CHAPTER 13
Intercorporate Investments

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 US 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 how different methods used to account for intercorporate investments affect financial statements and ratios.

Summary Overview

Intercompany investments play a significant role in business activities and create significant challenges for the analyst in assessing company performance. Investments in other companies 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 measured and reported as
  • fair value through profit or loss;
  • fair value through other comprehensive income; or
  • amortized cost.

IFRS and US GAAP treat investments in financial assets in a similar manner.

• Investments in associates and joint ventures 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 US 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 post-acquisition 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.
• IFRS and US GAAP accounting standards require the use of the acquisition method to account for business combinations. Fair value of the consideration given is the appropriate measurement for identifiable assets and liabilities acquired in the business combination.
• 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 US GAAP uses a two-step approach.
• If the acquiring company acquires less than 100%, non-controlling (minority) shareholders’ interests are reported on the consolidated financial statements. IFRS allows the non-controlling interest to be measured at either its fair value (full goodwill) or at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets (partial goodwill). US GAAP requires the non-controlling interest to be measured at fair value (full goodwill).
• Consolidated financial statements are prepared in each reporting period.
• Special purpose entities (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.

Problems

The following information relates to Questions 1–5

Cinnamon, Inc. is a diversified manufacturing company headquartered in the United Kingdom. It complies with IFRS. In 2017, Cinnamon held a 19 percent passive equity ownership interest in Cambridge Processing. In December 2017, Cinnamon announced that it would be increasing its ownership interest to 50 percent effective January 1, 2018 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 1) and Cambridge (Exhibit 2) for this purpose.

Exhibit 1 Selected Financial Statement Information for Cinnamon, Inc. (£ Millions)

Year ending December 31	2017	2018*
Revenue	1,400	1,575
Operating income	126	142
Net income	62	69
December 31	2017	2018*
Total assets	1,170	1,317
Shareholders’ equity	616	685

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

Exhibit 2 Selected Financial Statement Information for Cambridge Processing (£ Millions)

Year ending December 31	2017	2018*
Revenue	1,000	1,100
Operating income	80	88
Net income	40	44
Dividends paid	20	22
December 31	2017	2018*
Total assets	800	836
Shareholders’ equity	440	462

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

1. In 2018, if Cinnamon is deemed to have control over Cambridge, it will most likely account for its investment in Cambridge using:
   1. the equity method.
   2. the acquisition method.
   3. proportionate consolidation.

2. At December 31, 2018, Cinnamon’s total shareholders’ equity on its balance sheet would most likely be:
   1. highest if Cinnamon is deemed to have control of Cambridge.
   2. independent of the accounting method used for the investment in Cambridge.
   3. highest if Cinnamon is deemed to have significant influence over Cambridge.

3. In 2018, Cinnamon’s net profit margin would be highest if:
   1. it is deemed to have control of Cambridge.
   2. it had not increased its stake in Cambridge.
   3. it is deemed to have significant influence over Cambridge.

4. At December 31, 2018, 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:
   1. equity method.
   2. full goodwill method.
   3. partial goodwill method.

5. Compared to Cinnamon’s operating margin in 2017, if it is deemed to have control of Cambridge, its operating margin in 2018 will most likely be:
   1. lower.
   2. higher.
   3. the same.

The following information relates to Questions 6–10

Zimt, AG is a consumer products manufacturer headquartered in Austria. It complies with IFRS. In 2017, Zimt held a 10 percent passive stake in Oxbow Limited. In December 2017, Zimt announced that it would be increasing its ownership to 50 percent effective January 1, 2018.

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 1) and Oxbow (Exhibit 2) for this purpose.

Exhibit 1 Selected Financial Statement Estimates for Zimt AG (€ Millions)

Year ending December 31	2017	2018*
Revenue	1,500	1,700
Operating income	135	153
Net income	66	75
31 December	2017	2018*
Total assets	1,254	1,421
Shareholders’ equity	660	735

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

Exhibit 2 Selected Financial Statement Estimates for Oxbow Limited (€ Millions)

Year ending December 31	2017	2018*
Revenue	1,200	1,350
Operating income	120	1350
Net income	60	680.
Dividends paid	20	22.0
December 31	2017	2018*
Total assets	1,200	1,283
Shareholders’ equity	660	7060

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

6. At December 31, 2018, Zimt’s total assets balance would most likely be:
   1. highest if Zimt is deemed to have control of Oxbow.
   2. highest if Zimt is deemed to have significant influence over Oxbow.
   3. unaffected by the accounting method used for the investment in Oxbow.

7. Based on Gelblum’s estimates, if Zimt is deemed to have significant influence over Oxbow, its 2018 net income (in € millions) would be closest to:
   1. €75.
   2. €109.
   3. €143.

8. Based on Gelblum’s estimates, if Zimt is deemed to have joint control of Oxbow, and Zimt uses the proportionate consolidation method, its December 31, 2018 total liabilities (in € millions) will most likely be closest to:
   1. €686.
   2. €975.
   3. €1,263.

9. Based on Gelblum’s estimates, if Zimt is deemed to have control over Oxbow, its 2018 consolidated sales (in € millions) will be closest to:
   1. €1,700.
   2. €2,375.
   3. €3,050.

10. Based on Gelblum’s estimates, Zimt’s net income in 2018 will most likely be:
    1. highest if Zimt is deemed to have control of Oxbow.
    2. highest if Zimt is deemed to have significant influence over Oxbow.
    3. independent of the accounting method used for the investment in Oxbow.

The following information relates to Questions 11–16

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 9. As part of his analysis, Howard has assembled data gathered from the financial statement footnotes of Confabulated’s 2018 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 December 31, 2017 and 2018 is presented in Exhibit 1. As part of his research, Howard is considering the possible effect on reported income of Confabulated’s accounting classification for fixed income investments.

Exhibit 1 Confabulated’s Investment Portfolio (€ Thousands)

Characteristic	Bugle AG	Cathay Corp	Dumas SA
Classification	FVPL	FVOCI	Amortized cost
Cost*	€25,000	€40,000	€50,000
Market value, December 31, 2017	€29,000	€38,000	€54,000
Market value, December 31, 2018	€28,000	€37,000	€55,000

* All securities were acquired at par value.

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

11. The balance sheet carrying value of Confabulated’s investment portfolio (in € thousands) at December 31, 2018 is closest to:
    1. 112,000.
    2. 115,000.
    3. 118,000.

12. The balance sheet carrying value of Confabulated’s investment portfolio at December 31, 2018 would have been higher if which of the securities had been reclassified as FVPL security?
    1. Bugle.
    2. Cathay.
    3. Dumas.

13. Compared to Confabulated’s reported interest income in 2018, if Dumas had been classified as FVPL, the interest income would have been:
    1. lower.
    2. the same.
    3. higher.

14. Compared to Confabulated’s reported earnings before taxes in 2018, if Dumas had been classified as a FVPL security, the earnings before taxes (in € thousands) would have been:
    1. the same.
    2. €1,000 lower.
    3. €3,000 higher.

15. Confabulated’s reported interest income would be lower if the cost was the same but the par value (in € thousands) of:
    1. Bugle was €28,000.
    2. Cathay was €37,000.
    3. Dumas was €55,000.

16. Confabulated’s special purpose entity is most likely to be:
    1. held off-balance sheet.
    2. consolidated on Confabulated’s financial statements.
    3. consolidated on Confabulated’s financial statements only if it is a “qualifying SPE.”

The following information relates to Questions 17–22

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 US 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 2018 in order to prepare his estimates of each company’s earnings and financial performance. This information is presented in Exhibit 1.

Exhibit 1 Selected Financial Statement Forecasts for Joint Venture ($ Millions)

Year ending December 31	2018
Revenue	1,430
Operating income	128
Net income	62
December 31	2018
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.

17. Compared to accounting principles currently in use, the pooling method BetterCare used for its Statewide Medical acquisition has most likely caused its reported:
    1. revenue to be higher.
    2. total equity to be lower.
    3. total assets to be higher.

18. Based on Ohalin’s estimates, the amount of joint venture revenue (in $ millions) included on BetterCare’s consolidated 2018 financial statements should be closest to:
    1. $0.
    2. $715.
    3. $1,430.

19. 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:
    1. higher for BetterCare.
    2. higher for Supreme Healthcare.
    3. the same for both BetterCare and Supreme Healthcare.

20. Based on Ohalin’s estimates, the amount of the joint venture’s December 31, 2018 total assets (in $ millions) that will be included on Supreme Healthcare’s consolidated financial statements will be closest to:
    1. $0.
    2. $750.
    3. $1,500.

21. Based on Ohalin’s estimates, the amount of joint venture shareholders’ equity at December 31, 2018 included on the consolidated financial statements of each venturer will most likely be:
    1. higher for BetterCare.
    2. higher for Supreme Healthcare.
    3. the same for both BetterCare and Supreme Healthcare.

22. If Supreme Healthcare sells its receivables to the SPE, its consolidated financial results will most likely show:
    1. a higher revenue for 2018.
    2. the same cash balance at December 31, 2018.
    3. the same accounts receivable balance at December 31, 2018.

The following information relates to Questions 23–28

Percy Byron, CFA, is an equity analyst with a UK-based investment firm. One firm Byron follows is NinMount PLC, a UK-based company. On December 31, 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’ 2019 financial results (excluding any merger accounting adjustments) will be identical to those of 2018.

NinMount’s and Boswell’s condensed income statements for the year ended December 31, 2018, and condensed balance sheets at December 31, 2018, are presented in Exhibits 1 and 2, respectively.

Exhibit 1 NinMount PLC and Boswell Company Income Statements for the Year Ended December 31, 2018 (£ millions)

	NinMount	Boswell
Net sales	950)00	510)0.
Cost of goods sold	(495)00	(305)0.
Selling expenses	(50)00	(15)0.
Administrative expenses	(136)00	(49)0.
Depreciation & amortization expense	(102)00	(92)0.
Interest expense	00(42)00	00(32)0.
Income before taxes	125)00	17)0.
Income tax expense	00(50)00	500(7)0.
Net income	00075)00	00110)0.

Exhibit 2 NinMount PLC and Boswell Company Balance Sheets at December 31, 2018 (£ millions)

	NinMount	Boswell
Cash	50	20
Receivables—net	70	45
Inventory	00130	00075
Total current assets	250	140
Property, plant, & equipment—net	1,570	930
Investment in Boswell	0,320	001—
Total assets	2,140	1,070
Current liabilities	110	90
Long-term debt	0,600	0,400
Total liabilities	710	490
Common stock	850	535
Retained earnings	0,580	00,45
Total equity	1,430	0,580
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.

23. NinMount’s current ratio on December 31, 2018 most likely will be highest if the results of the acquisition are reported using:
    1. the equity method.
    2. consolidation with full goodwill.
    3. consolidation with partial goodwill.

24. NinMount’s long-term debt to equity ratio on December 31, 2018 most likely will be lowest if the results of the acquisition are reported using:
    1. the equity method.
    2. consolidation with full goodwill.
    3. consolidation with partial goodwill.

25. Based on Byron’s forecast, if NinMount deems it has acquired control of Boswell, NinMount’s consolidated 2019 depreciation and amortization expense (in £ millions) will be closest to:
    1. 102.
    2. 148.
    3. 204.

26. Based on Byron’s forecast, NinMount’s net profit margin for 2019 most likely will be highest if the results of the acquisition are reported using:
    1. the equity method.
    2. consolidation with full goodwill.
    3. consolidation with partial goodwill.

27. Based on Byron’s forecast, NinMount’s 2019 return on beginning equity most likely will be the same under:
    1. either of the consolidations, but different under the equity method.
    2. the equity method, consolidation with full goodwill, and consolidation with partial goodwill.
    3. none of the equity method, consolidation with full goodwill, or consolidation with partial goodwill.

28. Based on Byron’s forecast, NinMount’s 2019 total asset turnover ratio on beginning assets under the equity method is most likely:
    1. lower than if the results are reported using consolidation.
    2. the same as if the results are reported using consolidation.
    3. higher than if the results are reported using consolidation.

The following information relates to Questions 29–36

John Thronen is an analyst in the research department of an international securities firm. He is preparing a research report on Topmaker, Inc., a publicly traded company that complies with IFRS.

On January 1, 2018, Topmaker invested $11 million in Blanca Co. debt securities (with a 5.0% stated coupon on par value, and interest payable each December 31). The par value of the securities is $10 million, and the market interest rate in effect when the bonds were purchased was 4.0%. Topmaker designates the investment as amortized cost. As of December 31, 2018, the fair value of the securities is $12 million.

Blanca Co. wants to raise $40 million in capital by borrowing against its financial receivables. Blanca plans to create a special-purpose entity (SPE), invest $10 million in the SPE, have the SPE borrow $40 million, and then use the funds to purchase $50 million of receivables from Blanca. Blanca meets the definition of control and plans to consolidate the SPE. Blanca’s balance sheet is presented in Exhibit 1.

Exhibit 1 Blanca Co. Balance Sheet at December 31, 2018 ($ millions)

Cash	20	Current liabilities	25
Accounts receivable	50	Noncurrent liabilities	30
Other assets	30	Shareholders’ equity	45
Total assets	100	Total liabilities and equity	100

Also on January 1, 2018, Topmaker acquired a 15% equity interest with voting power in Rainer Co. for $300 million. Topmaker has representation on Rainer’s board of directors and participates in Rainer’s policymaking process.Thronen believes that Topmaker underestimated the goodwill and balance sheet value of its investment account in Rainer. To estimate these figures, Thronen gathers selected financial information for Rainer as of December 31, 2018 in Exhibit 2. The plant and equipment are depreciated on a straight-line basis and have 10 years of remaining life.

Exhibit 2 Selected Financial Data for Rainer Co., Year Ending December 31, 2018 ($ millions)

	Book Value	Fair Value
Revenue	1,74000	N/A00
Net income	36000	N/A00
Dividends paid	22000	N/A00
Plant and equipment	2,90000	3,16000
Total assets	3,17000	3,43000
Liabilities	1,83000	1,83000
Net assets	1,34000	1,60000

During 2018, Rainer sold $60 million in inventory to Topmaker for $80 million. In 2019, Topmaker resold the entire inventory to a third party.

Thronen is concerned about possible goodwill impairment resulting from expected changes in the industry effective at the end of 2019. He calculates the impairment loss based on the projected consolidated balance sheet data shown in Exhibit 3, assuming that the cash-generating unit and reporting unit of Topmaker are the same.

Exhibit 3 Selected Financial Data for Topmaker, Inc., Estimated Year Ending December 31, 2019 ($ millions)

Carrying value of cash-generating unit/reporting unit	15,200
Recoverable amount of cash-generating unit/reporting unit	14,900
Fair value of reporting unit	14,800
Identifiable net assets	14,400
Goodwill	520

Finally, Topmaker announces its plan to increase its ownership interest in Rainer to 80% effective January 1, 2020. It will account for the investment in Rainer using the partial goodwill method. Thronen estimates that the fair market value of the Rainer’s shares on the expected date of exchange is $2 billion, with the identifiable assets valued at $1.5 billion.

29. The carrying value reported on the balance sheet of Topmaker’s investment in Blanca’s debt securities at December 31, 2018 is:
    1. $10,940,000.
    2. $11,000,000.
    3. $12,000,000.

30. Based on Exhibit 1 and Blanca’s plans to borrow against its financial receivables, the consolidated balance sheet will show total assets of:
    1. $50,000,000.
    2. $140,000,000.
    3. $150,000,000.

31. Topmaker’s influence on Rainer’s business activities can be best described as:
    1. significant.
    2. controlling.
    3. shared control.

32. Based on Exhibit 2, the goodwill included in Topmaker’s purchase of Rainer is:
    1. $21 million.
    2. $60 million.
    3. $99 million.

33. Based on Exhibit 2, the carrying value of Topmaker’s investment in Rainer at the end of 2018 is closest to:
    1. $282 million.
    2. $317 million.
    3. $321 million.

34. Which of the following statements regarding the sale of inventory by Rainer to Topmaker is correct?
    1. The sale represents a downstream sale.
    2. Topmaker’s unrealized profits are initially deferred.
    3. Profits will decline on Topmaker’s 2018 income statement.

35. Based on Exhibit 3, Topmaker’s impairment loss under IFRS is:
    1. $120 million.
    2. $300 million.
    3. $400 million.

36. The value of the minority interest at the acquisition date of January 1, 2020 is:
    1. $300 million.
    2. $400 million.
    3. $500 million.