated income statement should only reflect consolidated income earned subsequent to the acquisition date. (2) Intercompany revenues and expenses must be eliminated. 1. Understanding the need for the very different methods used to account for equity securities is aided by a general discussion of the nature of equity securities and the variety of reasons for companies to invest in them. It is important for students to understand the economic motivations and expectations behind each level of investment in order to understand the rationale for the accounting method. Figure 8 8 from the text (which summarizes the conditions under which the different methods are used) and end-of-chapter exercise 8 7 provide a vehicle to develop this understanding. 2. Several end-of-chapter problems are particularly useful for demonstrating the different accounting methods for equity securities, especially through comparison with other methods. Problem 8 5 emphasizes trading versus available-for-sale classifications; problem 8 8 compares the mark-to-market method with the equity method; and problem 8 9 compares the equity method to consolidated financial statements. ANSWERS TO IN-TEXT DISCUSSION QUESTIONS 334. Short-term investments are listed in the current assets section of the balance sheet. To be considered for such treatment, the investments must be both readily marketable and management must intend to convert the investments into cash within the time period of current assets (one year or the operating cycle, whichever is longer) Other long-term assets would be listed in the noncurrent section of Intel s balance sheet. To be treated as current assets, investments must be marketable; therefore, nonmarketable securities must be shown in the noncurrent section The accounting standard requires that management has the intention to convert the investments to cash in order justify the current classification. PepsiCo may not have violated the standard, even though one of the investments was not sold in the following year, if management s honest intention was, and remains, to sell the investment. The difficulty is that such a determination is at best subjective, and managers have an incentive to overstate current assets through such classifications Dividend income of $.3 million means that Biomet received cash dividends of that amount from investments in equity securities. Realized gains from short-term

9 investments arose from the sale of investments at amounts $.8 million greater than the cost of those securities With $18.2 billion invested in marketable securities, Apple s balance sheet could suffer from declines in the market. If most of the securities were treated as available for sale, a decline in the market value of the securities would not affect the income statement or the statement of cash flows. Conversely, improvements in the market could cause an increase in market values and an improvement in the balance sheet (but not the income statement or the statement of cash flows). If the securities were classified as trading by Apple s management, the market value fluctuations in the portfolio of securities would affect the income statement Unrealized gains (or losses) on available-for-sale securities are considered permanent accounts and are carried in the shareholders equity section of the balance sheet. If the investments were considered trading securities, these gains or losses would be considered temporary accounts, would appear on the income statement, and would be reflected in retained earnings The net unrealized losses on available-for-sale securities would be reflected in the statement of shareholders equity. If the equity investments were considered trading rather than available-for-sale, the losses would be reflected in the income statement An analyst would be interested in the amount of comprehensive income because it provides an estimate of the overall change in a company s wealth during a period from other than investments by owners or distributions to them. The wide variety of options for disclosure of comprehensive income would not be of great concern, because the standard for determination of the amount of comprehensive income is the same for all companies, and the statement of comprehensive income must be prominently displayed The acquisitions of Kinko s and Mail Boxes, Etc, by FedEx and UPS were strategic in nature and were not motivated by a desire to generate income from dividends or to benefit from stock appreciation. These acquisitions were made to take advantage of perceived synergies between the investor corporations and the acquired corporations and perceived competitive advantages that would flow from these synergies Intel s equity investment constituting only 8% of the affiliate company s outstanding common shares would be accounted for under the equity method if Intel had the ability to significantly influence the operating decisions and management policies of the affiliate. Such influence might be indicated by representation on the board of directors, interchange of management personnel, the frequency and nature of transactions between companies or other factors The investments by Boeing and Lockhead Martin Corp in United Launch Alliance were accounted for using the equity method. Each of these companies reported their investment as an asset, investments, in the case of Boeing and other assets in the case of Lockhead Martin The increase in the investment account could have been caused by 1) new investments in equity securities, by 2) Lilly s pro-rata share of earnings reported by the corporations Lilly had invested in, or by 3) cash dividends received by Lilly from its equity method affiliates. The investment in equity securities account is adjusted when new securities

10 are acquired, when old securities are sold (or written-off), when dividends are received from equity method affiliates, and (annually) for the pro-rata share of income (or loss) of equity method affiliates 346. The $874 million net loss from equity method investments would have included Coca- Cola s 35% share of the $4.4 billion loss reported by Coca-Cola Enterprises, or $1.54 billion. Because Coca Cola s share of the loss in Coca-Cola Enterprises exceeded their loss from all their equity method investments combined, we can infer that the other equity method investments of performed better and generated income for Coca Cola of $666 million Target Corporation s financial statements are referred to as consolidated because they are the combined (consolidated) financial statements of Target Corporation and Target s controlled subsidiaries The quote from the footnotes in General Electric s recent financial statement means that net income was reduced by a write-off of goodwill in the amount of $1.2 billion. The write-off was taken because the goodwill that had been recorded in connection with the acquisitions of GECS IT Solutions and GECS U.S. Auto and Home was discovered to have little or no value. Consequently, under the impairment test, it was necessary to write the goodwill associated with these two acquisitions down to its actual (negligible) value Coca-Cola s 30% interest in the bottling companies is currently carried using the equity method. If Coca-Cola increased its ownership interest beyond 50%, the assets and liabilities of the bottling affiliates would be incorporated into the consolidated financial statements and Coca-Cola s ratio of liabilities to total assets would go up. The bottling companies have a liabilities to total assets ratio of.705 ($35.3 billion $50.1 billion), compared to Coca-Cola s liabilities to total assets ratio of.496 ($20.1 billion $40.5 billion) Enron used the SPEs to hide liabilities. Because the SPEs were not consolidated into Enron s financial statements, the liabilities and the losses of the SPEs were not disclosed. Non-disclosure of this information misled investors Before the financial statements of foreign subsidiaries can be consolidated into the financial statements of the consolidated group, they need to be translated from the local currency into US dollars. Because of fluctuations in exchange rates between the foreign currency and the US dollar, the translation process usually reveals gains or losses due to these currency fluctuations. These gains and losses are known as foreign currency translation adjustments. Depending on the type of subsidiary, the foreign currency translation adjustments are reported in either the consolidated income statement (for Type I subsidiaries) or in the statement of comprehensive income (for Type II subsidiaries). The -$299 million currency adjustment cumulative balance reported on the balance sheet reflects the sum of all the currency translation adjustments for Type II foreign subsidiaries over the life of the consolidated entity. The -$11.0 billion currency translation adjustment reported on the 2008 statement of comprehensive income reflects the adjustment for the year The balance of the currency translation adjustment on the 2007 balance sheet would have been $10.7 billion.