Electronic Presentations in Microsoft® PowerPoint®

Prepared by

James Myers, C.A.

University of Toronto© 2010 McGraw-Hill Ryerson Limited

Chapter 2, Slide 1© 2010 McGraw-Hill Ryerson

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Chapter 2, Slide 2© 2010 McGraw-Hill Ryerson

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Chapter 2

Investments in Equity Securities

Chapter 2, Slide 3© 2010 McGraw-Hill Ryerson

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Learning Objectives

1. To describe the broad relationship between all the relevant standards from Part I of the CICA Handbook that comprise the ‘big picture’

2. To distinguish between the various types of equity investments

3. To evaluate relevant factors to determine whether an investor has significant influence over an investee

4. To prepare journal entries to account for investments under the cost and equity methods.

5. To state the disclosure requirements related to an investment in associate.

Chapter 2, Slide 4© 2010 McGraw-Hill Ryerson

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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: intending to hold for profit

Starting January 1, 2013 IFRS 9 requires all nonstrategic investments to be reported at fair value including private companies which do not have a quoted market value. IFRS is developing a standard

for fair value measurement.

Strategic

investments

Non-strategic

investments

Significant influence

Fair value through profit and loss (FVTPL)

Control Available-for- sale (AFS)

Joint control -Market value available--Market value not available

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Chapter 2, Slide 5© 2010 McGraw-Hill Ryerson

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

Type Reporting method Reporting

unrealized gains

Significant influence Equity method Not applicable

Control Full consolidation Not applicable

Joint control Proportionate consol-idation or equity

Not applicable

FVTPL Fair value method In net income

Available-for-sale

- FMV available

- FMV not available

- Fair value method- Cost method

- In OCI- Not applicable

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Chapter 2, Slide 6© 2010 McGraw-Hill Ryerson

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Equity Investments: The Big Picture When IFRS 9 becomes mandatory in 2013, the

available-for-sale investment category disappears. However an entity will still be able to elect to report fair

value changes on an equity investment that is not held for short-term trading in other comprehensive income (OCI) This is the same treatment presently allowed for AFS

investments However unlike current treatment, when such investments are

sold accumulated gains or losses in OCI are cleared directly to retained earnings, not net income

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Chapter 2, Slide 7© 2010 McGraw-Hill Ryerson

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Equity Investments: The Big PictureDirectly related IFRSs

IFRS Description

IAS 27 – Consolidated and Separate Financial Statements

If J Company controls K Company then J is the “parent” and must consolidate K the “subsidiary” by replacing J’s investment in K with the assets and liabilities from K’s balance sheet.

Control exists if J has the power to direct the activities of K to generate returns for J.

Refer to IAS 28, IAS 31, and IAS 39 if control does not exist.

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Chapter 2, Slide 8© 2010 McGraw-Hill Ryerson

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IFRS Description

IAS 28 – Investments in Associates

An associate is an investee over which the investor exercises significant influence and is reported using the equity method.

Significant influence allows the investor to affect the strategic operating and financing policies of the investee but does not convey control or joint control

An investment of between 20% and 50% of the voting shares, without control being present, is presumed to be significant influence in the absence of contrary evidence

Equity Investments: The Big Picture

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Chapter 2, Slide 9© 2010 McGraw-Hill Ryerson

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Equity Investments: The Big PictureIFRS Description

IAS 31 – Joint Arrangements Joint arrangements (“ventures”) have two or more owners (“venturers”) that have a contractual arrangement among themselves to exercise joint control over the venture and therefore no venturer can exercise unilateral control. Report using either proportionate consolidation or the equity method

IFRS 9 – Financial Instruments – Classsification and Measurement

Nonstrategic equity investments are valued at fair value with changes reported in profit or loss

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Chapter 2, Slide 10© 2010 McGraw-Hill Ryerson

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IFRS Description

IFRS 9 – Financial Instruments – Classsification and Measurement

Nonstrategic equity investments are valued at fair value with changes reported in profit or loss.

For equity instruments not held for short-term trading an entity can elect on initial recognition to record fair value changes in OCI, while recording dividends received in income. Under this election, gains and losses on sale of the investment are cleared from OCI directly to retained earnings without being reported in profit or loss.

Equity Investments: The Big Picture

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Chapter 2, Slide 11© 2010 McGraw-Hill Ryerson

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Equity Investments: The Big PictureOther Related IFRSs

IAS 39 – Financial Instruments – Recognition and Measurement

Indicates how and when hedge accounting standards can be applied to report gains and losses on hedged and hedging items in the same period.

IFRS 3 – Business Combinations A business can obtain control either by investing in voting shares or purchasing the net assets of another business.

IFRS 8 – Operating Segments Disclosure of operating segments within consolidated financial statements.

IAS 1 – Presentation of Financial Statements

Financial statements include balance sheet (statement of financial position), and statements of comprehensive income, changes in equity, and cash flows

IFRS 12 – Income Taxes Refer to Chapters 6 and 9.

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Chapter 2, Slide 12© 2010 McGraw-Hill Ryerson

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Equity Investments: The Big PictureOther Related IFRSs

IAS 21 – The Effects of Changes in Foreign Exchange Rates

Addresses translation of the financial statements of foreign investees, subsidiaries, and joint arrangements. (Chapters 10 and 11)

IAS 36 – Impairment of Assets Applies impairment tests to all assets including investments in associates, goodwill, and intangibles. (Chapter 5)

IFRIC 16 – Hedges of a Net Investment in a Foreign Operation

Refer to Chapter 11.

SIC 12 – Consolidation – Special Purpose Entities

Refer to Chapter 9.

SIC 13 – Jointly Controlled Entities – Non-monetary Contributions by Venturers

Guidance in determining the gain that a venturer can recognize when contributing non-monetary assets to a joint arrangement (Chapter 9)

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Chapter 2, Slide 13© 2010 McGraw-Hill Ryerson

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Investments Valued at Fair ValueFair Value Through Profit and Loss (FVTPL) investments

Include investment held for short-term trading and any other investments the reporting entity wishes to designated as FVTPL

Classified as current assets since they actively trade and are intended to be sold within one year.

Recorded at fair value. Unrealized gains and losses as well as dividends received or receivable are reported in income.

Available for sale investments 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 (OCI). Dividends are recorded in income. When sold, previously unrealized gains and losses are

removed from OCI and reported in net income. Account at cost if market value is not available.

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Chapter 2, Slide 14© 2010 McGraw-Hill Ryerson

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Investments Valued at Fair Value Other comprehensive income can be presented

either at the end of one single statement of comprehensive income, or on a separate statement of other comprehensive income (OCI). In either case, both statements show “comprehensive

income” as the last line on the statement. Net income is added to retained earnings and

OCI is added to “Cumulative Other Comprehensive Income” which is a separate component of shareholders’ equity.

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Chapter 2, Slide 15© 2010 McGraw-Hill Ryerson

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Investments Not Valued at Fair Value Reported using either the cost or equity method. Cost method:

Used for available-for-sale investments when market value is not reliably measurable

Can be used to report control investments in non-consolidated separate entity financial statements (Chapter 5)

Can be used to record control investments (Chapter 5) Impairment losses are reported in net income. Dividends are reported in income. Cumulative dividends received in excess of net income since

acquisition (“liquidating dividends”) are reported in income

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Chapter 2, Slide 16© 2010 McGraw-Hill Ryerson

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Investments Not Valued at Fair Value Equity method applies to investments in associates, where

the investee has the ability to exercise significant influence. Indications of significant influence include: Representation on board of directors Participation in policy-making processes or decisions about

dividends and distributions Material transactions between investor and investee Exchange of management personnel Exchange of essential technical information

Generally holding between 20% and 50% of voting shares indicates the presence of significant influence, which can also exist with less than 20%.

Determination of significant influence requires the application of judgment.

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Chapter 2, Slide 17© 2010 McGraw-Hill Ryerson

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Investments Not Valued at Fair Value When one investor has control, other

investors usually do not have significant influence

The equity method records the investor’s share of the changes in the associate’s shareholders’ equity Adjustments are made for acquisition costs greater

than book value, unrealized intercompany profits, impairment losses, and other factors.

The equity method provides information on the potential for future cash flows

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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 (“acquisition differential”)

Eliminates after-tax unrealized intercompany profits

Investments Not Valued at Fair Value

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Chapter 2, Slide 19© 2010 McGraw-Hill Ryerson

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Equity Method Accounting Initial investment is recorded at cost

EXAMPLE

On January 1, 2010, 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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Equity Method Accounting

• Each investment has a unique account

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Equity Method Accounting Investor recognizes its share of investee’s net

operating income (loss) on the income statement Based on percentage ownership

EXAMPLE

For all of 2010, Newer’s net operating income was $400,000.

Prepare the journal entry for New.

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Chapter 2, Slide 22© 2010 McGraw-Hill Ryerson

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Equity Method Accounting

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

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Equity Method Accounting

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

EXAMPLEAlso in 2010, 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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Equity Method Accounting

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

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Equity Method Accounting: 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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Chapter 2, Slide 26© 2010 McGraw-Hill Ryerson

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Equity Method Accounting

Investee records its share of investee’s non-operating income/loss

EXAMPLEAlso in 2010, Newer recorded an discontinued

operations loss of $100,000.

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

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Equity Method Accounting

New’s ownership percentage × Newer’s discontinued operations loss = 20% × $100,000 = $20,000

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Equity Method Accounting

Investor amortizes acquisition costs paid in excess of book value (“acquisition differential”)

EXAMPLEWhen New paid $1,000,000 for Newer on January 1, 2010

Newer’s net book value was $4,000,000 (New’s 20% share = $800,000). New’s $200,000 acquisition

differential 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 acquisition

differential on New’s books for 2010.

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Chapter 2, Slide 29© 2010 McGraw-Hill Ryerson

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Equity Method Accounting

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

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Equity Method Accounting

Investor eliminates unrealized profits on intercompany transactions until the assets are sold to outsiders or consumed by the purchaser.

EXAMPLEIn 2010 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, 2010. New pays income tax at a rate of 30%

Prepare the journal entry to eliminate the unrealized intercompany profit on New’s books for 2010.

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Equity Method Accounting

Downstream sale (investor selling to investee, investor’s books reflect profit) eliminate 20% x $100,000 x 40% gross profit x (1-30% tax rate) = $5,600

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Other Equity Accounting Considerations Change from FVTPL to equity method: once

significant influence is achieved on an investment previously reflected as FVTPL, begin using equity method.

Change from equity method to FVTPL: if significant influence is lost, begin using fair value method prospectively; adjust investment to market value at date of change and at each reporting date and report adjustments to market value in profit and loss.

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Chapter 2, Slide 33© 2010 McGraw-Hill Ryerson

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Other Equity Accounting Considerations Losses Exceeding Investment Account Balance (IAS 28):

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.

If there are no such guarantees or commitments, leave investment balance at nil and begin recording future share of investee profits only after they exceed the investor’s share of previous losses not recognized.

Impairment losses (IAS 36): Compare the investment’s recoverable amount (higher of fair value less costs of selling and value in use) to its carrying amount and if recoverable amount < carrying amount, then write down to recoverable amount. Write down can be reversed if recoverable amount increases in future.

Gains and Losses on Sale of Investments: When a portion of shares held are sold, gain or loss is calculated based on average cost of shares sold, not FIFO, LIFO, or specific identification.

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GAAP for Private Enterprises CICA Handbook Part II Sections 3051 and 3856:

Permits use of either equity or cost method to account for all significant influence investments that are not publicly traded on the same basis.

Investments in and income from cost-accounted investments should be reported separately, net of any impairment losses which are reported in net income.

Allows investors to elect to report any equity investment at fair value.

Prohibits use of the cost method to account for publicly traded investments, which must be reported at fair value with changes reflected in profit and loss

Does not require amortization of the acquisition differential

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