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Investment in Debt or Equity

Investment in Debt or Equity

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CHAPTER
11
Investments in Debtand Equity Securities
The cash flow associated with an investment in thesecurities of another company can be straightforward.Such an investment is usually purchased for cash,produces an annual cash flow of interest or dividendsthat can be recorded as revenue, and is sold for cash.What can be so complicated?First, the cost and market value of an investmentwill be different over the period for which it is held.If the investments can or will be sold, market valueinformation is likely far more relevant to the financialstatement user, and it is objectively determinable insecurities markets. It stands to reason that marketvalue should be recorded. The related issue is what todo with any gain or loss on the value of the investmentwhile it is held. It hasn’t been realized though a saletransaction. Is it income or not?Accounting for investments is further complicatedby the fact that investments in voting securities canrepresent more than just a passive investment under-taken to generate investment income. Long-term invest-mentsin voting shares may be used to establish anintercompany relationship through which the investorcorporation can control or significantly influence theoperating, investing, and financing strategies of theinvestee corporation. If the investor can control orinfluence the dividend policy of the investee, dividendsreceived from the investee are not the result of anarm’s-length transaction. If investment revenue wasmeasured as dividends declared, the amount couldeasily be manipulated. Furthermore, if a control rela-tionship exists, it may not be possible to grasp theactivities of the economic entity—both the investorand investee corporations—unless their records areconsolidated, or added together.In accounting for investments in the shares of othercorporations, the accounting problem is twofold:
1.
What is the nature of the investment?
2.
How can the investment, and the investment revenue,be reported to reveal the economic impact of theinvestment rather than just its legal form?We’ll explore these questions in this chapter, andprovide an overview of this complex area. Keep inmind, though, that many accounting programs devotean entire course to this issue, so what we’re doing hereis only the tip of the proverbial iceberg!
INTRODUCTION
 
609
CHAPTER 11Investments in Debt and Equity Securities
CLASSIFICATION OF INTERCORPORATE INVESTMENTS
Investment Objectives
Companies invest in the securities ofother enterprises for a variety ofreasons.The invest-ment can be a
passive investment
,meant primarily to increase investment income,or a
strategic investment
,meant to enhance operations in some way:
Investment ofIdle Cash.
Companies often have cash on hand that is not needed at presentbut will be needed in the future.Rather than allow the idle cash to remain in a low-inter-est bank account,companies find temporary investments with short terms that provide ahigher return.These investments typically have low risk and are easily converted to cash.Cash on hand can be invested in investments that may generate return through inter-est or dividends and also may be sold when market price has increased.These invest-ments will likely be ofhigher risk and/or a longer term,but the intent is to sell the invest-ment when money is needed for other activities and/or when the price is attractive.
Active Trading InvestmentPortfolio
.Some companies,primarily financial institutions,invest intrading portfolios.Securities in the portfolio are actively traded as part ofthe normal courseofbusiness,generally yielding a return because ofprice fluctuations or a dealer’s margin.
Long-Term Investments to Generate Earnings.
Cash on hand can be invested in less liq-uid securities in order to increase investment income.These investments are usually money market instruments (for example,bonds),and the intent is to keep the invest-ment until maturity.
Strategic Alliances.
An investment,especially in voting shares,may establish or cement abeneficial intercompany relationship that will increase the profitability ofthe investingcompany,both directly and indirectly.Strategic decisions may be made to invest in sup-pliers,customers,and even competitors.
Legal Frameworks.
Companies may choose to establish operations in one large companwith numerous branches,or organize activities in a set ofsmaller companies,all or par-tially controlled by a central holding company.This may be done for tax reasons,toallow outside shareholders a small stake in particular operations,to satisfy legal require-ments in particular jurisdictions,and/or to limit potential liability claims to particularportions ofthe enterprise.
CLASSIFICATION OF INVESTMENTS
Many securities are
financial instruments
under the definitions established in Section 3860ofthe
CICA Handbook 
.A financial instrument is any contract that gives rise to both a finan-cial asset ofone party and a financial liability or equity instrument ofanother party.In thecontext ofintercorporate investments,financial assets are defined as any contractual rightto receive cash or another financial asset from another company.Bonds and share invest-ment meet this definition.Investments that are financial instruments are classified according to the rules in propsosedSection 3855,“Financial Instruments—Recognition and Measurement.These classifications andrules are brand new,effective in any fiscal year beginning after 1 October 2006—that is,in the2007 fiscal year.This chapter is based on the 2003 exposure draft in this area;
strategic investments 
in shares are specifically excluded from the financial instruments sections ofthe
CICA Handbook 
,but are accorded specific attention in other sections.For those interested in the rules in place upto 2006,refer to the superceded investments chapter available on the Online Learning Centre.This section explores the classification rules in depth.The classifications that follow aresummarized in Exhibit 11-1.
DEBT VERSUS EQUITY INVESTMENTS
An investment in a debt instrumentofanother entity can be classified as available for sale,held to maturity,or a trading investment.An investment in common shares may be available for sale,held to maturity,or a trading invest-ment,or,ifstrategic,a control investment,a significant influence investment,or a joint venture.It depends on intent and circumstances.We’ll define these terms in the sections that follow.
passive investment
an intercorporate investmentin which the investor cannotsignificantly influence orcontrol the operations ofthe investee company
strategic investment
an investment in anothercompany for strategicpurposes; usually conveyscontrol or significant influenceor is a joint venture
 
Held-to-Maturity Investments
Held-to-maturity 
investments must meet three tests:
First,rather obviously,the securities must have a maturity date.This includes bonds andother money market instruments,but excludes common shares and any other invest-ment with an indeterminate length.
The securities must have fixed or determinable payments:set amounts at set points in time.
Management must have the positive intent to hold the investments to their maturity dates.For example,ifa company buys a bond with a 10-year maturity date,and managementplans to hold it until maturity,it is classified as a held-to-maturity security.On the otherhand,ifmanagement stands ready to sell the investment ifthe price is appealing or ifthecompany needs cash,then the bond is an available-for-sale investment.Ifmanagement plansfor the investment are
undecided 
,the investment is available for sale.This is the meaningofpositive intent—there must be an
active will 
to hold to maturity.
MANAGEMENT INTENT
Management intent can be a slippery classification tool.Management can change its intentions,or even misrepresent its intentions.This reducesthe credibility ofthe financial statements,and future management representations.
RECLASSIFICATION OR SALE
Reclassification,or sale,ofa held-to-maturity investment calls the integrity ofthe original classification into question.Therefore,[Ifthe company] ...has sold or reclassified more than an insignificant amountofheld-to-maturity investments in the past two years,then no securities can beclassified as held-to-maturity.(
CICA
ED 3855)Ofcourse,there are a few exceptions to this sweeping prohibition—for example,ifthere was
an isolated event (e.g.,a change in tax law or a major business combination) that causedthe reclassification or sale;
610
CHAPTER 11Investments in Debt and Equity Securities
EXHIBIT 11-1
CLASSIFICATION OF INVESTMENTS
StrategicJoint VentureControlSignificantInfluencePassiveTradingAvailable-for-SaleHeld-to-Maturity
held-to-maturity investments
those investments that havea defined maturity date, fixedor determinable payments,and for which there is posi-tive intent to hold to maturity

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