REading 19 - Intercorporate Investments

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KevPei

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I’ve been pulling my hair out over this reading, it seems impossible to remember all the details presented. What are three things that will most likely show up on the exam from this reading? Any suggestions/methods/short cuts?
 
I don’t know about the three things that will most likely show up but here is how I would try to break it down.
There are 4 main types of intercorporate investments
1) Financial assets (passive investment, usually less than 20%)
2) Associates (between 20 % and 50%, with significant influence) => equity method
3) Business combination (usally more the 50 %, with control) => pooling interest of acquisition methods
4) Joint ventures (shared control)
When you work out through the end of chapter problems, try to identify which ones of these 4 types it is. Then remember the features of each, how they are recognized and so on. I would recommend to work through the questions at the end of the chapter, and go back in the chapter to precise your understanding of the concepts used. Close it, don’t think about it for a day or two (move on to other chapters) and come back to it and try to do the same exercises quickly. You will find it a lot easier, once again go back to the chapter for the one you still struggle with or post (and explain) what you don’t understand.
All in all, it’s not a hard chapter but there is a lot of material to remember and multiple questions that can be asked.
I hope it helps
 
The three most important things to remember are:
  1. Know.
  2. It.
  3. All.
Phil gives good advice; the fact is that they could ask you anything about anything on this material. If you want to ensure passing, know it all. If you want to take a risk … well … you pays your money and you takes your chances.
 
thanks guys, looks like I just gotta suck it up and commit abunch of stuff to memory..
btw, @s2000magician do you own a s2000?
 
Hi KevPei, Here are a couple points that are important to remember about the Intercorporate investment reading.
Remember 4 Type of investments & Equity method, proportionate consolidation & acqusition method
  1. Investment in Financial Assets
  • No significant influence
  • Usually less that 20% stake
  • 4 types:
    • held to maturity (debt): historical cost on B/S & interest on I/S
    • Available for sale: Fair value on B/S, interest/dividends on I/S, unrealized Gain/loss in OCI
    • Available for trading: Fair value on B/S, interest/dividends on I/S, unrealized Gain/Loss in I/S
    • Reclassification as Fair Value: main point is that IFRS does not let you move in or out of Fair value
  1. Investment in Associates (Equity Method)
  • Significance influence but not control (e.g someone sitting on the board)
  • Equity Method (one line item, in noncurrent asset and the other side in the IS
    • Does not affect Revenue or Equity
  1. Business combination (Acquisition Method)
- Acquisition method (combine assets, Liabilities, revenues and expenses of the parent and the subsidiary and recognized a non controlling interest (minority interest) under equity in the consolidated balance sheet.
  1. Investment in Joint Ventures: (Equity Method or Proportionate Consolidation)
  • IFRS: Equity Method or proportionate consolidation (preferred)
  • US GAAP: Equity Method
Equity Method (associate & Joint Venture)
  • Investment initially reported at historical cost on B/S
  • Dividends payed by investee increase Cash and decrease the investment account (non current asset)
  • A proportionate share of the investee net income is reported in the investment account and in the income statements
Acquisition method (for business acquisition)
  • Consolidate everything net of intercorporate transfers (updtream & downstream)
  • Minority interest must be reported (the stake the parent does not own)
Proportionate Consolidation
  • Allowed under IFRS for joint venture
  • The parent reports its share of the assets and liabilities as well as revenues and expenses
  • Net income will be the same for the equity method and proportionate consolidation but the ratios won’t be the same.
Correct me if I am wrong. I hope that helps.
If you do the EOC exercices, it will become easier.
Good Luck
- Phil
PS: It did not quite understand the pooling of interest method if you can explain your understanding of it would help.
 
@PhilMtxthanks man, what you’ve outlined is very concise and helpful.

As far as pooling of interest method goes, I believe it was discontinued in 2001 for GAAP and 2004 for IFRS, and now mandates the use of the aquisition method for business combinations. I think the key for the pooling of interest method to remember is that it assumes continuity of ownership interest for accounting purposes, therefore the assets and liabilities of the two firms are combined at their historical book values instead of their fair values. As a result, the combined entity may report lower assets and liabilities on the balance sheet (if fair values are greater than historic book values). In the income statement, the pooling of interest method will result in higher income bc of the lower depreciation expense associated with lower assets recorded @ book values. That is why managers tend to favor pooling of interest method for its lower depreciation expense. I hope that helps.
 
Kev Pei, pooling of interest results in higher reported earnings which is due to the lower depreciation charge. Why would you think there is a higher depreciation tax shelter under this method?
 
S2000magician wrote:
I do: a red ‘01. On Friday it turned over 200,000 miles.
Click to expand...
Awesom, congrats! I had a grey 03, but had to trade it in for a more practical Canadian winter car. Loved it in the summer tho!
 
Wojtek wrote:
Kev Pei, pooling of interest results in higher reported earnings which is due to the lower depreciation charge. Why would you think there is a higher depreciation tax shelter under this method?
Click to expand...
You are correct, I confused myself.
 
KevPei wrote:
  • Significance influence but not control (e.g someone sitting on the board)
  • Equity Method (one line item, in noncurrent asset and the other side in the IS
    • Does not affect Revenue or Equity
Click to expand...
Can you explain how come this does not affect Revenue or Equity for the Investor?
 
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Hello Bloodline,
in my notes about Equity Method (posted above) I indicated that the equity method did not affect the revenue or the shareholder’s equity because (correct me If I am wrong)
The Equity Method is only a one line item reported on the B/S in non current assets as investment in Associate:
- First, we recognized the historical value of our investment in the associate (If I am right we used Cash to pay for it, so cash goes down by the same amount)
- then, as time passes we recognized our gain/loss on the net income of the associate within that investment in associate account and record the same gain/loss value in our consolidated I/S. So it should balance.
Consequently, revenue (sales) which is the first item in the I/S is not affected and the Shareholder’s equity does not change either as the gain or loss recognized in the investment account (B/S) is balanced in the I/S by the same amount, thus Shareholder’s equity on the consolidated balance sheet should not change (other things held equal)
I hope that is correct!
If you look at question 3 p159 in the CFAi Book,
“At 31 Dec 2010, Cinammon shareholder’s equity on its balance sheet will most likely:”
The option C should be dismissed “Highest if Cinammon is deemed to have significant influence over cambridge”. It is not correct because: significant influence means we used the Equity Method and under the Equity method there would be no change in shareholder’s equity (p.167 solution practice)
If you look at question 4 p 159
“In 2010, Net Profit Margin would be highest if”
note: Net Profit Margin = Net income / total Sales (or Revenue)
The Option C is also to be dismissed ” if it is deemed to have significant influence over Cambridge”, Again Significant influence, we use Equity method in that case, and Revenue is not affected by the equity method, the only item that will change on the income statement is that gain/loss of the investee’s net income which comes after Revenue in the I/S, thus Revenue is not affected.
I hope I understand that right, keep in mind that I have been tackling this topic only for a week or so, maybe someone else could offer a better explanation or correct me if I am wrong.
In any case, I hope it helps
-Phil
 
PhilMtx wrote:
#next_pages_container { width: 5px; hight: 5px; position: absolute; top: -100px; left: -100px; z-index: 2147483647 !important; }
Hello Bloodline,
in my notes about Equity Method (posted above) I indicated that the equity method did not affect the revenue or the shareholder’s equity because (correct me If I am wrong)
The Equity Method is only a one line item reported on the B/S in non current assets as investment in Associate:
- First, we recognized the historical value of our investment in the associate (If I am right we used Cash to pay for it, so cash goes down by the same amount)
- then, as time passes we recognized our gain/loss on the net income of the associate within that investment in associate account and record the same gain/loss value in our consolidated I/S. So it should balance.
Consequently, revenue (sales) which is the first item in the I/S is not affected and the Shareholder’s equity does not change either as the gain or loss recognized in the investment account (B/S) is balanced in the I/S by the same amount, thus Shareholder’s equity on the consolidated balance sheet should not change (other things held equal)
I hope that is correct!
If you look at question 3 p159 in the CFAi Book,
“At 31 Dec 2010, Cinammon shareholder’s equity on its balance sheet will most likely:”
The option C should be dismissed “Highest if Cinammon is deemed to have significant influence over cambridge”. It is not correct because: significant influence means we used the Equity Method and under the Equity method there would be no change in shareholder’s equity (p.167 solution practice)
If you look at question 4 p 159
“In 2010, Net Profit Margin would be highest if”
note: Net Profit Margin = Net income / total Sales (or Revenue)
The Option C is also to be dismissed ” if it is deemed to have significant influence over Cambridge”, Again Significant influence, we used Equity method in that case, and Revenue is not affected by the equity method, the only item that will change on the income statement is that gain/loss of the investee’s net income which comes after Revenue in the I/S, thus Revenue is not affected.
I hope I understand that right, keep in mind that I have been tackling this topic only for a week or so, maybe someone else could offer a better explanation or correct me if I am wrong.
In any case, I hope it helps
-Phil
Click to expand...
Please correct me if I’m wrong, but I thought shareholders’ equity will change/be adjusted similar to assets: initially the investment is recoreded at cost under ‘non-current assets’, subsequently the investment account is adjusted by including % of (NI of investee) and also by excluding % of (Div of investee). Holding liability the same, equity will be adjusted according to the changes made in asset. There is an example on page 74 of Schweser book 2.
P.S. I don’t understand why Q3 on page 159 of CFAI says the equity is unchanged. But clearly A is correct. So if anyone knows the explanation, please inform me.
 
Pablosad, I agree :) … I also don’t get why the answer suggests that equity will not be impacted. That statement would be true if we were talking about equity at the acquisition date. Subsequent to that, equity does indeed change as a result of taking our share of the investee’s net income to our income statement.
 
This reading is a %#$ - On my second pass doing EOC, there are a lot of things to trip you up. Do the EOC and review those once more to get it under wraps.
 
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