Notes

In this session, we will focus on the investing activities of the firm. Investing activities of the firm are reflected in firm's balance sheet in the form of new assets that will generate economic benefits in the future. So far, we have discussed firms' investments in long-lived assets, both tangible (PPE) and intangibles (Patents, trademarks, franchises, brands). Yet, investment in long-lived assets is not the only type of investments that firms can undertake. Firms can also decide to invest in companies.

We can distinguish between two types of investments:

• Passive Investments
• Active Investments

Passive investments are investments in other firms with the mere goal of earning a financial return. In other words, the firm has excess financial resources and decides to invest them in another firm to obtain a gain rather than keeping them inside the firm.

Instead, active investments are investments where the firm not only wants to earn a financial gain, but also influence firms' activities. Hence, they are more strategic. Examples are investments in suppliers or retailers through which the firm can influence their decisions.

Another important distinction is between:

• Debt Investments
• Equity Investments

Indeed, the firm can decide to lend money to another firm thus acting as a bank or a bondholder, or to become a shareholder by purchasing other firm's shares.

Debt investments are considered as passive investments as debtholders do not have the power and the right to influence the decision-making process. On the contrary, as a debtholder, the firm has the right to receive interests and the principal at the end of the contract. Hence, when a firm is the debtholder of another one, it has a mere financial interest in the company.

Instead, equity investments can be both active and passive investments. Indeed, as equityholder, the firm has both cash flow and voting rights. Cash flow rights imply that the firm has the right to receive dividends and the residual value at the end of the life of the firm. Yet, the influence that the company can exert (and then the extent to which the investment can be considered as active or passive) will depend on the percentage of outstanding shares purchased by the firm.

If the firm buys less than 20% of the outstanding shares, then the equity investment can be considered as passive as owning less than 20% of the outstanding shares does not allow the firm to influence firm's choices. If the firm owns between 20% and 50% of firm's outstanding shares, the firm can influence firms' decisions so that the investment can be considered as active. Finally, if the firm owns more than 50% of firm's outstanding shares, the investment allows the firm to control the other company.

Such distinctions are relevant as they determine the choice of the accounting method to use to recognize the investment in the other corporation.

In particular, in the case of debt investments, we can use:

• Amortized Cost Method if the investment is held-to-maturity. In other words, if the company wants to keep the investment until maturity, then, the investment is classified as held-to-maturity and the amortized cost is used.
• Fair Value Method if the investment is not held to maturity. If the company does not want to keep the investment until maturity, then the investment is classified either as trading (if the intent is to trade the debt securities in a short period of time) or available-for-sale (residual category) and the fair value method is used. Until 31^st^ December 2017, both equity and debt securities could be included in the category of the available-for-sale investments. Starting from 1^st^ January 2018, only debt securities can be classified as available-for-sale investments. Thus, it is like a residual category where debt securities are included if we want to sell them but not in the immediate future.

Instead, in the case of equity investments, we have:

• Fair Value Method if the equity investment is passive (that is, the firm owns less than 20% of outstanding shares).
• Equity Method if the equity investment is active but does not imply control (that is, the firm owns between 20% and 50% of outstanding shares).
• Consolidation if the equity investment is active and gives the firm the right to control the other firm (that is, the firm owns more than 50% of the outstanding shares).