Chapter 2 Electronic Presentations in Microsoft ® PowerPoint ® Prepared by James Myers, C.A....

Chapter 2

Electronic Presentations in Microsoft® PowerPoint®

Prepared by

James Myers, C.A.

University of Toronto© 2008 McGraw-Hill Ryerson Limited

Chapter 2© 2008 McGraw-Hill Ryerson Limited

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Chapter 2

Investments in Equity Securities


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Learning Objectives

– To describe the broad relationship between all the relevant sections of the CICA Handbook that comprise the ‘big picture’

– To distinguish between held-for-trading, available-for-sale, and significant influence investments

– To apply the basic concepts behind the cost and equity methods

– To prepare equity method entries to amortize the purchase discrepancy


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Learning Objectives

– To prepare equity method journal entries to reflect unrealized profits on asset transfers

– To explain the concepts involved with differential reporting


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Equity Investments: The Big Picture

• Companies invest in the shares of other companies for strategic reasons (intending to maintain a long-term relationship) and non-strategic reasons.

• There are 5 types of intercorporate investment

– Significant influence

– Control– Joint control (joint venture)– Held-for-trading– Available-for-sale

• Each type is accounted for differently

Strategic

investment

Non-strategic

investment

Significant influence

Held-for-trading

Control Available-for- sale

Joint control (joint venture)


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Equity Investments: The Big PictureReporting methods for investments in equity securities

Type Reporting method Recording unrealized gains

Significant influence Equity method Not applicable

Control Full consolidation Not applicable

Joint control Proportionate consolidation

Not applicable

Held-for-trading Fair value method In net income

Available-for-sale

- FMV available

- FMV not avail.

-Fair value method- Cost method

- In other comp. inc.- Not applicable


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Equity Investments: The Big PictureDirectly related Handbook Sections

Handbook Section Description

1590 – “Subsidiaries” If J Company controls K Company then J is the “parent” and must consolidate K the “subsidiary”

3051 – “Investments” Report significant influence investments by the equity method reflecting investor’s pro rata share of investee earnings/ loss adjusted for purchase discrepancy & elimination of un-realized intercompany profits between investor and investee.


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Equity Investments: The Big Picture•

Handbook Section Description

3055 – “Investments in Joint Ventures” (JV’s)

JV exists where owners (“venturers”) have a contractual arrangement establishing joint control over the venture. Each venturer uses the proportionate consolidation method to report its investment in the JV.

3855 – “Financial Instruments – Recognition and Measurement”

Held-for-trading and available-for-sale investments recorded at cost and subsequently revalued at fair value. No revaluation for available-for-sale investments for which market value is not available.


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Equity Investments: The Big PictureOther Related Handbook Sections:• Section 1300: “Differential Reporting”• Section 1530: “Comprehensive Income”• Section 1581: “Business Combinations”• Section 1600: “Consolidated Financial

Statements”• Section 1625: “Comprehensive Revaluation of

Assets and Liabilities”• Section 1651: “Foreign Currency Translation”• Section 1701: “Segmented Disclosures”


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Equity Investments: The Big PictureOther Related Handbook Sections (cont’d):• Section 3062: “Goodwill and Other Intangible

Assets”• Section 3465: “Income Taxes”• Section 3475: “Discontinued Operations”• Section 3865: “Hedges”• Accounting Guideline 15: “Consolidation of

Variable Interest Entities”• EIC Abstracts: various


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Investments Valued at Fair ValueHeld for trading investments (Handbook 3855)• Classified as current assets since they actively

trade and are intended to be sold within one year.• Unrealized gains and losses are reported in income

together with dividends received or receivable.Available for sale investments (Handbook 3855)• Classified as current or noncurrent assets

depending on how long management intends to hold on to these shares.

• Unrealized gains/losses are recorded in other comprehensive income. Dividends are recorded in income.

• Account at cost if market value is not available.


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Investment Valued at Fair Value• Other comprehensive income comprises

revenues, expenses, gains and losses that are required to be included in comprehensive income, but excluded from net income, and includes such items as:– Gains and losses on available-for-sale securities– Gains and losses on derivatives designated as

cash flow hedges– Unrealized gains and losses on translating

financial statements of self-sustaining foreign operations

• Cumulative other comprehensive income is a separate component of shareholders’ equity


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Investments Not Valued at Fair Value

• Sections 3855 and 3051 cover two types of investments which will not be valued at fair value and describe two methods of accounting for them.

• The two types are (i) available-for-sale investments for which a quoted market price in an active market is not available and (ii) significant influence investments.


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Investments Not Valued at Fair Value• Available-for-sale With No Quoted Market Value –

if a quoted price in an active market is not available, then these investments are reported at cost. Cost is reduced for any permanent impairment in value, and for any dividends received greater than investee’s net incomes since acquisition (liquidating dividends).

• Significant Influence Investment – is an investment in the voting shares of a corporation that permits the investor to exercise significant influence over the strategic operating, financing, and investing policies of the investee. At the same time, however, it does not establish control or joint control over that investee. These investments are accounted for using the equity method.


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Investments Not Valued at Fair Value• The following conditions are possible

indicators that significant influence is present:– The ability to elect members to the board of

directors– The right to participate in the policy-making

process– Significant intercompany transactions between the

two companies– The size of ownership of the other shareholders of

the investee– Exchange of management and technology

between the two companies


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Investments Not Valued at Fair Value• Section 3051 suggests that a holding

between 20 percent and 50 percent may indicate the presence of significant influence, but it also states that a holding of this size does not necessarily mean that such influence exists.

• It is also possible that holding less than 20 percent could also result in significant influence, for example if the remaining shares of the investee are widely distributed with no one holding a block of greater size.


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Additional Features Associated with the CICA Equity Method

• Using the equity method, the investor:– records its proportionate share of the investee’s

operating income as its own operating income– reduces the investment account by its share of

investee dividends received – Records its proportionate share of the investee’s

non-operating income (e.g. discontinued operations, extraordinary items) separately

– Amortizes acquisition costs greater than book value of investee (“purchase discrepancy”)

– Eliminates after-tax unrealized intercompany profits


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Equity Method Accounting

• Initial investment is recorded at cost

EXAMPLE

On January 1, 2008, New Inc. buys 20% of Newer Co. for $1,000,000 cash.

Prepare the journal entry to record the acquisition on New’s books.


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• Each investment has a unique account


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• Investor recognizes its share of investee’s net operating income (loss) on the income statement– Based on percentage ownership

EXAMPLE

For all of 2008, Newer’s net operating income was $400,000.

Prepare the journal entry for New.


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New’s ownership percentage × Newer’s net income = 20% × $400,000 = $80,000


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• Dividends paid by the investee are treated as a reduction of the investor’s investment account

EXAMPLEAlso in 2008, Newer paid $70,000 of dividends to its

shareholders.

Prepare the journal entry to record New’s receipt of the its portion of the dividends from Newer.


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• New’s ownership percentage × Newer’s dividend = 20% × $70,000 = $14,000


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Equity Method Accounting: Summary of Investment Account Basics

• The initial investment is recorded at cost• The investee’s net income (loss) results in a proportional

increase (decrease) in the investor’s investment account • The investor’s investment account is reduced by the amount of

the dividends it receives from the investee.

Investment in Newer $ 1,000,000 80,000 $ 14,000 $ 1,066,000


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Equity Method Accounting• Investee records its share of investee’s

non-operating income/loss

EXAMPLEAlso in 2008, Newer recorded an extraordinary

loss of $100,000.

Prepare the journal entry to record New’s portion of this extraordinary loss.


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• New’s ownership percentage × Newer’s extraordinary loss = 20% × $100,000 = $20,000


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Equity Method Accounting• Investor amortizes acquisition costs paid in

excess of book value (“purchase discrepancy”

• EXAMPLEWhen New paid $1,000,000 for Newer on January 1, 2008 Newer’s net book value was $4,000,000 (New’s 20% share = $800,000). New’s $200,000 purchase discrepancy was attributable entirely to a building

owned by Newer, with a 20-year remaining life, the fair value of which was $1,000,000 greater than its

book value.Prepare the journal entry to amortize the purchase

discrepancy on New’s books for 2008.


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• New’s ownership percentage × purchase discrepancy allocated to building / remaining life = 20% × $1,000,000 / 20 = $10,000


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Equity Method Accounting• Investor eliminates unrealized intercompany

profits:

• EXAMPLEIn 2008 New sold inventory for $100,000 to Newer and

recorded a 40% gross profit on the transaction. Newer’s inventory still contains these items on

December 31, 2008. New pays income tax at a rate of 30%

Prepare the journal entry to eliminate the unrealized intercompany profit on New’s books for 2008.


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• Downstream sale (investor selling to investee, investor’s books reflect profit) eliminate 100% x $100,000 x 40% gross profit x (1-30% tax rate) = $28,000


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Other Equity Accounting Considerations

• Changes to and from the equity method: once significant influence is achieved, begin using equity method, leaving any previously recorded gains and losses in other comprehensive income until the investment is sold. If significant influence is lost, begin using cost method prospectively, adjusting investments with market values available to fair value at each reporting date.

• Loss in market value of investment: if permanent impairment is evident, write down investment to fair value. Do not reverse write-down if fair value subsequently increases, record increase only on sale.


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Other Equity Accounting Considerations

Continued:• Losses Exceeding Investment Account Balance: EIC-

8 indicates that if investor has guaranteed investee’s obligations or is committed to providing additional financial support, continue recording losses and reflect negative investment balance as a liability; otherwise leave investment balance at nil.

• Gains and Losses on Sale of Investments: When a portion of shares held are sold, book value of shares sold is calculated using average cost not FIFO, LIFO, or specific identification.


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Differential Reporting

• Section 1300 – this section on differential reporting was issued effective January 1, 2002 and allows a qualifying enterprise to select which reporting options it will apply when it prepares its financial statements. – Qualifying enterprises are those whose shares

and debt do not trade on public markets and whose owners unanimously consent to use the differential reporting options.


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• Significant influence investments – the differential reporting option available is:– A qualifying enterprise may elect to use the cost

method to account for its investments in companies subject to significant influence that would otherwise be accounted for by the equity method in accordance with Section 3051

• All investments in companies subject to significant influence should be accounted for using the same method


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• Investments in companies subject to significant influence accounted for using the cost method should be presented separately in the balance sheet

• Income from those investments should be presented separately in the income statement

• An enterprise that has applied the alternative method should disclose the basis of accounting used to account for investment in companies subject to significant influence

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