CHAPTER 14

INTERCORPORATE INVESTMENTS

Susan Perry Williams

Charlottesville, VA, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities.
• Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
• Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments.

1. INTRODUCTION

Intercorporate investments can have a significant impact on the investing entity’s financial performance and position. Companies invest in the debt and equity securities of other companies to diversify their asset base, enter new markets, obtain competitive advantages, and achieve additional profitability. Debt securities include commercial paper, corporate and government bonds and notes, redeemable preferred stock, and asset-backed securities. Equity securities include common stock and nonredeemable preferred stock. The percentage of equity ownership a company acquires in an investee depends on the resources available, the ability to acquire the shares, and the desired level of influence or control.

The accounting standards that apply to the classification, measurement, and disclosure of intercorporate investments are increasingly reflective of a joint project undertaken by the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB). The objective of this project is to remove differences between the sets of standards and to converge on a set of high-quality standards. The IASB and the FASB have issued a series of pronouncements that focus on the measurement, classification, and disclosure of intercorporate investments. These pronouncements have reduced differences between the two accounting standards and have improved the relevance, transparency, and comparability of information provided in financial statements.

As examples of the movement towards convergence, in December 2007 the FASB issued two new standards: SFAS 141(R), Business Combinations,1 and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements.2 These statements introduced significant changes in the accounting for and reporting of business acquisitions and noncontrolling interests in a subsidiary. Both apply to business combinations occurring on or after 15 December 2008, with early adoption prohibited. In January 2008, the IASB revised IFRS 3, Business Combinations and amended IAS 27, Consolidated and Separate Financial Statements. These new requirements became effective on 1 July 2009, although entities were permitted to adopt them earlier. This reading includes accounting standards issued by IASB and FASB through 31 December 2009. Thus, the references for U.S. GAAP are typically those of the FASB Accounting Standards Codification™ (FASB ASC).

Although convergence between IFRS and U.S. GAAP is occurring and accounting is the same or similar for many transactions, differences still remain. In the case of differences, there is generally enough transparency in the disclosures to allow financial statement users to adjust for the differences. Understanding the appropriate accounting treatment for different intercorporate investments and the similarities and differences that exist between IFRS and U.S. GAAP will enable analysts to make better comparisons between companies and improve investment decision making. The terminology used in this reading is IFRS oriented. U.S. GAAP may not use identical terminology but in most cases, the terminology is similar.

This reading is organized as follows: Section 2 explains the basic categorization of corporate investments. Section 3 describes reporting for investments in financial assets; in this reading, financial assets are limited to debt and equity securities of other entities. Section 4 describes reporting for investments in associates where significant influence can exist, and Section 5 describes reporting for joint ventures, a common, important type of investment where control is shared. Section 6 describes reporting for business combinations, the parent/subsidiary relationship, and consolidated financial statements. Section 7 describes reporting for variable interest and special purpose entities. A summary and practice problems in the CFA Institute item set format complete the reading.

2. BASIC CORPORATE INVESTMENT CATEGORIES

In general, investments in marketable debt and equity securities can be categorized as (1) investments in financial assets in which the investor has no significant influence or control over the operations of the investee, (2) investments in associates in which the investor can exert significant influence (but not control) over the investee, and (3) business combinations, including investments in subsidiaries, in which the investor has control over the investee. The distinction between investments in financial assets, investments in associates, and business combinations is based on the degree of influence or control rather than purely on the percent holding. However, lack of influence is generally presumed when the investor holds less than a 20 percent equity interest, significant influence is generally presumed between 20 percent and 50 percent, and control is presumed when the percentage of ownership exceeds 50 percent. A fourth category, investments in joint ventures, indicates shared control by two or more entities.

The following excerpt is from the 2007 Annual Report of Volvo Group, a Swedish manufacturer of commercial vehicles, and illustrates the categorization in practice:

Consolidated financial statements comprise the Parent Company, subsidiaries, joint ventures, and associated companies. Subsidiaries are defined as companies in which Volvo holds more than 50% of the voting rights or in which Volvo otherwise has a controlling interest. Joint ventures are companies over which Volvo has joint control together with one or more external parties. Associated companies are companies in which Volvo has a significant influence, which is normally when Volvo’s holding equals at least 20% but less than 50% of the voting rights.

A summary of the accounting treatments and relevant standards for various types of corporate investment is presented in Exhibit 14-1 (the headings in Exhibit 14-1 use the terminology of IFRS; U.S. GAAP categorizes intercorporate investments similarly but not identically). The reader should be alert to the fact that value measurement and/or the treatment of changes in value can vary depending on the portfolio classification and whether IFRS or U.S. GAAP is used. The alternative treatments are discussed in greater depth later in this reading.

EXHIBIT 14-1 Summary of Accounting Treatments for Investments

3. INVESTMENTS IN FINANCIAL ASSETS

Investments in financial assets are considered passive; the investor cannot exert significant influence or control over the operations of the investee. IFRS and U.S. GAAP are similar regarding the accounting for investments in financial assets. IFRS has three basic categories of investments in financial assets: (1) held-to-maturity, (2) fair value through profit or loss, and (3) available-for-sale. Under IFRS, fair value through profit or loss includes held for trading financial assets and those designated as fair value through profit or loss, whereas U.S. GAAP has two separate categories: held for trading, and investments designated at fair value. These categories determine the reporting for the investments.

Generally, investments in financial assets are initially recognized at fair value. Dividend and interest income from investments in financial assets, regardless of categorization, are reported in the income statement. The reporting of subsequent changes in fair value and the treatment of transaction costs, however, depends on the classification of the financial asset investment.

3.1. Held-to-Maturity

Held-to-maturity investments are investments in financial assets with fixed or determinable payments and fixed maturities (debt securities) that the investor has the positive intent and ability to hold to maturity. Held-to-maturity investments are exceptions from the general requirement (under both IFRS and U.S. GAAP) that investments in financial assets are subsequently recognized at fair value. Therefore, strict criteria apply before this designation can be used. Under both IFRS and U.S. GAAP, the investor must have a positive intent and ability to hold the security to maturity.

Reclassifications and sales prior to maturity may call into question the company’s intent and ability. Under IFRS, an entity is not permitted to classify any financial assets as held-to-maturity if it has, during the current or two preceding financial reporting years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity unless the sale or reclassification meets certain criteria. Similarly, under U.S. GAAP, a sale (and by inference a reclassification) is taken as an indication that intent was not truly present and use of the held-to-maturity category will be precluded.

IFRS require that held-to-maturity securities be initially recognized at fair value plus transaction costs, whereas U.S. GAAP require held-to-maturity securities be initially recognized at cost including transaction costs. In most cases, however, initial fair value is equal to cost excluding transaction costs, so the treatment is identical. At each reporting date (subsequent to initial recognition), IFRS and U.S. GAAP require that held-to-maturity securities are reported at amortized cost using the effective interest rate method,3 unless objective evidence of impairment exists. Any difference—discount or premium—between maturity (par) value and fair value, typically including transaction costs, existing at the time of purchase is amortized over the life of the security. A discount (par value exceeds fair value) occurs when the stated interest rate is less than the effective rate, and a premium (fair value exceeds par value) occurs when the stated interest rate is greater than the effective rate. Amortization impacts the carrying value of the security. Any interest payments received are adjusted for amortization and are reported as interest income. If the security is sold before maturity (with the potential consequences described earlier), any realized gains or losses arising from the sale are recognized in profit or loss of the period.

3.2. Held for Trading4

Held for trading investments are debt or equity securities acquired with the intent to sell them in the near term. Held for trading securities are reported at fair value. Transaction costs are not included in fair value at initial or subsequent recognition points. At each reporting date, the held for trading investments are remeasured and recognized at fair value with any unrealized gains and losses arising from changes in fair value reported in profit or loss. Also included in profit or loss are interest received on debt securities and dividends received on equity securities.

3.3. Available-for-Sale5

Available-for-sale investments are debt and equity securities not classified as held-to-maturity or held for trading, and not designated at fair value through profit or loss. Under both IFRS and U.S. GAAP, investments classified as available-for-sale are initially measured at fair value, plus transaction costs. At each subsequent reporting date, the investments are remeasured and recognized at fair value, excluding transaction costs, with any unrealized gains or losses arising from changes in fair value reported in equity as other comprehensive income. The amount reported in other comprehensive income is net of taxes. When they are sold, the cumulative gain or loss previously recognized in other comprehensive income is reclassified (i.e., reversed out of comprehensive income) and reported as a reclassification adjustment on the income statement. Interest (calculated using the effective method) from debt securities and dividends from equity securities are included in profit or loss.

IFRS and U.S. GAAP differ on the treatment of foreign exchange gains and losses on available-for-sale debt securities.6 Under IFRS, for the purpose of recognizing foreign exchange gains and losses, a debt security is treated as if it were carried at amortized cost in the foreign currency. Exchange rate differences arising from changes in amortized cost are recognized in profit or loss, and other changes in the carrying amount are recognized in other comprehensive income. In other words, the total change in fair value of an available-for-sale debt security is divided into two components, with any portion attributable to foreign exchange gains and losses recognized on the income statement (in profit or loss) and the remaining portion recognized in other comprehensive income. Under U.S. GAAP, the total change in fair value of available-for-sale debt securities (including foreign exchange rate gains or losses) is included in other comprehensive income. For equity securities, under IFRS and U.S. GAAP, the gain or loss that is recognized in other comprehensive income arising from changes in fair value includes any related foreign exchange component. There is no separate recognition of foreign exchange gains or losses.

3.4. Designated at Fair Value7

Both IFRS and U.S. GAAP allow entities to initially designate investments at fair value that might otherwise be classified as available-for-sale or held-to-maturity. The accounting treatment for investments designated at fair value is similar to that of held for trading investments. At each subsequent reporting date, the investments are remeasured at fair value with any unrealized gains and losses arising from changes in fair value as well as any interest and dividends received included in profit or loss.

The accounting treatment for investments in financial assets under IFRS is illustrated in Exhibit 14-2. This excerpt from the 2007 Annual Report of Deutsche Bank, a global investment bank, describes how its investments are classified, measured, and reported on its financial statements.

3.5. Reclassification of Investments

Both IFRS and U.S. GAAP permit entities to reclassify their intercorporate investments; however, there are certain restrictions and criteria that must be met. Reclassification may result in changes in how the asset value is measured and how unrealized gains or losses are recognized.

IFRS generally prohibits the reclassification of securities into or out of the designated-at-fair-value category,8 and reclassification out of the held for trading category is severely restricted. Held-to-maturity (debt) securities can be reclassified as available-for-sale if a change in intention or a change in ability to hold the security until maturity occurs. At the time of reclassification to available-for-sale, the security is remeasured at fair value with the difference between its carrying amount (amortized cost) and fair value recognized in other comprehensive income. Recall that the reclassification has implications for the use of the held-to-maturity category for existing debt securities and new purchases. A mandatory reclassification and a prohibition from future use may result from the reclassification.

Debt securities initially designated as available-for-sale may be reclassified to held-to-maturity if a change in intention or ability has occurred. The fair-value carrying amount of the security at the time of reclassification becomes its new (amortized) cost. Any previous gain or loss that had been recognized in other comprehensive income is amortized to profit or loss over the remaining life of the security using the effective interest method. Any difference between the new amortized cost of the security and its maturity value is amortized over the remaining life of the security using the effective method.

Any financial asset classified as available-for-sale may be reclassified at cost, in the rare instances where there is no reliable measure of fair value and no evidence of impairment. However, if a reliable fair value measure becomes available, the financial asset must be reclassified to the available-for-sale category with changes in value recognized in other comprehensive income.

U.S. GAAP allows reclassifications (transfers) of securities between all categories using the fair value of the security at the date of transfer. However, recall that the reclassification of securities from the held-to-maturity category has implications for the use of this category for other securities. The treatment of unrealized holding gains and losses on the transfer date, however, depends on the initial classification of the security. For a security initially classified as held for trading that is being reclassified as available-for-sale, any unrealized gains and losses (arising from the difference between its carrying value and current fair value) are recognized in income. For a security transferred into the held-for-trading category, the unrealized gains or losses are recognized immediately. In the case of transfer from available-for-sale, the cumulative amount of gains and losses previously recognized in other comprehensive income is recognized in income on the date of transfer. For a debt security transferred into the available-for-sale category from held-to-maturity, the unrealized holding gain or loss at the date of the transfer (i.e., the difference between the fair value and amortized cost) is reported in other comprehensive income. For a debt security transferred into the held-to-maturity category from available-for-sale, the cumulative amount of gains or losses previously reported in other comprehensive income will be amortized over the remaining life of the security as an adjustment of yield (interest income) in the same manner as a premium or discount.

3.6. Impairments

A financial asset (in this case debt or equity securities) becomes impaired whenever its carrying amount is expected to permanently exceed its recoverable amount. There are key differences in the approaches that IFRS and U.S. GAAP take to determine if a financial asset is impaired and how the impairment loss is measured and reported.

Under IFRS, at the end of each reporting period, financial assets not carried at fair value through profit or loss (individually or as a group) need to be assessed, whether there is any objective evidence that the assets are impaired. Since investments classified as fair value through profit or loss and held for trading are reported at fair value, any impairment loss will have already been recognized in profit or loss as the events were occurring or will be recognized in profit or loss immediately.

A debt security is impaired if one or more events (loss events) occur after initial recognition that has impact on its estimated future cash flows that can be reliably estimated. Although it may not be possible to identify a single specific event that caused the impairment, the combined effect of several events may cause the impairment. Losses expected as a result of future events no matter how likely are not recognized. Examples of loss events causing impairment are:

• Significant financial difficulty of the issuer.
• Default or delinquency in interest or principal payments.
• The borrower experiences financial difficulty and receives a concession from the lender as a result.
• It becomes probable that the borrower will enter bankruptcy or other financial reorganization.

The disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. A downgrade of an entity’s credit rating or a decline in fair value of a security below its cost or amortized cost is also not by itself evidence of impairment. However, it may be evidence of impairment when considered with other available information.

For equity securities, objective evidence of a loss event includes:

• Significant changes in the technological, market, economic, and/or legal environments that have an adverse affect on the investee and indicate that the initial cost of the equity investment may not be recovered.
• A significant or prolonged decline in the fair value of an equity investment below its cost.

For held-to-maturity (debt) investments that have become impaired, the amount of the loss is measured as the difference between the security’s carrying value and the present value of its estimated future cash flows discounted at the security’s original effective interest rate (the effective interest rate computed at initial recognition). The carrying amount of the security is then reduced either directly or through the use of an allowance account, and the amount of the loss is recognized in profit or loss. If in a subsequent period the amount of the impairment loss decreases and the decrease can be objectively related to an event occurring after the impairment was recognized (for example, an improvement in the debtor’s credit rating), the previously recognized impairment loss can be reversed either directly (by increasing the carrying value of the security) or by adjusting the allowance account. The amount of this reversal is then recognized in profit or loss.

For available-for-sale securities that have become impaired, the cumulative loss that had been recognized in other comprehensive income is reclassified from equity to profit or loss as a reclassification adjustment. The amount of the cumulative loss to be reclassified is the difference between acquisition cost (net of any principal repayment and amortization) and current fair value, less any impairment loss that has previously been recognized in profit or loss. Impairment losses on available-for-sale equity securities cannot be reversed. However, impairment losses on available-for-sale debt securities can be reversed if a subsequent increase in fair value can be objectively related to an event occurring after the impairment loss was recognized in profit and loss. In this case, the impairment loss is reversed with the amount of the reversal recognized in profit or loss.

Exhibit 14-3 contains an excerpt from Deutsche Bank’s 2007 annual report that describes how impairment losses for its financial assets are determined, measured, and recognized on its financial statements.

Under U.S. GAAP, the determination of impairment and the calculation of the impairment loss are different than under IFRS. For securities classified as available-for-sale or held-to-maturity, the investor is required to determine at each balance sheet date, whether the decline in value is other than temporary. For debt securities classified as held-to-maturity, this means that the investor will be unable to collect all amounts due according to the contractual terms existing at acquisition. If the decline in fair value is deemed to be other than temporary, the cost basis of the security is written down to its fair value, which then becomes the new cost basis of the security. The amount of the write-down is treated as a realized loss and reported on the income statement.

For available-for-sale securities (both debt and equity) if the decline in fair value is other than temporary, the cost basis of the security is written down to its fair value, which becomes the new cost basis, and the amount of the write-down is treated as a realized loss. However, the new cost basis cannot be increased for subsequent increases in fair value. Instead, subsequent increases in fair value (and decreases if other than temporary) are treated as unrealized gains or losses and included in other comprehensive income.

The convergence between IFRS and U.S. GAAP in the classification and reporting standards for investments in financial assets has made it easier for analysts to evaluate investment returns. Analysts typically evaluate performance separately for operating and investing activities. Analysis of operating performance should exclude items related to investing activities such as interest income, dividends, and realized and unrealized gains and losses. For comparative purposes, analysts should exclude nonoperating assets in the determination of return on net operating assets. IFRS and U.S. GAAP10 require disclosure of fair value of each class of investment in financial assets. Using market values and adjusting pro forma financial statements for consistency improves assessments of performance ratios across companies.

4. INVESTMENTS IN ASSOCIATES

Under both IFRS and U.S. GAAP, when an entity (investor) holds 20 to 50 percent of the voting rights of an associate (investee), either directly or indirectly (i.e., through subsidiaries), it is presumed (unless circumstances demonstrate otherwise) that the entity has (or can exercise) significant influence, but not control, over the investee’s business activities.11 Conversely, if the investor holds, directly or indirectly, less than 20 percent of the voting power of the associate (investee), it is presumed that the investor does not have (or cannot exercise) significant influence, unless such influence can be demonstrated. IAS 28 (IFRS) and FASB ASC Topic 323 (U.S. GAAP) apply to most investments in which an investor has significant influence; they also provide guidance on accounting for investments in associates using the equity method.12 These standards note that significant influence may be evidenced by

• Representation on the board of directors.
• Participation in the policy-making process.
• Material transactions between the investor and the investee.
• Interchange of managerial personnel.
• Technological dependency.

Being able to exert significant influence means that the financial and operating performance of the investee is partly attributable to the management decisions and operational skills of the investor. The equity method of accounting for the investment reflects the economic reality of this relationship and provides a more objective basis for reporting investment income.

Under the equity method of accounting, the investment is initially recognized at cost and is increased (decreased) to recognize the investor’s share of the investee’s profit (loss) and decreased by any distributions (dividends) received from the investee after the acquisition date. As a result the change in the investment account reflects the investor’s proportionate share of the change in the investee’s net assets. The investor also reports its share of the investee’s profit or loss on its income statement.

4.1. Equity Method of Accounting: Basic Principles

Under the equity method of accounting, the equity investment is initially recorded on the investor’s balance sheet at cost. In subsequent periods, the carrying amount of the investment is adjusted to recognize the investor’s proportionate share of the investee’s earnings or losses, and these earnings or losses are reported in income. Dividends or other distributions received from the investee are treated as a return of capital and reduce the carrying amount of the investment and are not reported in the investor’s profit or loss. The equity method is often referred to as “one-line consolidation” since the investor’s proportionate ownership interest in the assets and liabilities of the investee is disclosed as a single line item (net assets) on its balance sheet, and the investor’s share of the revenues and expenses of the investee is disclosed as a single line item on its income statement (contrast these disclosures with the disclosures on consolidated statements in Section 6). Equity method investments are classified as noncurrent assets on the balance sheet. The investor’s share of the profit or loss of equity method investments, and the carrying amount of those investments, must be separately disclosed on the income statement and balance sheet.

This simple example implicitly assumes that the purchase price equals the purchased equity in the book value of Williams’ net assets. Sections 4.2 and 4.3 will cover the more common case in which the purchase price does not equal the proportional share of the book value of the investee’s net assets.

Using the equity method, the investor includes its share of the investee’s profit and losses on the income statement. The equity investment is carried at cost, plus its share of postacquisition income less dividends received. The recorded investment value can decline as a result of investee losses or a permanent decline in the investee’s market value (see Section 4.5 for treatment of impairments). If the investment value is reduced to zero, the investor usually discontinues the equity method and does not record further losses. If the investee subsequently reports profits, the equity method is resumed after the investor’s share of the profits equals the share of losses not recognized during the suspension of the equity method. Exhibit 14-4 contains an excerpt from Deutsche Bank’s 2007 annual report in which it describes the treatment for its investments in associates.

It is interesting to note the explanations for the treatment as associates when the ownership percentage is less than 20 percent or is greater than 50 percent. The equity method reflects the strength of the relationship between the investor and its associates. In the instances where the percentage ownership is less than 20 percent, Deutsche Bank uses the equity method because it has significant influence over these associates’ operating and financial policies either through its representation on their boards of directors and/or material intercompany transactions. The equity method provides a more objective basis for reporting investment income than the accounting treatment for investments in financial assets, since the investor can potentially influence the timing of dividend distributions.

4.2. Investment Costs That Exceed the Book Value of the Investee

The cost (purchase price) to acquire shares of an investee is often greater than the book value of those shares. This is because many of the investee’s assets and liabilities reflect historical cost rather than fair values. IFRS allow an entity to measure its property, plant, and equipment using either historical cost or fair value (less accumulated depreciation).13 U.S. GAAP, however, require the use of historical cost (less accumulated depreciation) to measure property, plant, and equipment.14

When the cost of the investment exceeds the investor’s proportionate share of the investee’s (associate’s) net identifiable assets (e.g., inventory, property, plant, and equipment), the difference is first allocated to specific assets (or categories of assets). These differences are then amortized to the investor’s proportionate share of the investee’s profit or loss over the economic lives of the assets whose fair values exceeded book values. It should be noted that the allocation is not recorded formally; what appears initially in the investment account on the balance sheet of the investor is the cost. Over time, as the differences are amortized, the balance in the investment account will come closer to representing the ownership percentage of the book value of the net assets of the associate.

IFRS and U.S. GAAP both treat the difference between the cost of the acquisition and investor’s share of the fair value of the net identifiable assets as goodwill. Therefore, any remaining difference between the acquisition cost and the fair value of net identifiable assets that cannot be allocated to specific assets is treated as goodwill and is not amortized. Instead it is reviewed for impairment on a regular basis, and written down for any identified impairment. Goodwill, however, is included in the carrying amount of the investment, since investment is reported as a single line item on the investor’s balance sheet.15

4.3. Amortization of Excess Purchase Price

The excess purchase price allocated to the assets and liabilities is accounted for in a manner that is consistent with the accounting treatment for the specific asset or liability to which it is assigned. Amounts allocated to assets and liabilities that are expensed (such as inventory) or periodically depreciated or amortized (plant, property, and intangible assets) must be treated in a similar manner. These allocated amounts are not reflected on the financial statements of the investee (associate), and the investee’s income statement will not reflect the necessary periodic adjustments. Therefore, the investor must directly record these adjustment effects by reducing the carrying amount of the investment on its balance sheet and by reducing its share of the investee’s profit recognized on its income statement. Amounts allocated to assets or liabilities that are not systematically amortized (e.g., land) will continue to be reported at their fair value as of the date the investment was acquired. As stated earlier, goodwill is included in the carrying amount of the investment instead of being separately recognized. It is not amortized since it is considered to have an indefinite life.

Using the previous example and assuming a 10-year useful life for plant, property, and equipment and using straight-line depreciation, the annual amortization is as follows:

Annual amortization would reduce the investor’s share of the investee’s reported income (equity income) and the balance in the investment account by €900 for each year over the 10-year period.

4.4. Fair Value Option

Both IFRS and U.S. GAAP give the investor the option to account for their equity method investment at fair value.16 Under U.S. GAAP this option is available to all entities; however, under IFRS, its use is restricted to venture capital organizations, mutual funds, unit trusts, and similar entities, including investment-linked insurance funds.

Both standards require that the election to use the fair value option occur at the time of initial recognition and is irrevocable. Subsequent to initial recognition, the investment is reported at fair value with unrealized gains and losses arising from changes in fair value as well as any interest and dividends received included in the investor’s profit or loss (income). Under the fair value method, the investment account on the investor’s balance sheet does not reflect the investor’s proportionate share of the investee’s profit or loss, dividends, or other distributions. In addition, the excess of cost over the fair value of the investee’s identifiable net assets is not amortized, nor is goodwill created.

4.5. Impairment

Both IFRS and U.S. GAAP require periodic reviews of equity method investments for impairment. If the fair value of the investment is below its carrying value and this decline is deemed to be other than temporary, an impairment loss must be recognized.

Under IFRS, there must be objective evidence of impairment as a result of one or more (loss) events that occurred after the initial recognition of the investment, and that loss event has an impact on the investment’s future cash flows, which can be reliably estimated. Because goodwill is included in the carrying amount of the investment and is not separately recognized, it is not separately tested for impairment. Instead, the entire carrying amount of the investment is tested for impairment by comparing its recoverable amount with its carrying amount.17 The impairment loss is recognized on the income statement, and the carrying amount of the investment on the balance sheet is either reduced directly or through the use of an allowance account.

U.S. GAAP takes a different approach. If the fair value of the investment declines below its carrying value and the decline is determined to be permanent, U.S. GAAP18 requires an impairment loss to be recognized on the income statement and the carrying value of the investment on the balance sheet is reduced to its fair value.

Both IFRS and U.S. GAAP prohibit the reversal of impairment losses even if the fair value later increases.

Section 6.4.5 of this reading discusses impairment tests for the goodwill attributed to a controlling investment (consolidated subsidiary). Note the distinction between the disaggregated goodwill impairment test for consolidated statements and the total fair value of impairment test for equity method investments.

4.6. Transactions with Associates

An investor company can influence the terms and timing of transactions with its associates so profits from such transactions cannot be realized until confirmed through use or sale to third parties. Accordingly, the investor company’s share of any unrealized profit must be deferred by reducing the amount recorded under the equity method. In the subsequent period(s) when this deferred profit is considered confirmed, it is added back to the equity income. At that time, the equity income is again based on the recorded values in the associate’s accounts.

Transactions between the two affiliates may be upstream (associate to investor) or downstream (investor to associate). In an upstream sale, the profit on the intercompany transaction is recorded on the associate’s income (profit or loss) statement. The investor’s share of the unrealized profit is thus included in equity income on the investor’s income statement. In a downstream sale, the profit is recorded on the investor’s income statement. Both IFRS and U.S. GAAP require that the unearned profits be eliminated to the extent of the investor’s interest in the associate.19 The result is an adjustment to equity income on the investor’s income statement.

4.7. Disclosure

The notes to the financial statements are an integral part of the information necessary for investors. Both IFRS and U.S. GAAP require disclosure about the assets, liabilities, and results of equity method investments. For example, in their 2007 annual report, Deutsche Bank reports that:

Investments in associates and jointly controlled entities are accounted for under the equity method of accounting. The Group’s share of the results of associates and jointly controlled entities is adjusted to conform with the accounting policies of the Group. Unrealized gains on transactions are eliminated to the extent of the Group’s interest in the investee.

Under the equity method of accounting, the Group’s investments in associates and jointly controlled entities are initially recorded at cost, and subsequently increased (or decreased) to reflect both the Group’s pro-rata share of the post acquisition net income (or loss) of the associate or jointly controlled entity and other movements included directly in the equity of the associate or jointly controlled entity. Goodwill arising on the acquisition of an associate or a jointly controlled entity is included in the carrying value of the investment (net of any accumulated impairment loss). Equity method losses in excess of the Group’s carrying value of the investment in the entity are charged against other assets held by the Group related to the investee. If those assets are written down to zero, a determination is made whether to report additional losses based on the Group’s obligation to fund such losses.

For practical reasons, associated companies’ results are sometimes included in the investor’s accounts with a certain time lag, normally not more than one quarter. Dividends from associated companies are not included in investor income because it would be a double counting. Applying the equity method recognizes the investor’s full share of the associate’s income. Dividends received involve exchanging a portion of equity interest for cash. In the consolidated balance sheet, the book value of shareholdings in associated companies is increased by the investor’s share of the company’s net income and reduced by amortization of surplus values and the amount of dividends received.

4.8. Issues for Analysts

Equity method accounting presents several challenges for analysis. First, analysts should question whether the equity method is appropriate. For example, an investor holding 19 percent of an associate may in fact exert significant influence but may attempt to avoid using the equity method to avoid reporting associate losses. On the other hand, an investor holding 25 percent of an associate may be unable to exert significant influence and may be unable to access cash flows, and yet prefers the equity method to capture associate income.

Second, the investment account represents the investor’s percentage ownership in the net assets of the investee company through “one-line consolidation.” There can be significant assets and liabilities of the investee that are not reflected on the investor’s balance sheet, which will significantly affect debt ratios. Net margin ratios could be overstated because income for the associate is included in investor net income but is not specifically included in sales. An investor may actually control the investee with less than 50 percent ownership but prefer the financial results using the equity method. Careful analysis can reveal financial performance driven by accounting structure.

Finally, the analyst must consider the quality of the equity method earnings. The equity method assumes that a percentage of each dollar earned by the investee company is earned by the investor (i.e., a fraction of the dollar equal to the fraction of the company owned), even if cash is not received. Analysts should, therefore, consider potential restrictions on dividend cash flows (the statement of cash flows).

5. JOINT VENTURES

Joint ventures—ventures undertaken and controlled by two or more parties—can be a convenient way to enter foreign markets, conduct specialized activities, and engage in risky projects. They can be organized in a variety of different forms and structures. Some joint ventures are primarily contractual relationships, whereas others have common ownership of assets. They can be partnerships, corporations, or other legal forms (unincorporated associations, for example).

Joint ventures are defined differently under IFRS and U.S. GAAP. This can result in the same arrangement being classified differently under the two standards. In turn, this can affect reported financial results, ratios, and covenants.

IFRS identify the following common characteristics of joint ventures: (1) contractual arrangement exists between two or more venturers and (2) the contractual arrangement establishes joint control. IFRS distinguish between three types of joint ventures with each type having specific accounting requirements, although proportionate consolidation is the generally preferred accounting treatment. Proportionate consolidation requires the venturer’s share of the assets, liabilities, income, and expenses of the joint venture to be combined on a line-by-line basis with similar items on the venturer’s financial statements. The three types of joint venture identified under IFRS are:

Proportionate consolidation requires the venturer’s share of the assets, liabilities, income, and expenses of the joint venture to be combined on a line-by-line basis with similar items on the venturer’s financial statements.21 In contrast, as explained in Section 4, the equity method results in a single line item (equity in income of the joint venture) on the income statement and a single line item (investment in joint venture) on the balance sheet.

Because the single line item on the income statement under the equity method reflects the net effect of the sales and expenses of the joint venture, the total income recognized is identical under the two methods. In addition, because the single line item on the balance sheet item (investment in joint venture) under the equity method reflects the investors’ share of the net assets of the joint venture, the total net assets of the investor is identical under both methods. There can be significant differences, however, in ratio analysis between the two methods because of the differential effects on values for total assets, liabilities, sales, expenses, and so forth.

Under U.S. GAAP the term joint venture refers only to a jointly controlled separate entity in which business activities are conducted. A corporate joint venture is a corporation that is owned and operated by two or more venturers as a separate and specific business for the mutual benefit of the venturers.22 U.S. GAAP requires the use of the equity method to account for joint ventures. Proportionate consolidation is generally not permitted except for unincorporated entities operating in certain industries.

6. BUSINESS COMBINATIONS

Business combinations (controlling interest investments) involve the combination of two or more entities into a larger economic entity. Business combinations are typically motivated by expectations of added value through synergies, including elimination of duplicate costs, tax advantages, coordination of the production process, and efficiency gains in the management of assets.

Under IFRS, there is no distinction among business combinations based on the resulting structure of the larger economic entity. For all business combinations, one of the parties to the business combination is identified as the acquirer. Under U.S. GAAP, an acquirer is identified, but business combinations are categorized as merger, acquisition, or consolidation based on the structure after the combination. Each of these types of business combinations has distinctive characteristics that are described in Exhibit 14-5. Exhibit 14-5 also describes the features of variable interest and special purpose entities. Variable interest and special purpose entities are additional instances where control is exerted by another entity.

In the past, business combinations could be accounted for either as a purchase transaction or as a uniting (or pooling) of interests. The accounting standards that currently govern business combinations are reflective of the joint project between IASB and FASB to converge on a single set of high-quality accounting standards. As part of the first phase of the project, in 2001 the FASB issued SFAS 141, Business Combinations and SFAS 142, Goodwill and other Intangible Assets.23 In 2004, the IASB issued IFRS 3, Business Combinations. These standards prohibited the use of the pooling of interests (uniting of interest) method, required the use of the acquisition (purchase) method, and prohibited the amortization of goodwill.

In the second phase of the joint project, the FASB and IASB further reduced differences between IFRS and U.S. GAAP and ensured that the standards would be applied consistently. In December 2007, the FASB issued two new standards, SFAS 141(R), Business Combinations, and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements.24 Both statements applied prospectively to business combinations occurring on or after 15 December 2008, with early adoption prohibited. In January 2008, the IASB issued a revised IFRS 3, Business Combinations and an amended IAS 27, Consolidated and Separate Financial Statements. These “new” standards became effective on 1 July 2009, although entities were permitted to adopt them earlier. These standards are expected to improve the relevance, representational faithfulness, transparency, and comparability of information provided in financial statements about business combinations and their effects on the reporting entity.

IFRS and U.S. GAAP now require that all business combinations be accounted for as acquisitions, whereby one entity (the parent) takes management control of another entity (subsidiary), or the parent takes control of the subsidiary’s assets and liabilities.25 The acquisition method developed by the IASB and the FASB replaces the purchase method, and substantially reduces any differences between IFRS and U.S. GAAP for business combinations. By requiring acquirers to account for business combinations in a similar manner, it should make it easier for analysts to evaluate how the operations of acquirer and the target business will combine and the effect of this combination on the combined entity’s subsequent financial performance and position.

6.1. Pooling of Interests

Prior to June 2001, under U.S. GAAP, combining companies that met twelve strict criteria could use the pooling of interests accounting method for the business combination. Companies not meeting these criteria used the purchase method. In a pooling of interests, the combined companies were portrayed as if they had always operated as a single economic entity. Consequently, assets and liabilities were recorded at book values, and the precombination retained earnings were included in the balance sheet of the combined companies. This treatment was consistent with the view that there was a continuity of ownership and no new basis of accounting existed. Similar rules applied under IFRS, which used the term uniting of interests in reference to the same concept. IFRS permitted use of the uniting of interests method until March 2004. Currently, neither IFRS nor U.S. GAAP allows use of the pooling/uniting of interests method.

In contrast, a combination accounted for as a purchase is viewed as a purchase of net assets, and those net assets are recorded at fair values. An increase in the value of depreciable assets resulted in additional depreciation expense. As a result, for the same level of revenue, the purchase method resulted in lower reported income than the pooling of interests method. For this reason, managers had a tendency to favor the pooling of interests method.

Although the pooling of interests method is no longer allowed, companies may continue to use pooling of interests accounting for business combinations that occurred prior to its disallowance as a method. We discuss the method here because pooling of interests accounting was commonly used and will have an impact on financial statements for the foreseeable future. Because of the ongoing effect, an understanding of pooling of interests will facilitate the analyst’s assessment of the performance and financial position of the company.

6.2. Acquisition Method

IFRS and U.S. GAAP currently require the acquisition method of accounting for business combinations, although both have a few specific exemptions.

Fair value of the net assets acquired at the acquisition date is the appropriate measurement for acquisitions. The fair value is usually equal to the consideration given by the acquiring firm. Direct costs of the business combination, such as professional and legal fees, valuation experts, and consultants, are expensed as incurred.

The acquisition method (which replaces the purchase method) addresses three major accounting issues that often arise in business combinations and the preparation of consolidated (combined) financial statements:

6.2.1. Recognition and Measurement of Identifiable Assets and Liabilities

IFRS and U.S. GAAP require that the acquirer measure the identifiable assets and liabilities of the acquiree (acquired entity) at fair value as of the date of the acquisition. The acquirer must also recognize any assets and liabilities that the acquiree had not previously recognized as assets and liabilities in its financial statements. For example, identifiable intangible assets (brand name, patent) that the acquiree developed internally would be recognized by the acquirer.

6.2.2. Recognition and Measurement of Contingent Liabilities26

On the acquisition date, the acquirer must recognize any contingent liability assumed in the acquisition if (1) it is a present obligation that arises from past events, and (2) it can be measured reliably. Costs that the acquirer expects (but is not obliged) to incur, however, are not recognized as liabilities as of the acquisition date. Instead, the acquirer recognizes these costs in future periods as they are incurred. For example, expected restructuring costs arising from exiting an acquiree’s business will be recognized in the period in which they are incurred.

There is a small difference between IFRS and U.S. GAAP in their inclusion of contingent liabilities. IFRS include contingent liabilities if their fair values can be reliably measured. U.S. GAAP includes only those contingent liabilities that are probable and can be reasonably estimated.

6.2.3. Recognition and Measurement of Indemnification Assets

On the acquisition date, the acquirer must recognize an indemnification asset if the seller (acquiree) contractually indemnifies the acquirer for the outcome of a contingency or an uncertainty related to all or part of a specific asset or liability. The seller may also indemnify the acquirer against losses above a specified amount on a liability arising from a particular contingency. For example, the seller guarantees that an acquired contingent liability will not exceed a specified amount. In this situation, the acquirer recognizes an indemnification asset at the same time it recognizes the indemnified liability, with both measured on the same basis. If the indemnification relates to an asset or a liability that is recognized at the acquisition date and measured at its acquisition date fair value, the acquirer will also recognize the indemnification asset at the acquisition date at its acquisition date fair value.

6.2.4. Recognition and Measurement of Financial Assets and Liabilities

At the acquisition date, the acquirer can reclassify the financial assets and liabilities of the acquiree on the basis of the contractual terms, economic conditions, and the acquirer’s operating or accounting policies and other pertinent conditions, as they exist at the acquisition date. For example, the acquirer may chose to reclassify particular financial assets of the acquiree as fair value through profit or loss instead of available-for-sale or held-to-maturity.

6.2.5. Recognition and Measurement of Goodwill

Goodwill represents the value that the acquirer sees in the acquiree beyond the fair value of the acquiree’s tangible and identifiable intangible assets.27 Under current IFRS (IAS 36), goodwill is recognized as the fair value of the acquisition (purchase price) less the acquirer’s share of the fair value of all identifiable tangible and intangible assets, liabilities, and contingent liabilities acquired. This is sometimes referred to as “partial goodwill.” U.S. GAAP considers the entity as a whole.28 Goodwill is recognized as the fair value of the acquisition less the fair value of identifiable net assets. IFRS also permits this 100 percent goodwill under the “full goodwill” option on a transaction-by-transaction basis. Because goodwill is considered to have an indefinite life, it is not amortized. Instead, it is tested for impairment annually or more frequently if events or circumstances indicate that goodwill might be impaired.

6.2.6. Recognition and Measurement When Acquisition Price Is Less Than Fair Value

Occasionally, a company faces adverse circumstances such that its market value drops below the fair value of its net assets. In an acquisition where the purchase price is less than the fair value of the target’s net assets, the acquisition is considered to be a bargain acquisition. Any contingent consideration must be measured and recognized at fair value at the time of the business combination. Any subsequent changes in value of the contingent consideration are recognized in profit or loss. IFRS requires the difference between the fair value of the acquired net assets and the purchase price to be recognized immediately as a gain in profit or loss. Under U.S. GAAP, for business combinations prior to 15 December 2008, the difference was allocated as a pro rata reduction in the fair value of the acquired assets other than cash and cash equivalents, trade receivables, inventory, financial assets carried on the balance sheet at fair value, assets to be disposed of by sale, and deferred tax assets. If an amount remained after the eligible assets were reduced to zero, the excess was recognized as an extraordinary gain. For business combinations on or after 15 December 2008, the treatment of a bargain purchase is the same as that under IFRS.

6.3. Impact of the Acquisition Method on Financial Statements, Postacquisition

In the periods subsequent to the business combination, the financial statements continue to be affected by the acquisition method. Net income reflects the performance of the combined entity. Under the acquisition method, amortization/depreciation is based on historical cost of Franklin’s assets and the fair value of Jefferson’s assets. Using Example 14-8, in the year the inventory is sold, the cost of goods sold would be €15,000,000, and depreciation on PP&E would be €2,000,000 higher over the life of the asset (€31.5 million versus €29.5 million).30

6.4. Consolidated Financial Statements

Consolidated financial statements combine the results of operations for distinct legal entities, the parent and its subsidiaries, as if they were one economic unit. IFRS and U.S. GAAP both require consolidation, but each is based on a different control model. The control model is important when considering variable interest and special purpose entities. These entities will be discussed in more detail in Section 7 but some of the implications are mentioned here.

Under the principles-based framework of IFRS, consolidation is required when one company (the parent) has the ability to govern (control) the financial and operating policies of another company (the subsidiary). Control is presumed to exist when the parent owns either directly or indirectly (i.e., through its subsidiaries), more than half of the voting shares of another entity (voting interest model). In situations where the parent owns half or less of the voting share, consolidation is based on an overall assessment of all of the relevant factors, including the allocation of risks and benefits between the parties.

U.S. GAAP uses a two-component consolidation model that includes both a variable interest component and a voting interest (control) component. Under the variable interest component, U.S. GAAP31requires the primary beneficiary of a variable interest entity (VIE) to consolidate the VIE regardless of its voting interests (if any) in the VIE or its decision-making authority. The primary beneficiary is defined as the party that will absorb the majority of the VIE’s expected losses, receive the majority of the VIE’s expected residual returns, or both.

6.4.1. The Consolidation Process

Consolidation combines the assets, liabilities, revenues, and expenses of subsidiaries with the parent company. Transactions between the parent and subsidiary (intercompany transactions) are eliminated to avoid double counting and premature income recognition. Consolidated statements are presumed to be more meaningful in terms of representational faithfulness. It is important for the analyst to consider the differences in IFRS and U.S. GAAP, valuation bases, and other factors that could impair the validity of comparative analyses.

6.4.2. Business Combination with Less than 100 Percent Acquisition

In a merger or consolidation, the acquirer purchases 100 percent of the equity of the target company. In an acquisition, however, the acquirer does not have to purchase 100 percent of the equity of the target in order to achieve control. The acquiring company may purchase less than 100 percent of the target because it may be constrained by resources or it may be unable to acquire all the outstanding shares. As a result, both the acquirer and the target remain separate legal entities. Both IFRS and U.S. GAAP presume a company has control if it owns more than 50 percent of the voting shares of an entity. In this case, the acquiring company is viewed as the parent, and the target company is viewed as the subsidiary. Both the parent and the subsidiary prepare their own financial records, but the parent also prepares consolidated financial statements at each reporting period. The consolidated financial statements are the primary source of information for investors and analysts.

6.4.3. Noncontrolling (Minority) Interests: Balance Sheet

A noncontrolling (minority) interest is the portion of the subsidiary’s equity (residual interest) that is held by third parties (i.e., not owned by the parent). Noncontrolling interests are created when the parent acquires less than a 100 percent controlling interest in a subsidiary.

IFRS and U.S. GAAP have converged on how noncontrolling interests are classified.32 Both now require noncontrolling interests in consolidated subsidiaries to be presented on the consolidated balance sheet as a separate component of stockholders’ equity. Previously, companies using IFRS reported noncontrolling interests as equity, whereas those applying U.S. GAAP reported noncontrolling interests either as liabilities or between (mezzanine section) liabilities and equity.

IFRS and U.S. GAAP still differ, however, on the measurement of noncontrolling interests. Under IFRS, the parent can measure the noncontrolling interest at either its fair value (full goodwill method) or at the noncontrolling interest’s proportionate share of the acquiree’s identifiable net assets (partial goodwill method). Under U.S. GAAP, the parent must use the full goodwill method and measure the noncontrolling interest at fair value.

Example 14-9 illustrates the current differences in reporting requirements.

6.4.4. Noncontrolling (Minority) Interests: Income Statement

On the income statement, noncontrolling (minority) interests are presented as a line item reflecting the allocation of profit or loss for the period. Intercompany transactions, if any, are eliminated in full.

Using assumed data consistent with the facts in Example 14-9, the amounts included for the subsidiary in the consolidated income statements under IFRS and U.S. GAAP are presented here:

	Full Goodwill	Partial Goodwill
Sales	€250,000	€250,000
Cost of goods sold	137,500	137,500
Interest expense	10,000	10,000
Depreciation expense	39,000	39,000
Income from continuing operations	€63,500	€63,500
Noncontrolling interest (10%)	(6,350)	(6,350)
Consolidated net income to shareholders	€57,150	€57,150

Income to the parent’s shareholders is €57,150 using either method. This is because the fair value of the PP&E is allocated to noncontrolling shareholders as well as to the controlling shareholders under the full goodwill and the partial goodwill methods. Therefore, the noncontrolling interests will share in the adjustment for excess depreciation due to the €60,000 increase in PP&E. Since depreciation expense is the same under both methods, it results in identical net income to all shareholders, whichever method is used to recognize goodwill and to measure the noncontrolling interest.

Although net income to shareholders is the same, the impact on ratios would be different, because total assets and stockholders’ equity would differ.

Impact on Ratios
	Full Goodwill (%)	Partial Goodwill (%)
Return on assets	8.28	8.33
Return on equity	13.44	13.57

Over time, the value of the subsidiary will change as a result of net income and changes in equity. As a result, the value of the noncontrolling interest on the parent’s consolidated balance sheet will also change.

6.4.5. Goodwill Impairment

Although goodwill is not amortized, it must be tested for impairment at least annually or more frequently if events or changes in circumstances indicate that it might be impaired. If it is probable that some or all of the goodwill will not be recovered through the profitable operations of the combined entity, it should be partially or fully written off by charging it to an expense. Once written down, goodwill cannot be later restored.

IFRS and U.S. GAAP differ on the definition of the levels at which goodwill is assigned and tested for impairment.

Under IFRS, at the time of acquisition, the total amount of goodwill recognized is allocated to each of the acquirer’s cash-generating units that will benefit from the expected synergies resulting from the combination with the target. A cash-generating unit represents the lowest level within the combined entity at which goodwill is monitored for impairment purposes.33 Goodwill impairment testing is then conducted under a one-step approach. The recoverable amount of a cash-generating unit is calculated and compared with the carrying value of the cash-generating unit.34 An impairment loss is recognized if the recoverable amount of the cash-generating unit is less than its carrying value. The impairment loss (the difference between these two amounts) is first applied to the goodwill that has been allocated to the cash-generating unit. Once this has been reduced to zero, the remaining amount of the loss is then allocated to all of the other assets in the unit on a pro rata basis.

Under U.S. GAAP, at the time of acquisition, the total amount of goodwill recognized is allocated to each of the acquirer’s reporting units. A reporting unit is an operating segment or component of an operating segment that is one level below the operating segment as a whole. Goodwill impairment testing is then conducted under a two-step approach: identification of impairment and then measurement of the loss. First, the carrying amount of the reporting unit (including goodwill) is compared to its fair value. If the carrying value of the reporting unit exceeds its fair value, an impairment loss has occurred. The second step is then performed to measure the amount of the impairment loss. The amount of the impairment loss is the difference between the implied fair value of the reporting unit’s goodwill and its carrying amount. The implied fair value of goodwill is determined in the same manner as in a business combination (it is the difference between the fair value of the reporting unit and the fair value of the reporting unit’s assets and liabilities). The impairment loss is applied to the goodwill that has been allocated to the reporting unit. After the goodwill of the reporting unit has been eliminated, no other adjustments are made to the carrying values of any of the reporting unit’s other assets or liabilities.

Under both IFRS and U.S. GAAP, the impairment loss is recorded as a separate line item in the consolidated income statement.

6.5. Financial Statement Presentation Subsequent to the Business Combination

The presentation of consolidated financial statements is similar under IFRS and U.S. GAAP. For example, selected financial statements for GlaxoSmithKline are shown in Exhibits 14-6 and 14-7. GlaxoSmithKline is a leading pharmaceutical company headquartered in the United Kingdom.

The consolidated balance sheet in Exhibit 14-6 combines the operations of Glaxo SmithKline and its subsidiaries. The analyst can observe that in 2007 GlaxoSmithKline had investments in financial assets (other investments of £517,000,000 and liquid investments of £1,153,000,000), and investments in associates and joint ventures of £329,000,000. In 2007 GlaxoSmithKline acquired a 100 percent interest in three companies. The increase in goodwill on the balance sheet reflects the fact that GlaxoSmithKline paid an amount in excess of the fair value of the identifiable net assets in these acquisitions. The analyst can also note that GlaxoSmithKline is the parent company in a less than 100 percent acquisition. The minority interest of £307,000,000 in the equity section is the portion of the combined entity that accrues to noncontrolling shareholders. Because the company used the partial goodwill method under IFRS, the noncontrolling interest was reflected at the acquisition date based on the noncontrolling interest’s share of the fair value of the net assets acquired.

EXHIBIT 14-6 GlaxoSmithKline Consolidated Balance Sheet at 31 December 2007

The consolidated income statement for GlaxoSmithKline is presented in Exhibit 14-7. IFRS and U.S. GAAP have similar formats for consolidated income statements. Each line item (e.g., turnover [sales], cost of sales, etc.) includes 100 percent of the parent and the subsidiary transactions after eliminating any upstream (subsidiary sells to parent) or downstream (parent sells to subsidiary) intercompany transactions. The portion of income accruing to noncontrolling shareholders is presented as a separate line item on the consolidated income statement. Note that net income would be the same under IFRS and U.S. GAAP.35 The analyst will need to make adjustments for any analysis comparing specific line items that might differ between IFRS and U.S. GAAP.

EXHIBIT 14-7 GlaxoSmithKline Consolidated Income Statement for the Year Ended 31 December 2007

6.6. Additional Issues in Business Combinations That Impair Comparability

Accounting for business combinations is a complex topic. In addition to the basics covered so far in this reading, we briefly mention some of the more common issues that impair comparability between IFRS and U.S. GAAP.

6.6.1. Contingent Assets and Liabilities

Under IFRS, the cost of an acquisition is allocated to the fair value of assets, liabilities, and contingent liabilities. Contingent liabilities are recorded separately as part of the cost allocation process, provided that their fair values can be measured reliably. Subsequently, the contingent liability is measured at the higher of the amount initially recognized or the best estimate of the amount required to settle. Contingent assets are not recognized under IFRS.

Under U.S. GAAP, contractual contingent assets and liabilities are recognized and recorded at their fair values at the time of acquisition. Noncontractual contingent assets and liabilities must also be recognized and recorded only if it is “more likely than not” they meet the definition of an asset or a liability at the acquisition date. Subsequently, a contingent liability is measured at the higher of the amount initially recognized or the best estimate of the amount of the loss. A contingent asset, however, is measured at the lower of the acquisition date fair value or the best estimate of the future settlement amount.

6.6.2. Contingent Consideration

Contingent consideration may be negotiated as part of the acquisition price. For example, the parent may agree to pay additional money to the subsidiary’s shareholders if certain sales or profit levels are attained by the combined entity. Under both IFRS and U.S. GAAP, contingent consideration is initially measured at fair value. IFRS and U.S. GAAP classify contingent consideration as either a financial liability or equity. In addition, U.S. GAAP allows contingent consideration to also be classified as an asset. In subsequent periods, changes in the fair value of liabilities (and assets, in the case of U.S. GAAP) are recognized in the consolidated income statement. Both IFRS and U.S. GAAP do not remeasure equity classified contingent consideration; instead, settlement is accounted for within equity.

6.6.3. In-Process R&D

IFRS and U.S. GAAP recognize in-process research and development (R&D) acquired in a business combination as a separate intangible asset and measure it at fair value (if it can be measured reliably). In subsequent periods, R&D is subject to amortization upon completion or impairment.

6.6.4. Restructuring Costs

IFRS and U.S. GAAP do not recognize restructuring costs that are associated with the business combination as part of the cost of the acquisition. Instead, they are recognized as an expense in the periods the restructuring costs are incurred.

7. VARIABLE INTEREST AND SPECIAL PURPOSE ENTITIES

Special purpose entities (SPEs) are enterprises that are created to accommodate specific needs of the sponsoring entity.36 The sponsoring entity (on whose behalf the SPE is created) frequently transfers assets to the SPE, obtains the right to use assets held by the SPE, or performs services for the SPE, while other parties (capital providers) provide funding to the SPE. SPEs can be a legitimate financing mechanism for a company to segregate certain activities and thereby reduce risk. SPEs may take the form of a corporation, trust, partnership, or unincorporated entity. They are often created with legal arrangements that impose strict and sometimes permanent limits on the decision-making powers of their governing board or management.

Beneficial interest in an SPE may take the form of a debt instrument, an equity instrument, a participation right, or a residual interest in a lease. Some beneficial interests may simply provide the holder with a fixed or stated rate of return, while beneficial interests give the holder the rights or the access to future economic benefits of the SPE’s activities. In most cases, the creator/sponsor of the entity retains a significant beneficial interest in the SPE even though it may own little or none of the SPE’s voting equity.

In the past, sponsors were able to avoid consolidating SPEs on their financial statements because they did not have “control” (i.e., own a majority of the voting interest) of the SPE. SPEs were structured so that the sponsoring company had financial control over their assets or operating activities, while third parties held the majority of the voting interest in the SPE.

These outside equity participants often funded their investments in the SPE with debt that was either directly or indirectly guaranteed by the sponsoring companies. The sponsoring companies, in turn, were able to avoid the disclosure of many of these guarantees as well as their economic significance. In addition, many sponsoring companies created SPEs to facilitate the transfer of assets and liabilities from their own balance sheets. As a result, they were able to recognize large amounts of revenue and gains, because these transactions were accounted for as sales. By avoiding consolidation, sponsoring companies did not have to report the assets and the liabilities of the SPE; financial performance as measured by unconsolidated financial statements was potentially misleading. The benefit to the sponsoring company was improved asset turnover, lower operating and financial leverage metrics, and higher profitability.

Enron, for example, used SPEs to obtain off-balance sheet financing and artificially improve its financial performance. Its subsequent collapse was partly attributable to its guarantee of the debt of the SPEs it had created.

To address the accounting issues arising from the misuse and abuse of SPEs, the IASB and the FASB have augmented their existing consolidation models to take into account financial arrangements where parties other than the holders of the majority of the voting interests exercise financial control over another entity. In addition, they have revised their standards concerning the measurement, reporting, and disclosure of all guarantees.

Currently, IAS 27 requires the consolidation of entities when the substance of the relationship indicates that the entity is controlled by the reporting entity.

However, the standard does not provide explicit guidance about the circumstances under which an SPE should be consolidated. SIC 12 does provide indicators of control:

• The SPE activities are conducted for the benefit of the sponsoring entity.
• The sponsoring entity has decision-making powers to obtain benefits.
• The sponsoring entity is able to absorb the risks and rewards of the SPE.
• The sponsoring entity has a residual interest in the SPE.

Under the revised IAS 39, a financial guarantee contract is defined as a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due. IFRS 3 requires financial guarantees to be initially recognized at fair value and in subsequent periods to be reported at the higher of the best estimate to settle the guarantee or the amount initially recognized.

In developing new accounting standards to address the consolidation issue, the FASB used the more general term variable interest entity (VIE) to more broadly define an entity that is financially controlled by one or more parties that do not hold a majority voting interest. Therefore, under U.S. GAAP, a VIE includes other entities besides SPEs. SFAS 140 and Interpretation FIN 46R provide guidance for U.S. GAAP,37 which classifies special purpose entities as variable interest entities if:

• Total equity at risk is insufficient to finance activities without financial support from other parties.
• Equity investors lack any one of the following:
  • The ability to make decisions.
  • The obligation to absorb losses.
  • The right to receive return.

Common examples of variable interests are entities created to lease real estate or other property, entities created for the securitization of financial assets, or entities created for R&D activity.

Under FIN 46R, the primary beneficiary of a VIE must consolidate it as its subsidiary regardless of how much of an equity investment it has in the VIE. The primary beneficiary (which is often the sponsor) is the entity that is expected to absorb the majority of the VIE’s expected losses, receive the majority of the VIE’s residual returns, or both. If one entity will absorb a majority of the VIE’s expected losses and another unrelated entity will receive a majority of the VIE’s expected residual returns, the entity absorbing a majority of the losses must consolidate the VIE. If there are noncontrolling interests in the VIE, these would also be shown in the consolidated balance sheet and consolidated income statement of the primary beneficiary.

7.1. Qualifying Special Purpose Entities

Prior to the revision of SFAS 140 and FIN 46 (effective 15 December 2008), it was possible under U.S. GAAP to structure a special purpose entity in a way that did not meet the variable interest criteria and consolidation requirements. To be a qualifying special purpose entity (QSPE) an entity had to (1) be independent and legally separate from the sponsoring company, (2) have complete control over its assets, and (3) hold only financial assets. In addition, the sponsoring company had to be bankruptcy remote, which means that its financial risk was limited to either its investment or to an explicit recourse obligation in the SPE.

Therefore, a sponsor company did not have to consolidate a QSPE since it was not its primary beneficiary (i.e., it had no control over the entity’s assets, nor was it expected to absorb the majority of its expected losses). This enabled the sponsoring company to derecognize the transferred assets (remove them from their balance sheet) and report the transaction as a sale.

The subprime crisis in 2007 and the resulting credit crisis in 2008 revealed that many of the sponsoring companies (transferors) had more continuing involvement with the transferred assets than they should have had in order to derecognize the assets and record the original transaction as a sale. Many banks and other financial institutions were forced to place the assets that were previously transferred to QSPEs back on their balance sheets and recognize substantial losses due to a decline in value of these assets. As a result, many financial statements users voiced concerns about their inability to understand the nature of the transferor’s relationship with the QSPE, its maximum risk exposure, and the extent of its risk exposure.

The elimination of QSPEs by the FASB is intended to increase the transparency and comparability of companies involved with VIEs and further convergence, since QSPEs did not exist under IFRS. Revisions in SFAS 140 and FIN 46R have provided financial statement users with a better understanding of a company relationship with a VIE in terms of the extent of its involvement, its maximum risk exposure, and the current status of its exposure. The revised accounting standards have increased the consolidation of entities that formerly met the QSPE criteria and reduced the types of transferred financial assets that would have previously been eligible for derecognition and classified as a sale. In addition, sponsoring companies are now required to disclose the risks that they continue to be exposed to from their continuing involvement in transferred assets.

In an effort to more closely align with IFRS, the revised FIN 46R replaced a quantitative-based risks and reward calculation with a principles-based approach. This makes it easier to determine which enterprise will receive the majority of the expected residual returns from the VIE and which is expected to absorb the majority of expected losses.

7.2. Illustration of an SPE for a Leased Asset

Consider the situation in which a sponsoring company creates a special purpose entity with minimal and independent third party equity. The SPE borrows from the debt market and acquires or constructs an asset. The asset may be acquired from the sponsoring company or from an outside source. The sponsoring company then leases the asset, and the cash flow from lease payments is used to repay the debt and provide a return to equity holders. Because the asset is pledged as collateral, risk is reduced and a lower interest rate may be offered by the financing organization. In addition, because equity investors are not exposed to all the business risks of the sponsoring company but only those of the restricted SPE, they may be more willing to invest in this relatively safe investment. The sponsor retains the risk of default and receives the benefits of ownership of the leased asset through a residual value guarantee. Under these conditions, the sponsor is the primary beneficiary and consolidates the SPE.

In 1996, Dreamworks Animation SKG entered into an agreement with financial institutions to construct their Glendale animation campus in Glendale, California. The 326,000 square foot facility houses a majority of Dreamworks employees. In 2002, Dreamworks created a special purpose entity that acquired the property from the financial institution for $73.0 million. The special purpose entity leases the facility back to Dreamworks. It has been determined that Dreamworks Animation SKG is the primary beneficiary of the SPE. Dreamworks Animation SKG discloses the following information about its use of special purpose entities in its 2007 annual report (see Exhibit 14-8).

7.3. Securitization of Assets

Special purpose entities are often established for the securitization of receivables. The SPE issues debt to acquire all or a portion of the sponsoring company receivables. Repayment of the debt and interest are made with the cash flow generated by the receivables.

For example, Fiat S.p.A. sells its trade receivables to an SPE to improve its cash flows in a cost-effective manner. Fiat, one of the largest industrial companies in Italy, is engaged principally in the manufacture and sale of automobiles, agricultural and construction equipment, trucks, and commercial vehicles. Regarding the sale of receivables, in its 2007 Annual report Fiat states:

The Group sells a significant part of its financial, trade and tax receivables through either securitisation programs or factoring transactions. A securitisation transaction entails the sale of a portfolio of receivables to a securitisation vehicle. This special purpose entity finances the purchase of the receivables by issuing asset-backed securities (i.e. securities whose repayment and interest flow depend upon the cash flow generated by the portfolio). Asset-backed securities are divided into classes according to their degree of seniority and rating: the most senior classes are placed with investors on the market; the junior class, whose repayment is subordinated to the senior classes, is normally subscribed for by the seller. The residual interest in the receivables retained by the seller is therefore limited to the junior securities it has subscribed for. In accordance with SIC 12—Consolidation—Special Purpose Entities (SPE), all securitisation vehicles are included in the scope of consolidation, because the subscription of the junior asset-backed securities by the seller entails its control in substance over the SPE. Furthermore, factoring transactions may be with or without recourse to the seller; certain factoring agreements without recourse include deferred purchase price clauses (i.e. the payment of a minority portion of the purchase price is conditional upon the full collection of the receivables), require a first loss guarantee of the seller up to a limited amount or imply a continuing significant exposure to the receivables cash flow. These kinds of transactions do not meet IAS 39 requirements for assets derecognition, since the risks and rewards have not been substantially transferred. Consequently, all receivables sold through both securitisation and factoring transactions which do not meet IAS 39 derecognition requirements are recognised as such in the Group financial statements even though they have been legally sold; a corresponding financial liability is recorded in the consolidated balance sheet as “Asset-backed financing.” Gains and losses relating to the sale of such assets are not recognised until the assets are removed from the Group balance sheet.

Securitizations raise several issues for the analyst. First, the analyst should assess the relationship to ensure that SPEs are consolidated when appropriate. Second, securitization can have a significant impact on operating cash flows and financial leverage and may need to be adjusted for analysis. Finally, securitization may affect the volatility of operating cash flows.

7.4. Consolidated versus Nonconsolidated Securitization Transactions

A common type of QSPE is a securitization transaction. To illustrate the differences between a consolidated and nonconsolidated securitization transaction consider the following:

Securitized Transaction: Qualified Special Purpose Entity	Securitized Transaction: Special Purpose Entity
Originator of receivables sells financial assets to an SPE. The originator does not own or hold or expect to receive beneficial interest. SFAS 140 (before 2008 revision) allowed seller to derecognize the sold assets if transferred assets- have been isolated from the transferor and are beyond the reach of bankruptcy, and - are financial assets.	Originator of receivables sells financial assets to an SPE. Seller is primary beneficiary; absorbs risks and rewards. Seller maintains some level of control. Seller is required to consolidate. Seller’s balance sheet would still show receivables as an asset. Debt of SPE would appear on seller’s balance sheet.

IFRS do not recognize a qualifying special purpose entity. As Deutsche Telekom AG notes in its 2006 20-F filing with the SEC:

We have entered into agreements to sell, on a continual basis, certain eligible trade receivables to Special Purpose Entities (SPEs). Under IFRS, these SPEs are consolidated and included in our consolidated financial statements, whereas under U.S. GAAP, these SPEs are considered Qualifying Special Purpose Entities (QSPEs) and are therefore not consolidated. As a result, the transferred receivables are removed from the balance sheet, with a gain or loss recognized on the sale for U.S. GAAP. The measurement of the gain or loss depends on the carrying bases of the transferred receivables, allocated between the receivables sold and the interests and obligations retained, based on their relative fair values as of the date of transfer. Under these agreements, we retain without remuneration the servicing obligation relating to the sold receivables, which are recognized for U.S. GAAP, but not for IFRS.

Capital One, in its 2007 10-K filing, provides a reconciliation that illustrates the effect of the securitization on some common performance inputs (see Exhibit 14-9). The first column reflects the information as reported and does not include consolidation of qualified special purpose entities. The third column reflects the “as if” consolidated. This provides the analyst with an example of how off-balance sheet accounting can affect financial analysis ratios.

The impact is apparent in this example. Noninterest income is higher and total assets are lower when the qualified special purpose entity is not consolidated. Therefore, noninterest return on assets is significantly higher without consolidation (5.34 percent versus 2.89 percent).

There is also significant debt that is not reported on the balance sheet when the special purpose entity is not required to be consolidated. This disclosure by Capital One illustrates the effect of off-balance sheet special purpose entities and the usefulness of this type of financial information for performance analysis.

8. SUMMARY

Intercompany investments play a significant role in business activities and create significant challenges for the analyst in assessing company performance. Investments in other corporations can take five basic forms: investments in financial assets, investments in associates, joint ventures, business combinations, and investments in special purpose and variable interest entities. Key concepts are as follows:

• Investments in financial assets are those in which the investor has no significant influence. They can be designated as held-to-maturity investments, held for trading securities, or available-for-sale securities. IFRS and U.S. GAAP treat investments in financial assets in a similar manner.
  • Held-to-maturity investments are carried at cost.
  • Held for trading securities are carried at fair value; unrealized gains and losses are reported on the profit or loss (income) statement.
  • Available-for-sale securities are carried at fair value; unrealized gains and losses are reported in other comprehensive income in the equity section of the balance sheet.
  • Gains or losses on investments designated as fair value are reported on the profit and loss (income) statement.
  • Both IFRS and U.S. GAAP allow investments that would be classified as either held-to-maturity or available-for-sale to be carried at fair value, with unrealized losses reported in profit or loss (income statement).
• Investments in associates are those in which the investor has significant influence, but not control, over the investee’s business activities. Because the investor can exert significant influence over financial and operating policy decisions, IFRS and U.S. GAAP require the equity method of accounting because it provides a more objective basis for reporting investment income.
  • The equity method requires the investor to recognize income as earned rather than when dividends are received.
  • The equity investment is carried at cost, plus its share of postacquisition income (after adjustments) less dividends received.
  • The equity investment is reported as a single line item on the balance sheet and on the income statement.
• Joint ventures are entities owned and operated by a small group of investors with shared common control. IFRS and U.S. GAAP apply different standards to joint ventures. IFRS favor proportionate consolidation, which requires the venturer’s share of the assets, liabilities, income, and expenses of the joint venture to be combined on a line-by-line basis with similar items in the venturer’s financial statements. However, IFRS does allow the use of the equity method to account for jointly controlled entities. U.S. GAAP requires the equity method accounting for joint ventures.
• Business combinations can be structured as mergers, acquisitions, or consolidations under U.S. GAAP. IFRS makes no such distinction among business combinations.
• An acquisition allows for the legal continuity for each of the combining companies. Both companies continue as separate entities through a parent–subsidiary relationship.
  • If the acquiring company acquires less than 100 percent, noncontrolling (minority) shareholders’ interests are reported on the consolidated financial statements.
  • Consolidated financial statements are prepared in each reporting period.
• Current IFRS and U.S. GAAP accounting standards require the use of the acquisition method to account for business combinations. Fair value is the appropriate measurement for identifiable assets and liabilities acquired in the business combination. If the acquisition is less than 100 percent, IFRS allow the noncontrolling interest to be measured at either its fair value (full goodwill) or at the noncontrolling interest’s proportionate share of the acquiree’s identifiable net assets (partial goodwill). U.S. GAAP requires the noncontrolling interest to be measured at fair value (full goodwill).
• Goodwill is the difference between the acquisition value and the fair value of the target’s identifiable net tangible and intangible assets. Because it is considered to have an indefinite life, it is not amortized. Instead, it is evaluated at least annually for impairment. Impairment losses are reported on the income statement. IFRS use a one-step approach to determine and measure the impairment loss, whereas U.S. GAAP use a two-step approach.
• Special purpose (SPEs) and variable interest entities (VIEs) are required to be consolidated by the entity which is expected to absorb the majority of the expected losses or receive the majority of expected residual benefits.
• U.S. GAAP has eliminated the use of qualified special purpose entities resulting in a convergence with IFRS over the accounting treatment of SPEs.

PROBLEMS

The following information relates to Questions 1 through 6.

Cinnamon, Inc. is a diversified manufacturing company headquartered in the United Kingdom. It complies with IFRS. In 2009, Cinnamon held a 19 percent passive equity ownership interest in Cambridge Processing that was classified as available-for-sale. During the year, the value of this investment rose by £2 million. In December 2009, Cinnamon announced that it would be increasing its ownership interest to 50 percent effective 1 January 2010 through a cash purchase. Cinnamon and Cambridge have no intercompany transactions.

Peter Lubbock, an analyst following both Cinnamon and Cambridge, is curious how the increased stake will affect Cinnamon’s consolidated financial statements. He asks Cinnamon’s CFO how the company will account for the investment, and is told that the decision has not yet been made. Lubbock decides to use his existing forecasts for both companies’ financial statements to compare the outcomes of alternative accounting treatments.

Lubbock assembles abbreviated financial statement data for Cinnamon (Exhibit A) and Cambridge (Exhibit B) for this purpose.

EXHIBIT A Selected Financial Statement Information for Cinnamon, Inc. (£ in millions)

Year Ending 31 December	2009	2010*
Revenue	1,400	1,575
Operating income	126	142
Net income	62	69
31 December	2009	2010*
Total assets	1,170	1,317
Shareholders’ equity	616	685

*Estimates made prior to announcement of increased stake in Cambridge.

EXHIBIT B Selected Financial Statement Information for Cambridge Processing (£ in millions)

Year Ending 31 December	2009	2010*
Revenue	1,000	1,100
Operating income	80	88
Net income	40	44
Dividends paid	20	22
31 December	2009	2010
Total assets	800	836
Shareholders’ equity	440	462

*Estimates made prior to announcement of increased stake by Cinnamon.

1. In 2009, Cinnamon’s earnings before taxes includes a contribution (in £ millions) from its investment in Cambridge Processing that is closest to:

A. £3.8.

B. £5.8.

C. £7.6.

2. In 2010, if Cinnamon is deemed to have control over Cambridge, it will most likely account for its investment in Cambridge using:

A. the equity method.

B. the acquisition method.

C. proportionate consolidation.

3. At 31 December 2010, Cinnamon’s shareholders’ equity on its balance sheet would most likely be:

A. highest if Cinnamon is deemed to have control of Cambridge.

B. independent of the accounting method used for the investment in Cambridge.

C. highest if Cinnamon is deemed to have significant influence over Cambridge.

4. In 2010, Cinnamon’s net profit margin would be highest if:

A. it is deemed to have control of Cambridge.

B. it had not increased its stake in Cambridge.

C. it is deemed to have significant influence over Cambridge.

5. At 31 December 2010, assuming control and recognition of goodwill, Cinnamon’s reported debt to equity ratio will most likely be highest if it accounts for its investment in Cambridge using the:

A. equity method.

B. full goodwill method.

C. partial goodwill method.

6. Compared to Cinnamon’s operating margin in 2009, if it is deemed to have control of Cambridge, its operating margin in 2010 will most likely be:

A. lower.

B. higher.

C. the same.

The following information relates to Questions 7 through 12.

Zimt, AG is a consumer products manufacturer headquartered in Austria. It complies with IFRS. In 2009, Zimt held a 10 percent passive stake in Oxbow Limited that was classified as held for trading securities. During the year, the value of this stake declined by €3 million. In December 2009, Zimt announced that it would be increasing its ownership to 50 percent effective 1 January 2010.

Franz Gelblum, an analyst following both Zimt and Oxbow, is curious how the increased stake will affect Zimt’s consolidated financial statements. Because Gelblum is uncertain how the company will account for the increased stake, he uses his existing forecasts for both companies’ financial statements to compare various alternative outcomes.

Gelblum gathers abbreviated financial statement data for Zimt (Exhibit C) and Oxbow (Exhibit D) for this purpose.

EXHIBIT C Selected Financial Statement Estimates for Zimt AG (€ in millions)

Year Ending 31 December	2009	2010*
Revenue	1,500	1,700
Operating income	135	153
Net income	66	75
31 December	2009	2010
Total assets	1,254	1,421
Shareholders’ equity	660	735

*Estimates made prior to announcement of increased stake in Oxbow.

EXHIBIT D Selected Financial Statement Estimates for Oxbow Limited (€ in millions)

Year Ending 31 December	2009	2010*
Revenue	1,200	1,350
Operating income	120	135
Net income	60	68
Dividends paid	20	22
31 December	2009	2010
Total assets	1,200	1,283
Shareholders’ equity	660	706

* Estimates made prior to announcement of increased stake by Zimt.

7. In 2009, Zimt’s earnings before taxes includes a contribution (in € millions) from its investment in Oxbow Limited closest to:

A. (€0.6).

B. (€1.0).

C. €2.0.

8. At 31 December 2010, Zimt’s total assets balance would most likely be:

A. highest if Zimt is deemed to have control of Oxbow.

B. highest if Zimt is deemed to have significant influence over Oxbow.

C. unaffected by the accounting method used for the investment in Oxbow.

9. Based on Gelblum’s estimates, if Zimt is deemed to have significant influence over Oxbow, its 2010 net income (in € millions) would be closest to:

A. €75.

B. €109.

C. €143.

10. Based on Gelblum’s estimates, if Zimt is deemed to have joint control of Oxbow, and Zimt uses the proportionate consolidation method, its 31 December 2010 total liabilities (in € millions) will most likely be closest to:

A. €686.

B. €975.

C. €1,263.

11. Based on Gelblum’s estimates, if Zimt is deemed to have control over Oxbow, its 2010 consolidated sales (in € millions) will be closest to:

A. €1,700.

B. €2,375.

C. €3,050.

12. Based on Gelblum’s estimates, Zimt’s net income in 2010 will most likely be:

A. highest if Zimt is deemed to have control of Oxbow.

B. highest if Zimt is deemed to have significant influence over Oxbow.

C. independent of the accounting method used for the investment in Oxbow.

The following information relates to Questions 13 through 18.

Burton Howard, CFA, is an equity analyst with Maplewood Securities. Howard is preparing a research report on Confabulated Materials, SA, a publicly traded company based in France that complies with IFRS. As part of his analysis, Howard has assembled data gathered from the financial statement footnotes of Confabulated’s 2009 Annual Report and from discussions with company management. Howard is concerned about the effect of this information on Confabulated’s future earnings.

Information about Confabulated’s investment portfolio for the years ended 31 December 2008 and 2009 is presented in Exhibit E. As part of his research, Howard is considering the possible effect on reported income of Confabulated’s accounting classification for fixed income investments.

EXHIBIT E Confabulated’s Investment Portfolio (€ thousands)

In addition, Confabulated’s annual report discusses a transaction under which receivables were securitized through a special purpose entity (SPE) for Confabulated’s benefit.

13. The balance sheet carrying value of Confabulated’s investment portfolio (in € thousands) at 31 December 2009 is closest to:

A. 112,000.

B. 115,000.

C. 118,000.

14. The balance sheet carrying value of Confabulated’s investment portfolio at 31 December 2009 would have been higher if which of the securities had been reclassified as a held for trading security?

A. Bugle.

B. Cathay.

C. Dumas.

15. Compared to Confabulated’s reported interest income in 2009, if Dumas had been classified as available-for-sale, the interest income would have been:

A. lower.

B. the same.

C. higher.

16. Compared to Confabulated’s reported earnings before taxes in 2009, if Bugle had been classified as a held for trading security, the earnings before taxes (in € thousands) would have been:

A. the same.

B. €1,000 lower.

C. €3,000 higher.

17. Confabulated’s reported interest income would be lower if the cost was the same but the par value (in € thousands) of:

A. Bugle was €28,000.

B. Cathay was €37,000.

C. Dumas was €55,000.

18. Confabulated’s special purpose entity is most likely to be:

A. held off-balance sheet.

B. consolidated on Confabulated’s financial statements.

C. consolidated on Confabulated’s financial statements only if it is a “qualifying SPE.”

The following information relates to Questions 19 through 24.

BetterCare Hospitals, Inc. operates a chain of hospitals throughout the United States. The company has been expanding by acquiring local hospitals. Its largest acquisition, that of Statewide Medical, was made in 2001 under the pooling of interests method. BetterCare complies with U.S. GAAP.

BetterCare is currently forming a 50/50 joint venture with Supreme Healthcare under which the companies will share control of several hospitals. BetterCare plans to use the equity method to account for the joint venture. Supreme Healthcare complies with IFRS and will use the proportionate consolidation method to account for the joint venture.

Erik Ohalin is an equity analyst who covers both companies. He has estimated the joint venture’s financial information for 2010 in order to prepare his estimates of each company’s earnings and financial performance. This information is presented in Exhibit F.

EXHIBIT F Selected Financial Statement Forecasts for Joint Venture ($ in millions)

Year Ending 31 December	2010
Revenue	1,430
Operating income	128
Net income	62
31 December	2010
Total assets	1,500
Shareholders’ equity	740

Supreme Healthcare recently announced it had formed a special purpose entity through which it plans to sell up to $100 million of its accounts receivable. Supreme Healthcare has no voting interest in the SPE, but it is expected to absorb any losses that it may incur. Ohalin wants to estimate the impact this will have on Supreme Healthcare’s consolidated financial statements.

19. Compared to accounting principles currently in use, the pooling method BetterCare used for its Statewide Medical acquisition has most likely caused its reported:

A. revenue to be higher.

B. total equity to be lower.

C. total assets to be higher.

20. Based on Ohalin’s estimates, the amount of joint venture revenue (in $ millions) included on BetterCare’s consolidated 2010 financial statements should be closest to:

A. $0.

B. $715.

C. $1,430.

21. Based on Ohalin’s estimates, the amount of joint venture net income included on the consolidated financial statements of each venturer will most likely be:

A. higher for BetterCare.

B. higher for Supreme Healthcare.

C. the same for both BetterCare and Supreme Healthcare.

22. Based on Ohalin’s estimates, the amount of the joint venture’s 31 December 2010 total assets (in $ millions) that will be included on Supreme Healthcare’s consolidated financial statements will be closest to:

A. $0.

B. $750.

C. $1,500.

23. Based on Ohalin’s estimates, the amount of joint venture shareholders’ equity at 31 December 2010 included on the consolidated financial statements of each venturer will most likely be:

A. higher for BetterCare.

B. higher for Supreme Healthcare.

C. the same for both BetterCare and Supreme Healthcare.

24. If Supreme Healthcare sells its receivables to the SPE, its consolidated financial results will most likely show:

A. a higher revenue for 2010.

B. the same cash balance at 31 December 2010.

C. the same accounts receivable balance at 31 December 2010.

The following information relates to Questions 25 through 30.

Percy Byron, CFA, is an equity analyst with a U.K.-based investment firm. One firm Byron follows is NinMount PLC, a U.K.-based company. On 31 December 2008, NinMount paid £320 million to purchase a 50 percent stake in Boswell Company. The excess of the purchase price over the fair value of Boswell’s net assets was attributable to previously unrecorded licenses. These licenses were estimated to have an economic life of six years. The fair value of Boswell’s assets and liabilities other than licenses was equal to their recorded book values. NinMount and Boswell both use the pound sterling as their reporting currency and prepare their financial statements in accordance with IFRS.

Byron is concerned whether the investment should affect his “buy” rating on NinMount common stock. He knows NinMount could choose one of several accounting methods to report the results of its investment, but NinMount has not announced which method it will use. Byron forecasts that both companies’ 2009 financial results (excluding any merger accounting adjustments) will be identical to those of 2008.

NinMount’s and Boswell’s condensed income statements for the year ended 31 December 2008, and condensed balance sheets at 31 December 2008, are presented in Exhibits G and H, respectively.

EXHIBIT G NinMount PLC and Boswell Company Income Statements for the Year Ended 31 December 2008 (£ in millions)

	NinMount	Boswell
Net sales	950	510
Cost of goods sold	(495)	(305)
Selling expenses	(50)	(15)
Administrative expenses	(136)	(49)
Depreciation & amortization expense	(102)	(92)
Interest expense	(42)	(32)
Income before taxes	125	17
Income tax expense	(50)	(7)
Net income	75	10

EXHIBIT H NinMount PLC and Boswell Company Balance Sheets at 31 December 2008 (£ in millions)

	NinMount	Boswell
Cash	50	20
Receivables—net	70	45
Inventory	130	75
Total current assets	250	140
Property, plant, & equipment—net	1,570	930
Investment in Boswell	320	—
Total assets	2,140	1,070
Current liabilities	110	90
Long-term debt	600	400
Total liabilities	710	490
Common stock	850	535
Retained earnings	580	45
Total equity	1,430	580
Total liabilities and equity	2,140	1,070

Note: Balance sheets reflect the purchase price paid by NinMount, but do not yet consider the impact of the accounting method choice.

25. NinMount’s current ratio on 31 December 2008 most likely will be highest if the results of the acquisition are reported using:

A. the equity method.

B. consolidation with full goodwill.

C. consolidation with partial goodwill.

26. NinMount’s long-term debt to equity ratio on 31 December 2008 most likely will be lowest if the results of the acquisition are reported using:

A. the equity method.

B. consolidation with full goodwill.

C. consolidation with partial goodwill.

27. Based on Byron’s forecast, if NinMount deems it has acquired control of Boswell, NinMount’s consolidated 2009 depreciation and amortization expense (in £ millions) will be closest to:

A. 102.

B. 148.

C. 204.

28. Based on Byron’s forecast, NinMount’s net profit margin for 2009 most likely will be highest if the results of the acquisition are reported using:

A. the equity method.

B. consolidation with full goodwill.

C. consolidation with partial goodwill.

29. Based on Byron’s forecast, NinMount’s 2009 return on beginning equity most likely will be the same under:

A. either of the consolidations, but different under the equity method.

B. the equity method, consolidation with full goodwill, and consolidation with partial goodwill.

C. none of the equity method, consolidation with full goodwill, or consolidation with partial goodwill.

30. Based on Byron’s forecast, NinMount’s 2009 total asset turnover ratio on beginning assets under the equity method is most likely:

A. lower than if the results are reported using consolidation.

B. the same as if the results are reported using consolidation.

C. higher than if the results are reported using consolidation.

1FASB ASC Topic 805 [Business Combinations].

2FASB ASC Topic 810 [Consolidation].

3The effective interest method is a method of calculating the carrying value of a debt security and allocating the interest income to the period in which it is earned. It is based on the effective interest rate calculated at the time of purchase. Under U.S. GAAP, the calculation of the effective interest rate is generally based on contractual cash flows over the asset’s contractual life. Under IFRS, the effective rate is based on the estimated cash flows over the expected life of the asset. Contractual cash flows over the full contractual term of the security are only used if the expected cash flows over the expected life of the security cannot be reliably estimated.

4Under IFRS, securities classified as fair value through profit or loss include securities classified as held for trading.

5The “available-for-sale” classification does not appear in IFRS in 2010, although the relevant standard (IFRS 9 Financial Instruments) is not effective until 2013. However, although the available-for-sale category will not exist, IFRS still permit certain equity investments to be measured at fair value with any unrealized holding gains or losses recognized in other comprehensive income. Specifically, at the time a company buys an equity investment that is not held for trading, the company is permitted to make an irrevocable election to measure the asset in this manner. These assets are referred to as “financial assets measured at fair value through other comprehensive income.”

6Under IAS 21 a debt security is defined as a monetary item, because the holder (investor) has the right to receive a fixed or determinable number of units of currency in the form of contractual interest payments. An equity instrument is not considered a monetary item.

7IFRS uses the term “fair value through profit or loss,” whereas U.S. GAAP uses the term “designated at fair value.”

8In rare circumstances IFRS permits reclassification of a financial asset if it is no longer held for the purpose of selling it in the near term. The financial asset is reclassified at its fair value with any gain or loss recognized in profit or loss, and the fair value on the date of its reclassification becomes its new cost or amortized cost.

9The effective interest rate method applies the market rate in effect when the bonds were purchased to the current amortized cost (book value) of the bonds to obtain interest income for the period. Assume that the debt securities’ contractual cash flows are equal to estimated cash flows and that its contractual life is equal to its expected life.

10IFRS 7 Financial Instruments: Disclosures and FASB ASC Section 320-10-50 [Investments–Debt and Equity Securities–Overall–Disclosure].

11The determination of significant influence under IFRS also includes currently exercisable or convertible warrants, call options, or convertible securities that the investor owns, which give it additional voting power or reduce another party’s voting power over the financial and operating policies of the investee. Under U.S. GAAP, the determination of an investor’s voting stock interest is based only on the voting shares outstanding at the time of the purchase. The existence and effect of securities with potential voting rights are not considered.

12IAS 28 Investments in Associates and FASB ASC Topic 323 [Investments–Equity Method and Joint Ventures].

13After initial recognition, an entity can choose to use either a cost model or a revaluation model to measure its property, plant, and equipment. Under the revaluation model, property, plant, and equipment whose fair value can be measured reliably can be carried at a revalued amount. This revalued amount is its fair value at the date of the revaluation less any subsequent accumulated depreciation.

14Successful companies should be able to generate, through the productive use of assets, economic value in excess of the resale value of the assets themselves. Therefore, investors may be willing to pay a premium in anticipation of future benefits. These benefits could be as a result of general market conditions, the investor’s ability to exert significant influence on the investee, or other synergies.

15If the investor’s share of the fair value of the associate’s net assets (identifiable assets, liabilities, and contingent liabilities) is greater than the cost of the investment, the difference is excluded from the carrying amount of the investment and instead included as income in the determination of the investor’s share of the associate’s profit or loss in the period in which the investment is acquired.

16IAS 39 Financial Instruments: Recognition and Measurement. FASB ASC Section 825-10-25 [Financial Instruments–Overall–Recognition].

17Recoverable amount is the higher of “value in use” or net selling price. Value in use is equal to the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life. Net selling price is equal to fair value less cost to sell.

18FASB ASC Section 323-10-35 [Investments–Equity Method and Joint Ventures–Overall–Subsequent Measurement].

19IAS 28 Investments in Associates and FASB ASC Topic 323 [Investments–Equity Method and Joint Ventures].

20IAS 31 Interests in Joint Ventures. In September 2007, the IASB, as part of its convergence project with the FASB, issued a proposal to revise IAS 31 in two respects. The first change would be to eliminate the use of proportionate consolidation to account for jointly controlled entities. The second would be to change from treating the form of the arrangement as the most significant factor in determining the accounting. Instead, a dual approach would be used to account for joint arrangements that involve both jointly controlled assets and jointly controlled entities. Under this approach, the parties would account first for the assets and liabilities of the joint arrangement and use a residual approach to equity accounting for the joint venture portion of the joint arrangement.

21Under proportionate consolidation, the venturer has a choice between two presentation formats. First, the venture partner may include its share of the assets, liabilities, revenues, and expenses of the jointly controlled entity with similar items under its sole control. Alternatively, it can separately recognize its share of the joint venture’s assets, liabilities, revenues, and expenses, although still placing them within the proper grouping. In either case, the same category totals will be presented.

22FASB ASC Topic 323 [Investments–Equity Method and Joint Ventures].

23SFAS 141 and 142 are superseded by FASB ASC Topics 805 [Business Combinations] and 350 [Intangibles–Goodwill and Other].

24SFAS 141(R) and 160 are superseded by FASB ASC Topic 805 [Business Combinations].

25IFRS 3 Business Combinations and FASB ASC Topic 805 [Business Combinations].

26A contingent liability must be recognized even if it is not probable that an outflow of resources or economic benefits will be used to settle the obligation.

27Goodwill is only recognized under the acquisition or purchase methods. Under the uniting (pooling) of interest method, goodwill was not created since the combined companies are treated as if they had always operated as a single entity.

28FASB ASC Topic 805 [Business Combinations].

29Under the uniting (pooling) of interests method (which required an exchange of common shares), the shares issued by Franklin would be measured at their par value. In addition, the assets and liabilities of both companies would be combined at their book values resulting in no goodwill being recognized. The retained earnings of Jefferson would also be combined with that of Franklin on the consolidated balance sheet.

30Under the pooling method, cost of goods sold and depreciation expense would be lower, since both would be based on the book value of Jefferson’s assets. Therefore, analysts must be aware of companies that used the uniting (pooling) of interests prior to the method being disallowed. This is because in the periods after pooling was disallowed, the assets of an entity that had used uniting of interests (pooling) may be understated and income overstated relative to companies that used the acquisition method. These differences will affect the comparability of return on investment ratios.

31FASB ASC Topic 810 [Consolidation].

32IAS 27 Consolidated and Separate Financial Statements and FASB ASC Topic 810 [Consolidation].

33A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

34The recoverable amount of a cash-generating unit is the higher of net selling price (i.e., fair value less costs to sell) and its value in use. Value in use is the present value of the future cash flows expected to be derived from the cash-generating unit. The carrying value of a cash-generating unit is equal to the carrying value of the unit’s assets and liabilities including the goodwill that has been allocated to that unit.

35It is possible, however, for differences to arise through the application of different accounting rules (e.g., valuation of fixed assets).

36The term “special purpose entity” is used by IFRS and “variable interest entity” is used by U.S. GAAP.

37SFAS 140 and FIN 46R are superseded by FASB ASC Topic 810 [Consolidation].