A strong understanding of accounting rules and treatments is the backbone of quality financial analysis. Whether you're an established analyst at a large investment bank, working in a corporate finance advisory team, just starting out in the financial industry or still learning the basics in school, understanding how firms account for different investments, liabilities and other such positions is key in determining the value and future prospects of any business. In this article we will examine the different categories of intercorporate investments and how to account for them on financial statements.
Tutorial: Introduction To Accounting

Intercorporate investments are undertaken when companies invest in the equity or debt of other firms. The reasons behind why one company would invest in another are many, but could include the desire to gain access to another market, increase its asset base, gain a competitive advantage or simply increase profitability through an ownership (or creditor) stake in another company. Intercorporate investments are typically categorized depending on the percentage of ownership or voting control that the investing firm (investor) undertakes in the target firm (investee). Such investments are therefore generally categorized under GAAP in three categories: (1) investments in financial assets, (2) investments in associates and (3) business combinations.

Investments in Financial Assets
An investment in financial assets is typically categorized as having ownership of less than 20% in an investee. Such a position would be considered a "passive" investment because in most cases an investor would not have significant influence or control over an investee.

At acquisition, the assets (investment in investee) are recorded on the investing firm's (investor) balance sheet at fair value. As time elapses and the fair value of the assets changes, the accounting treatment will be dependent upon the classification of the assets. Assets are classified as:

  • Held-to-Maturity
    These are debt securities intended to be held till maturity. Long-term securities will be reported at amortized cost on the balance sheet, with interest income being reported on the investee's income statement.

  • Held-for-Trading
    Equity and debt securities held with the intent to be sold for a profit (hopefully) within a short time-horizon, typically three months. They are reported on the balance sheet at fair value, with any fair value changes (realized and unrealized) being reported on the income statement, along with any interest or dividend income.

  • Available-for-Sale
    These are neither held-to-maturity nor held-for-trading. Available-for-sale securities are similar to held-for-trading securities, however only realized changes in fair value are reported on the income statement (along with dividend and interest income), with all unrealized changes being reported as a component of shareholders' equity on the balance sheet.

The choice of classification is an important factor when analyzing financial asset investments. A firm that classifies securities as held-for-trading would report higher earnings if the fair value of the investment rises than if it had classified the investment as held-for-sale, since unrealized fair value changes in held-for-trading securities are reported on the firm's income statement, while a similar change in held-for-sale securities would be reported in shareholders' equity. Additionally, U.S.GAAP does not allow firms to reclassify investments which have been originally classified as held-for-trading or designated as fair value investments. So the accounting choices made by investing companies when making investments in financial assets can have a major effect on its financial statements. (For more, see What You Need To Know About Financial Statements.)

Investments in Associates
An investment in an associate is typically an ownership interest of between 20-50%. Although the investment would generally be regarded as non-controlling, such an ownership stake would be considered influential, due to the investor's ability to influence the investee's managerial team, corporate plan and policies along with the possibility of representation on the investee's board of directors.

An influential investment in an associate is accounted for using the equity method of accounting. The original investment is recorded on the balance sheet at cost (fair value). Subsequent earnings by the investee are added to the investing firm's balance sheet ownership stake (proportionate to ownership), with any dividends paid out by the investee reducing that amount. The dividends received from the investee by the investor however are recorded on the income statement.

The equity method also calls for the recognition of goodwill paid by the investor at acquisition, with goodwill defined as any premium paid over and above the book value of the investee's identifiable assets. Additionally, the investment must also be tested periodically for impairment. If the fair value of the investment falls below the recorded balance sheet value (and is considered permanent), the asset must be written-down. A joint venture, whereby two or more firms share control of an entity, would also be accounted for using the equity method.

A major factor that must also be considered for the purpose of investments in associates is intercorporate transactions. Since such an investment is accounted for under the equity method, transactions between the investor and the investee can have a significant impact on both companies' financials. For both, upstream (investee to investor) and downstream (investor to investee), the investor must account for its proportionate share of the investee's profits from any intercorporate transactions.

Keep in mind that these treatments are general guidelines and not hard rules. A company that exhibits significant influence over an investee with an ownership stake of less than 20% should be classified as an investment in an associate. While a company with a 20-50% stake that does not show any signs of significant influence could be classified as only having an investment in financial assets. (To learn more, see Impairment Charges: The Good, The Bad and The Ugly.)

Business Combinations
Business combinations are categorized as one of the following:

  • Merger – The acquiring firm absorbs the acquired firm, which from acquisition will cease to exist.

  • Acquisition – The acquiring firm along with the newly acquired firm continue to exist, typically in parent-subsidy roles.

  • Consolidation – The two firms combine to create a completely new company.
  • Special Purpose Entities – An entity typically created by a sponsoring firm for a single purpose or project.

When accounting for business combinations the acquisition method is used. Under the acquisition method, both the companies' assets, liabilities, revenues and expenses are combined. If the ownership stake of the parent company is less than 100%, it is necessary to record a minority interest account on the balance sheet to account for the amount of the subsidiary not controlled by the acquiring firm.

The purchase price of the subsidiary is recorded at cost on the parent's balance sheet, with any goodwill (purchase price over book value) being reported as an unidentifiable asset. In a case where the fair value of the subsidiary falls below the carrying value on the parent's balance sheet, an impairment charge must be recorded and reported on the income statement.

When examining the financial statements of companies with intercorporate investments, it is important to watch for accounting treatments or classifications that do not seem to fit the actualities of the business relationship. While such instances shouldn't automatically be looked at as "tricky accounting," being able to understand how the accounting classification effects a company's financial statements is an important part of financial analysis. (To learn more, see our Earnings Quality Tutorial.)

Related Articles
  1. Active Trading Fundamentals

    Understanding Investor Behavior

    Discover how some strange human tendencies can play out in the market, posing the question: are we really rational?
  2. Fundamental Analysis

    Analyze Cash Flow The Easy Way

    Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.
  3. Investing

    Off-Balance-Sheet Entities: An Introduction

    The theory and practice of these entities varies greatly. Investors need to learn what they're getting into.
  4. Fundamental Analysis

    Spotting Creative Accounting On The Balance Sheet

    Companies have ways of manipulating their balance sheets that investors should be aware of.
  5. Professionals

    Examining A Career As An Auditor

    Stricter government regulations have put auditing professionals in demand.
  6. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  7. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  8. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  9. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  10. Stock Analysis

    Understanding Chipotle's Financials (CMG)

    Learn about Chipotle Mexican Grill and its financial statements, including metrics such as comparable sales, operating margin and returns.
  1. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  2. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  3. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  4. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  5. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  6. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center