A good understanding of accounting rules and treatments is the backbone of quality financial analysis. Whether you’re an established analyst at a large investment bank, working on a corporate finance advisory team, new to the financial industry, or still learning the basics in school, understand how Companies accounting for different investments, liabilities and other positions is critical in determining the value and future prospects of any business. In this article, we will look at the different categories of intercompany investments and how to account for them in the financial statements.
Key points to remember
- Intercompany investments refer to investments that one company makes in another.
- Intercompany investments are generally classified under generally accepted accounting principles (GAAP) into three categories: investments in financial assets, investments in associates and business combinations.
- The accounting treatment for intercompany investments depends on the classification of the assets, described as held to maturity, held for trading or available for sale.
- A company that has an influential investment in an associated company, typically a 20% to 50% interest, will account for its investment using the equity method.
- When accounting for business combinations, the company will use the acquisition method.
Intercompany investments are made when companies invest in the equity or the debt of other companies. The reasons why one company would invest in another are many, but could include the desire to access another market, to increase its asset basewin a competitive advantageor simply increase profitability through a stake (or creditor) in another company.
Intercompany investments are generally classified according to the percentage of ownership or voting control that the investing company (investor) commits to the target company (investing entity). These investments are therefore generally classified in generally accepted accounting principles (GAAP) in three categories: investments in financial assets, investments in associates and business combinations.
Investments in financial assets
An investment in financial assets is generally classified as having an equity interest of less than 20% in the target company. Such a position would be considered a “passive” investment because, in most cases, an investor would not have significant influence or control over the target company.
Upon acquisition, the invested assets are recorded on the balance sheet of the investing company balance sheet at just value. As time passes and the fair value of assets changes, the accounting treatment will depend on the classification of the assets, described as held to maturity, held for trading or available for sale.
Held to maturity
Held to maturity (HTM) refers to debt securities intended to be kept until maturity. Long-term securities will be reported at amortized cost on the balance sheet, with interest income reported on the target company’s income statement.
Held for trading
Held for trading refers to stocks and debt securities held with the intention of being sold for profit in the short term, usually three months. They are recorded on the balance sheet at their fair value, with just value changes (realized and unrealized) being declared in the income statement, as well as any interest or dividend Income.
Available for sale
Available for sale Securities are debt or equity securities acquired by a company with the intention of keeping them for an indefinite period or selling them before maturity. They can be a temporary investment that a business makes for various reasons. For example, a company may use these investments to provide a higher return to shareholders, manage interest rate exposure, or meet liquidity requirements.
In 2016, the Financial Accounting Standards Board (FASB) has changed the accounting treatment of available-for-sale securities. Under FASB Accounting Standards Updates No. 2016-01, all changes in the fair value of equity securities will be included in net income rather than other comprehensive income (OCI). This change came into effect for public companies as of December 15, 2017.
Choice of classification
The choice of classification is an important factor when analyzing financial asset investments. US GAAP does not allow companies to reclassify investments that were originally classified as held for trading or designated as investments at fair value. Therefore the accounting choices made by investing companies when they invest in financial assets can have a major effect on their financial statements.
Investments in associates
An investment in a associated is generally between 20% and 50% ownership. Although investment is generally considered non-controlling, such participation would be considered influential, due to the investor’s ability to influence the management team, business plan and policies of the company. issuing entity, as well as the possibility of being represented within the issuing entity. board of directors.
An influential investment in an associate is accounted for using the equity method compatible. The initial investment is recorded on the balance sheet at cost (fair value). The investee’s subsequent profits are added to the equity stake in the investing company’s balance sheet (in proportion to the ownership), with dividends paid by the investee reducing this amount. Dividends received from the entity owned by the investor are, however, recorded in the income statement.
The equity method also provides for the recognition of Good will paid by the investor upon acquisition, goodwill being defined as any premium paid beyond the book value identifiable assets of the issuing entity. Additionally, the investment should also be periodically tested for impairment. If the fair value of the investment falls below the value on the balance sheet (and is considered permanent), the asset must be depreciated. A joint venture, in which two or more companies share control of an entity, would also be accounted for using the equity method.
An important factor that must also be taken into account for the purposes of investments in associates is intercompany transactions. Since such an investment is accounted for using the equity method, transactions between the investor and the investee can have a significant impact on the financial statements of both companies. For both, upstream (investor-owned entity) and downstream (investor to investee), the investor must account for its proportionate share of the profits of the investee from any intercompany transaction.
Keep in mind that these treatments are general guidelines, not hard and fast rules. A company that exercises significant influence over an investee with an ownership interest of less than 20% should be classified as an investment in an associate. A company with a 20% to 50% stake that shows no signs of significant influence could be classified as having only an investment in financial assets.
Business combinations are classified into one of the following categories:
- Merger: A merger refers to the time when the acquiring company absorbs the acquiree, which, as of the acquisition, will cease to exist.
- Acquisition: A acquisition refers to when the acquiring business, as well as the newly acquired business, continues to exist, usually in parent-subsidiary roles.
- Consolidation: Consolidation refers to when the two companies combine to create an entirely new company.
- Special purpose entities: A special purpose entity is an entity usually created by a corporate sponsor for a single purpose or project.
When accounting for business combinations, the acquisition method is used. Under the acquisition method, the assets, liabilities, income and expenses of businesses are combined. If the ownership interest of the head quarter is less than 100%, it is necessary to record a minority interest account on the balance sheet to recognize the amount of the subsidiary not controlled by the absorbing company. The purchase price of the subsidiary is recognized at cost on the balance sheet of the parent company, any goodwill (purchase price over book value) being recognized as an unidentifiable asset.
In the event that the fair value of the subsidiary falls below the book value on the parent company’s balance sheet, an impairment charge must be recorded and reported in the income statement.
When reviewing the financial statements of companies with intercompany interests, it is important to monitor accounting treatments or classifications that do not appear to correspond to the realities of the business relationship. Although such cases should not automatically be considered “tricky accounting”, being able to understand how accounting classification affects a company’s financial statements is an important part of financial analysis.