Chapter 15 Active Investments In Corporations Chapter 15 Active Investments In Corporations Mark Higgins

Chapter 15

Active Investments In Corporations

Chapter 15

Active Investments In Corporations

Mark HigginsMark HigginsMark HigginsMark Higgins

Transparency 15-2Transparency 15-2

Nature of Investments in Corporations

Passive Investment in Corporation – The acquisition of another entity’s stock with the intent earn a return on the investment (i.e., Chapter 10 – Marketable Securities).

Active Investment in Corporation – The acquisition of another entity’s stock with the intent to obtain influence or control the operations of that company.


Investments in Corporations

TerminologyThe entity purchasing the stock is termed

the investor.

The company whose stock is purchased, the investee.


Investments in CorporationsA corporation becomes an active investor with the intent to:

Increase efficiency of its present operations (e.g., through the purchase of a company in the same line of business).

Gain access to raw materials, distribution services, or markets (e.g., through a vertical integration).

Exploit its expertise by improving operations of the inefficiently run investee.


Economic Rationale for Investing in Another Corporations

The economic rationale for a corporation becoming an active investor is that it believes the combined value through efficiencies, vertical integration, etc., of the two entities will exceed the sum value of the separate entities.


Economic Rationale Example

The fair market value of Rhody is $18 million. Rhody decides to acquire the Minuteman Company, which has a fair market value of $8 million. Rhody believes that through operating efficiencies the combined entity is worth $32 million. How much would Rhody be willing to pay for the Minuteman Company?


Economic Rationale Example

Since the combined value of the two entities is $6 million more than the sum value of the entities, Rhody would be willing to pay $14 million (a $6 million dollar premium) for Minuteman.

$18 million + $ 8 million = $26 million

$32 million - $26 million = $ 6 million


Accounting for Investments in Corporations

GAAP requires a corporation that owns all or parts of other corporations to report on the relevant economic entity, regardless of the legal ownership structure. This is usually accomplished in one of two ways:

Consolidation – If ownership interest exceeds 50%, the operations of the investee company are included in the financial statements (e.g., income statement, balance sheet etc.) of the entity.

Minority interest – An ownership interest of 50% or less in the investee’s total stock outstanding.


Accounting for Minority InterestsAcconting for a minority interest depends on the size of the minority interest.

Small Minority Interest - are generally defined as less than 20% ownership. These are accounted for as available-for-sale securities as discussed in Chapter 10.

Large Minority Interest – are between 20% and 50% employ, the equity method to account for holdings. This method summarizes the ownership of the subsidiary as an asset line item and is not adjusted to reflect changes in the market value of the investment.


Equity Method Example

On January 1, 2005, Rhody Corporation acquires a 30% interest (45,000 shares) in Huskie Corporation for $540,000. What is the entry Rhody would make to record the purchase of Huskie stock?



The journal entry to record the investment is:

Investment in unconsolidated affiliate 540,000 Cash 540,000



On December 31, 2005, Huskie Corporation reports net income of $130,000. What impact does this have on Rhody’s investment in Huskie?



Rhody will increase its investment in Huskie by its pro rata share $39,000 ($130,000 x 30%) of Huskies’ net income.

Investment in Unconsolidated Affiliate 39,000 Equity in net earnings of unconsolidated affiliate

39,000



On January 15, 2006, Huskie Corporation declares a dividend of $20,000 payable on January 31, 2006. What impact does this have on Rhody’s investment in Huskie?


Equity Method ExampleRhody will decrease its investment in Huskie by its pro rata share $6,000 ($20,000 x 30%) of the dividend.

Declaration Date: Dividend receivable 6,000

Investment in Unconsolidated Affiliate 6,000

Payment Date:Cash 6,000

Dividend receivable 6,000


Consolidated Financial Statements

When a corporation’s ownership interest exceeds 50%, the consolidated financial statements (e.g., income statement, balance sheet, cash flow statement) reflect the combined activity for the year of all the entities minus any related party transactions (e.g., sales between the entities).


Consolidation Example

Rhody owns 100% of Minuteman Corporation. During the year, Rhody had sales of $100 million and Minuteman had sales of $40 million, of which $6 million were sales to Rhody. What will Rhody report as total sales for the year?


Consolidation Example

Since $6 million of Minuteman’s sales are to Rhody, the consolidated entity must reduce its combined sales of $140 ($100 + $40) by the $6 million of related party sales. Thus, Rhody will report total sales of $134 million ($100 + $40 - $6).


Treatment of Minority Interest on Consolidated Financial Statements

Balance Sheet:If a corporation holds more than a 50% interest but less than a 100% interest in another entity, this minority interest represents the minority owners’ claims against the net assets of the subsidiary. This account will usually appear after the liabilities, but before the shareholders’ equity section, in the consolidated balance sheet.


Treatment of Minority Interest on Consolidated Financial Statements

Income Statement:The consolidated income statement lists all revenue and expenses for the combined entities. The pro rata amount of income not belonging to the parent is captured in a line item called “minority interest”.

Cash Flow Statement:Minority interest is added back to the cash flow statement because it reduced net income but does not require the use of cash.

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Chapter 15 Active Investments In Corporations Chapter 15 Active Investments In Corporations Mark Higgins