Module 5: Financial Statement Analysis

Intercorporate investments refer to investments made by one company in another company. The accounting treatment depends on the level of ownership and control.

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Equity Method

The equity method is used when the investor has significant influence over the investee, typically ownership between 20 percent and 50 percent.

Under this method:

• The investment is initially recorded at cost
• The investor recognizes its share of the investee’s net income
• Dividends received reduce the carrying value of the investment

Example
If a company owns 30 percent of another company, it will report 30 percent of that company’s profits in its own financial statements.

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Acquisition Method

The acquisition method is used when the investor has control, usually ownership greater than 50 percent.

Under this method:

• The parent company consolidates the financial statements of the subsidiary
• All assets and liabilities of the subsidiary are included
• Non controlling interest is reported separately

This method reflects the economic reality that the parent company controls the subsidiary.

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Business combinations occur when one company acquires another company.

These transactions are important because they significantly affect financial statements.

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Goodwill Calculation

Goodwill represents the excess amount paid over the fair value of identifiable net assets.

Goodwill Formula

Goodwill = Purchase Price − Fair Value of Net Identifiable Assets

Goodwill reflects intangible factors such as:

• brand value
• customer relationships
• intellectual property

If goodwill becomes impaired, it must be written down, which reduces reported earnings.

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Consolidation of Financial Statements

When a company acquires control of another company, it must prepare consolidated financial statements.

Key steps include:

• combining financial statements of parent and subsidiary
• eliminating intercompany transactions
• recognizing non controlling interest

Consolidation provides a complete view of the financial position of the entire group.

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Many companies operate across multiple countries and deal with different currencies.

Multinational operations introduce complexity in financial reporting due to currency fluctuations.

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Currency Translation

Currency translation involves converting financial statements of foreign subsidiaries into the reporting currency of the parent company.

Two common methods are used.

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Current Rate Method

Used when the foreign subsidiary operates independently.

• Assets and liabilities are translated at current exchange rates
• Income statement items are translated at average rates

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Temporal Method

Used when the foreign subsidiary is closely integrated with the parent company.

• Monetary items are translated at current rates
• Non monetary items are translated at historical rates

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Effects on Financial Statements

Currency fluctuations can impact:

• reported revenue and profits
• asset and liability values
• equity

Exchange rate changes may create translation gains or losses, affecting financial performance.

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