Intercorporate Investments

5 minutes 5 Questions

Intercorporate investments involve one company investing in the equity of another, influencing its financial and operational policies. In the context of the Chartered Financial Analyst (CFA) Level 2 curriculum and Financial Statement Analysis, understanding intercorporate investments is crucial for…

Intercorporate Investments: A Comprehensive Guide for CFA Level 2 Candidates

Why Intercorporate Investments are Important:
Intercorporate investments are a crucial topic in the CFA Level 2 curriculum, particularly in the Financial Statement Analysis section. Understanding how companies invest in and influence each other is essential for analysts to accurately assess the financial health and performance of a company. Intercorporate investments can have significant impacts on a company's financial statements, and candidates must be able to interpret and analyze these investments to make informed decisions.

What are Intercorporate Investments?
Intercorporate investments refer to the ownership stakes that one company holds in another company. These investments can take various forms, such as common stock, preferred stock, or debt securities. The level of ownership and influence that the investing company has over the investee company determines how the investment is classified and accounted for in the financial statements.

How Intercorporate Investments Work:
There are three main types of intercorporate investments:
1. Investments in financial assets: These are passive investments where the investor has no significant influence over the investee. They are reported at fair value on the balance sheet, with changes in fair value recorded in the income statement or other comprehensive income, depending on the classification.
2. Investments in associates: These investments provide the investor with significant influence over the investee, typically with a 20-50% ownership stake. They are accounted for using the equity method, where the investor records its share of the investee's net income and adjusts the carrying value of the investment accordingly.
3. Investments in subsidiaries: These investments give the investor a controlling stake (usually >50%) in the investee. The investee's financial statements are consolidated with the investor's, and non-controlling interests are reported separately.

How to Answer Questions on Intercorporate Investments in an Exam:
1. Identify the type of intercorporate investment based on the ownership percentage and level of influence.
2. Determine the appropriate accounting treatment for the investment (fair value, equity method, or consolidation).
3. Analyze the impact of the investment on the investor's financial statements, including the balance sheet, income statement, and cash flow statement.
4. Consider any additional information provided in the question, such as transaction dates, fair values, or impairment indicators, and incorporate them into your analysis.

Exam Tips: Answering Questions on Intercorporate Investments
- Pay close attention to the ownership percentages and the level of influence the investor has over the investee, as these factors determine the accounting treatment.
- Be familiar with the key differences between the fair value, equity, and consolidation methods, and how they impact the financial statements.
- Watch for triggers that may require a change in accounting treatment, such as an increase or decrease in ownership stake or a loss of significant influence.
- Practice time management and prioritize questions based on their difficulty and point value to maximize your score.

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CFA Level 2 - Intercorporate Investments Example Questions

Test your knowledge of Intercorporate Investments

Question 1

Company A holds a 25% equity interest in Company B, which it acquired for $500,000. Company B reported net income of $300,000 and paid dividends of $50,000 during the current year. Under the equity method, what should Company A record as its share of Company B's net income and dividends for the year?

Company A should record $75,000 as its share of Company B's net income ($300,000 x 25%) and $50,000 as its share of dividends, as the full amount of dividends paid by Company B should be recognized by Company A under the equity method. Company A should record $75,000 as its share of Company B's net income ($300,000 x 25%) and $12,500 as its share of dividends ($50,000 x 25%), adjusting the carrying value of the investment accordingly. Company A should record $62,500 as its share of Company B's net income ($300,000 x 25% x 10/12) and $10,417 as its share of dividends ($50,000 x 25% x 10/12), assuming the investment was held for 10 months during the year, and the income and dividends should be prorated accordingly.

Correct Answer: Company A should record $75,000 as its share of Company B's net income ($300,000 x 25%) and $12,500 as its share of dividends ($50,000 x 25%), adjusting the carrying value of the investment accordingly.

Under the equity method, an investor records its proportionate share of the investee's net income and dividends. In this case, Company A holds a 25% equity interest in Company B. Company A's share of Company B's net income = $300,000 x 25% = $75,000 Company A's share of Company B's dividends = $50,000 x 25% = $12,500 Therefore, Company A should record $75,000 as its share of Company B's net income and $12,500 as its share of dividends, adjusting the carrying value of the investment accordingly.

Question 2

Company P acquires a 30% interest in Company Q for $6 million. At the acquisition date, the carrying value of Company Q's net assets is $15 million. The fair value of Company Q's identifiable net assets is $18 million, and the excess purchase price over the fair value of net assets is attributable to goodwill. How much should Company P record as goodwill related to its investment in Company Q under the equity method?

$1,800,000, representing the difference between the fair value and carrying value of Company Q's net assets $3,000,000 $900,000

Correct Answer: $900,000

The correct answer is $900,000. Here's the step-by-step explanation: Company P acquires a 30% interest in Company Q for $6 million. The fair value of Company Q's identifiable net assets is $18 million. Goodwill is calculated as the difference between the purchase price and the investor's proportionate share of the fair value of the investee's identifiable net assets. Purchase price: $6 million Company P's share of fair value of net assets: 30% × $18 million = $5.4 million Goodwill: $6 million - $5.4 million = $600,000 Therefore, Company P should record $600,000 as goodwill related to its investment in Company Q under the equity method.

Question 3

When a company purchases 10% of the outstanding voting shares of another company and does not have the ability to exercise significant influence over the investee, how should the investment be accounted for?

The investment should be accounted for using the cost method, with dividends received from the investee recognized as income when declared. The investment should be accounted for using the equity method, recognizing a proportionate share of the investee's net income or loss and adjusting the carrying value of the investment accordingly. The investment should be accounted for as a consolidated subsidiary, with the investee's assets, liabilities, revenues, and expenses combined with those of the investor in the consolidated financial statements.

Correct Answer: The investment should be accounted for using the cost method, with dividends received from the investee recognized as income when declared.

When a company purchases 10% of the outstanding voting shares of another company and does not have the ability to exercise significant influence over the investee, the investment should be accounted for using the cost method. Under the cost method, the investment is recorded at cost, and any dividends received from the investee are recognized as income when declared. The equity method is not appropriate in this case because the investor does not have the ability to exercise significant influence over the investee, which is typically presumed when the investor holds 20% or more of the voting stock. The threshold for using the equity method is higher than the 10% ownership stated in the question. Consolidation is also not appropriate because the investor does not have a controlling financial interest in the investee, which is required for consolidation. The 10% ownership stake does not provide the investor with control over the investee.

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