Key Takeaways
- Understanding accounting rules is essential for quality financial analysis.
- Analysts must know how firms account for various investments and liabilities.
- Proper accounting helps determine a business’s value and prospects.
- The article reviews different categories of intercorporate investments.
- Accounting for intercorporate investments is crucial on financial statements.
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 in the financial industry, or still learning the basics in school, understanding how firms account for different investments, liabilities, and other positions is key in determining the value and prospects of any business. In this article, we review different categories of intercorporate investments and how to account for them on financial statements.
What Are Intercorporate Investments?
Intercorporate investments happen when one company invests in the securities (debt or equity) of another. Companies invest in others to access new markets, increase their asset bases, to 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 generally accepted accounting principles (GAAP) in three categories: investments in financial assets, investments in associates, and business combinations.
Exploring Investments in Financial Assets
An investment in financial assets is typically categorized as having ownership of less than 20% in the target firm. Such a position would be considered a passive investment because, in most cases, an investor would not have significant influence or control over the target firm.
At acquisition, the invested assets are recorded on the investing firm’s balance sheet at fair value. As time elapses and the fair value of the assets changes, the accounting treatment will depend upon the classification of the assets, described as either held-to-maturity, held-for-trading, or available-for-sale.
Held-to-Maturity
Held-to-maturity (HTM) refers to debt securities intended to be held until they mature. Long-term securities will be reported at amortized cost on the balance sheet, with interest income being reported on the target firm’s income statement.
Held-for-Trading
Held-for-trading refers to equity and debt securities held with the intent to be sold for a profit 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
Available-for-sale securities are debt or equity securities purchased by a company to hold them for indefinite periods or to sell them before they mature. They can be a temporary investment a company makes for various reasons. For example, a company may use these investments to provide a higher return to shareholders, manage interest rate exposure, or meet liquidity requirements.
In 2016, the Financial Accounting Standards Board (FASB) changed the accounting treatment for available-for-sale securities. According to the FASB’s Accounting Standards Updates No. 2016-01, all changes in the fair value of equity securities will be included in net income instead of in other comprehensive income (OCI). This change became effective for public companies beginning after December 15, 2017.
Important
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.
Classification Choice
The choice of classification is an important factor when analyzing financial asset investments. U.S. GAAP does not allow firms to reclassify investments that were 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 their financial statements.
Investments in Associates
An investment in an associate is typically an ownership interest of between 20% and 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.
Equity Method of Accounting
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 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. 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 would also be accounted for using the equity method.
A major factor that must also be considered for investing 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 rather than hard rules. A company with significant influence over an investee and an ownership stake of less than 20% should be classified as an investment in an associate. A company with a 20% to 50% stake that does not show any signs of significant influence could be classified as only having an investment in financial assets.
Business Combinations
Business combinations are categorized as one of the following:
- Merger: A merger occurs when the acquiring firm absorbs the acquired firm, which will cease to exist.
- Acquisition: An acquisition refers to when the acquiring firm, along with the newly acquired firm, continues to exist, typically in parent-subsidiary roles.
- Consolidation: Consolidation refers to when the two firms combine to create a completely new company.
- Special Purpose Entities: A special purpose entity is an entity typically created by a sponsoring firm for a single purpose or project.
The acquisition method is used to account for business combinations. Both the companies’ assets, liabilities, revenues, and expenses are combined. If the ownership stake of the parent company is less than 100%, a minority interest account is added to the balance sheet to show part of the subsidiary that the parent doesn’t own. The subsidiary’s purchase price is recorded at cost on the parent’s balance sheet, with any goodwill (purchase price over book value) reported as an unidentifiable asset.
Does an Investment in a Company Mean Control?
A company can invest in another and still not have any control over it. One company can invest or own as much as 20% of stock in another company and exert little control over the other company. If it owns anywhere between 20% to 50% of the company, it may have a significant amount of influence on the company. But if it owns more than 50% of the company, it can exert a great deal of control over the company.
What Is an Intercorporate Dividend?
An intercorporate dividend is a dividend that one company receives from another in which it holds shares. This type of dividend allows companies to transfer profits within the corporate structure. Companies must consider the tax treatment and remain compliant with financial reporting.
Why Are Intercorporate Investments so Important?
An intercorporate investment gives a boost to the investor’s financial health. It also helps both companies grow by letting them invest in research and development (R&D), access new markets, and create new jobs. There are also other advantages, such as the ability to share knowledge, technology, and forge alliances with one another.
The Bottom Line
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.