Examples for Learning Module 1 - Intercorporate Investments

Learning Module 1 Intercorporate Investments EXAMPLE 1T Equity Method: Balance in Investment Account 1. Branch (a fictitious company) purchases a 20% interest in Williams (a fic- titious company) for €200,000 on 1 January 2016. Williams reports income and dividends as follows: 2016 Income Dividends €200,000 2017 €50,000 2018 400.000 €900,000 €350,000 Calculate the investment in Williams that appears on Branch's balance sheet as of the end of 2018. Solution: Investment in Williams at 31 December 2018: Initial cost €200,000 Equity income 2016 €40,000 = (20% of €200,000 Income) Dividends received 2016 (€10,000) = (20% of €50,000 Dividends) Equity income 2017 €60,000 (20% of €300,000 Income) Dividends received 2017 (€20,000) (20% of €100.000 Dividends) Equity income 2018 €80,000 (20% of €400,000 Income) Dividends received 2018 (€40,000) = (20% of €200,000 Dividends) Balance-Equity €310,000 €200,000+ 20% x (€900,000 Investment €350,000)] EXAMPLE 2 Equity Method Investment in Excess of Book Value 1. Blake Co. and Brown Co. are two hypothetical companies. Assume that Blake Co. acquires 30% of the outstanding shares of Brown Co. At the acquisition date, book values and fair values of Brown's recorded assets and liabilities are as follows: Book Value Fair Value Current assets €10,000 €10,000 Plant and equipment Land 190,000 140,000 120,000 €320,000 €370,000 Liabilities Book Value Fair Value Net assets €220,000 €270,000 Blake Co. believes the value of Brown Co. is higher than the book value of its identifiable net assets. They offer €100,000 for a 30% interest in Brown, which represents a €34,000 excess purchase price. The difference between the fair value and book value of the net identifiable assets is €50,000 (€270,000-220.000). Based on Blake Co's 30% ownership, €15,000 of the excess purchase price is attributable to the net identifiable assets, and the residual is attributable to goodwill. Calculate goodwill. Solution: Purchase price 30% of book value of Brown (30% x €220,000) Excess purchase price Attributable to net assets Plant and equipment (30% x €30,000) Goodwill (residual) €100.000 66,000 €34.000 69,000 Land (30% x €20.000) 6.000 19,000 €34,000 As illustrated above, goodwill is the residual excess not allocated to identifiable assets or liabilities. The investment is carried as a non-current asset on the Blake's book as a single line item (Investment in Brown, €100,000) on the acquisition date EXAMPLE 4 Equity Method with Sale of Inventory: Upstream Sale On 1 January 2018, Wicker Company acquired a 25% interest in Foxworth Company (both companies are fictitious) for €1,000,000 and used the equity method to account for its investment. The book value of Foxworth's net assets on that date was €3,800,000. An analysis of fair values revealed that all fair values of assets and liabilities were equal to book values except for a building. The building was undervalued by €40.000 and has a 20-year remaining life. The company used straight-line depreciation for the building. Foxworth paid €3,200 in dividends in 2018. During 2018, Foxworth reported net income of €20,000 During the year, Foxworth sold inventory to Wicker. At the end of the year, there was 68,000 profit from the upstream sale in Foxworth's net income. The inventory sold to Wicker by Foxworth had not been sold to an outside party. EXAMPLE 5 Equity Method with Sale of Inventory: Downstream Sale Jones Company owns 25% of Jason Company (both fictitious companies) and appropriately applies the equity method of accounting. Amortization of excess purchase price, related to undervalued assets at the time of the investment, is €8,000 per year. During 2017 Jones sold €96,000 of inventory to Jason for €160,000. Jason resold €120,000 of this inventory during 2017. The remainder was sold in 2018. Jason reports income from its operations of €800,000 in 2017 and €820,000 in 2018. 1. Calculate the equity income to be reported as a line item on Jones's 2017 income statement. Solution: Equity Income 2017 Jones's share of Jason's reported income (25% x €800,000) Amortization of excess purchase price Unrealized profit (25% x €16,000) Equity income 2017 €200,000 (8,000) (4,000) €188,000 Jones's profit on the sale to Jason €160,000 96,000 - €64,000 Jason sells 75% (€120,000/160,000) of the goods purchased from Jones, 25% is unsold. Total unrealized profit €64,000 × 25% = €16,000 Jones's share of the unrealized profit€16,000 25%-€4,000 Alternative approach: Jones's profit margin on sale to Jason: 40% (€64,000/€160,000) Jason's inventory of Jones's goods at 31 Dec 2017: €40,000 Jones's profit margin on this was 40% × 40,000-€16,000 Jones's share of profit on unsold goods €16,000 × 25% - €4,000 2. Calculate the equity income to be reported as a line item on lones's 2018 income statement. Solution: Equity Income 2018 Jones's share of Jason's reported income (25% €820,000) Amortization of excess purchase price Realized profit (25% x €16,000) Equity income 2018 €205,000 (8.000) 4,000 €201.000 Jason sells the remaining 25% of the goods purchased from Jones. EXAMPLE 6 Recognition and Measurement of Goodwill Acquirer contributes $800,000 for an 80% interest in Acquiree. The identifiable net assets have a fair value of $900,000. The fair value of the entire entity is determined to be $1 million. Fair value of consideration 80% of Fair value of identifiable net assets Goodwill recognized IFRS Partial Goodwill $800,000 720,000 $80,000 IFRS and US GAAP Full Goodwill Fair value of entity $1,000,000 Fair value of identifiable assets 900,000 Goodwill recognized $100,000 EXAMPLE 11 Receivables Securitization Odena, a (fictional) Italian auto manufacturer, wants to raise €55M in capital by borrowing against its financial receivables. To accomplish this objective, Odena can choose between two alternatives: Alternative 1 Borrow directly against the receivables; or Alternative 2 Create a special purpose entity, invest €5M in the SPE, have the SPE borrow €55M, and then use the funds to purchase €60M of receivables from Odena. Using the financial statement information provided below, describe the effect of each Alternative on Odena, assuming that Odena meets the definition of control and will consolidate the SPE. Odena Balance Sheet Cash Accounts receivable Other assets Total assets €130,000,000 Current liabilities. €27,000,000 Noncurrent liabilities Total liabilities €47,000,000 Shareholder equity €83,000,000 Total liabilities and equity €130,000,000 Alternative 1: Odena's cash will increase by €55M (to €85M) and its debt will increase by €55M (to €75M). Its sales and net income will not change. Odena: Alternative 1 Balance Sheet Cash Accounts receivable Other assets Total assets €85,000,000 €185,000,000 Current liabilities €27,000,000 75,000,000 Noncurrent liabilities. Total liabilities Shareholder equity Total liabilities and equity €102,000,000 €83,000,000 €185,000,000 Alternative 2: Odena's accounts receivable will decrease by €60M and its cash will increase by €55 (it invests €5M in cash in the SPE). However, if Odena is able to sell the receivables to the SPE for more than their carrying value (for example, €65), it would also report a gain on the sale in its profit and loss. Equally important, the SPE may be able to borrow the funds at a lower rate than Odena, since they are bankruptcy remote from Odena (i.e., out of reach of Odena's creditors), and the lenders to the SPE are the claimants on its assets (i.e., the purchased receivables). SPE Balance Sheet Accounts receivable Total assets Long-term debt €55,000,000 Equity Total liabilities and equity Because Odena consolidates the SPE, its financial balance sheet would look like the following: Odena: Alternative 2 Consolidated Balance Sheet Cash Accounts receivable €85,000,000 Other assets Total assets Current liabilities Noncurrent liabilities Total liabilities Shareholder equity €185,000,000 €27,000,000 75,000,000 €102,000,000 €83,000,000 Total liabilities and equity €185,000.000 Therefore, the consolidated balance sheet of Odena would look exactly the same