Sunday, December 6, 2009

Financial Statement Effects of Intercorporate Investments

For a wide variety of reasons, one company will often make an equity investment in another company. We could be simply talking about the parking of excess capital, or there could be strategic reasons such as a bid to gain control of a supplier or other important segment of the supply chain. These investments show up on corporate financial statements in a variety of ways, depending largely upon the size of the investment, and the ability of the investor to control the investee.

In terms of a relatively insignificant, non-controlling (<20%) stake in another firms equity, the financial statement effect will depend largely upon whether management classifies the investment as Available-for-Sale (AFS), or Trading (T) . The difference here really comes down to the intent of management; if management considers the investment a "buy and hold" kind of scenario, and generally won't sell unless the price is right, the investment is AFS. Securities classified as Trading are acquired with the intent to sell in a short period of time. This difference is extremely important due to the way GAAP requires companies to report unrealized gains (losses) from investments in the income statement. Market value changes of AFS securities flow to the Accumulated Other Comprehensive Income (AOCI) section of stockholders equity. Current period income and retained earnings are not affected. Market value fluctuations in Trading securities on the other hand, are counted as investment income (or loss) on the income statement, as well as an increase (decrease) of retained earnings. Dividends received in conjunction with both classifications are treated as other income on the current period income statement. Lastly, in both instances, these marketable securities are reported on the balance sheet at fair market value (FMV).

When the equity investment is such that the investor is able to exert significant control (between 20% and 50% stake) over the investee firm, the rules change just a bit.  Accountants refer to the financial statement treatment of these investments as the Equity Method. First of all, market value fluctuations affect neither the income statement or balance sheet. Dividends received are treated as a reduction in the investment basis. Additionally, the investor recognizes investment income - and concomitant increase in retained earnings - from its stake that is proportional to the stake held in the investee.For example:

On February 2nd, Company A purchases $2,000,000, or a 40% stake, in the equity securities of Company B. Let's say this corresponds to 400,000 of Company B's 1,000,000 outstanding shares. On March 31st, Company B pays a $1/share dividend to all common shareholders. On December 31st, Company B reports $5,000,000 of net income. The accounting for these events, from Company A's perspective, is as follows:

Investment in Company B                      $2,000,000
              Cash                                                                           $2,000,000

Cash                                                         $400,000
               Investment in Company B                                 $400,000

Investment in Company B                         $2,000,000
               Investment Income                                             $2,000,000

At the end of the year, Company A will report it's investment in Company on its balance sheet at $3,600,000 ($2,000,000 - $400,000 + $2,000,000)

Given that investments in marketable securities comprise a significant portion of most firm's balance sheets, and can have a significant impact on stockholders equity and retained earnings, its important to monitor them. You should read up on the footnotes associated with these investments, and monitor the way management changes its AFS or T classifications over time. Also, be wary of the income related to unrealized gains on trading securities; financial market volatility can significantly impact these numbers between each reporting period. Sphere: Related Content

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