Intercorporate Investments

2024 Curriculum CFA Program Level II Financial Reporting and Analysis

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Introduction

Intercorporate investments (investments in other companies) can have a significant impact on an investing company’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, deploy excess cash, 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 non-redeemable 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 International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) worked to reduce differences in accounting standards that apply to the classification, measurement, and disclosure of intercorporate investments. The resulting standards have improved the relevance, transparency, and comparability of information provided in financial statements.

Complete convergence between IFRS accounting standards and US GAAP did not occur for accounting for financial instruments, and some differences still exist. The terminology used in this reading is IFRS-oriented. US 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 under IFRS 9, the IASB standard for financial instruments. Section 4 describes equity method reporting for investments in associates where significant influence can exist including the reporting for joint ventures, a type of investment where control is shared. Section 5 describes reporting for business combinations, the parent/subsidiary relationship, and variable interest and special purpose entities. A summary concludes the reading.

Learning Outcomes

The member should be able to:

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

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.
- 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 (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.

2 PL Credit

If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.