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: investments in financial assets, investments in associates, and business combinations.
Investments in Financial Assets
An investment in financial assets is typically categorized as having ownership of less than 20 percent 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 and 50 percent. 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, not hard rules. A company that exhibits significant influence over an investee with an ownership stake of less than 20 percent should be classified as an investment in an associate. While a company with a 20 to 50 percent 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 are categorized as one of the following:
- Merger: The acquiring firm absorbs the acquired firm, which from the 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 affects a company's financial statements is an important part of financial analysis. (To learn more, see our "Earnings Quality Tutorial.")