You are on page 1of 36

Advanced Financial Accounting

RSM 321

Class 1
Ch. 2—Investments in Equity Securities

1
Objectives
 These lecture notes are not meant to be a substitute for the pre-
assigned readings or problems. They merely highlight the points we
will cover.
 In each lecture, we will address the how, why, and so what of each
topic. How means how to prepare the numbers, why means why
does this follow from first principles/theory, and so what means why
should users care if we do it that way (i.e. what is the potential
user/use impact.) This is mainly a “how” course, but you will be
rewarded on the exams for the underlying “whys” and “so whats”.)

2
Equity Investments: The Big Picture

 Companies invest in the Strategic Non-strategic


shares of other companies: investments investments
 Strategic investments:
intending to maintain a long- Significant Fair value
term relationship, and influence through profit
 Non-strategic investments: and loss
held for short-term trading
(FVTPL) and not held for short- (FVTPL)
term trading (FVTPL or, if Control Fair value
irrevocably elected, FVTOCI) through OCI
(FVTOCI)
Joint control

3
Equity Investments: The Big Picture
Reporting 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 Equity method Not applicable

FVTPL Fair value method In net income

FVTOCI Fair value method In OCI (elaboration to


follow in these slides)

4
Equity Investments: The Big Picture
Reporting methods for investments in equity securities
 Starting January 1, 2018, IFRS 9 requires all nonstrategic
investments to be reported at fair value including private
companies which do not have a quoted market value. Early
adoption is permitted.
 IFRS has developed a new standard for fair value measurement,
IFRS13
 Until then, IAS 39 applies and its requirements for non-strategic
investments are briefly explained later in these lecture notes.
For the midterm or final, you are responsible for IFRS 9, not
IAS 39.
 ASPE 3856 IFRS 9
 Note: For this course you are only responsible for IFRS and
not ASPE; however, you may want to familiarize yourself with
ASPE for preparation of professional exams in the future.

5
Equity Investments: The Big Picture
Directly related IFRSs
IFRS Description
IFRS 10 – Consolidated If J Company controls K Company
Financial Statements 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.

ASPE 1591 &1601 IFRS 10 ASPE 1591.24 allows either the cost
method or the equity method or full
consolidation for subsidiaries.
6
Equity Investments: The Big Picture
IFRS Description
IAS 28 – Investments in An associate is an investee over
Associates 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

ASPE 3051 IAS 28


7
Equity Investments: The Big Picture
IFRS Description
 IAS 28 – Joint ventures In a joint arrangement, participants
contribute resources to carry out a specific
IFRS 11 – Joint arrangements undertaking. Joint control is a key feature,
meaning that no one venturer can
unilaterally control the venture regardless
of the size of equity contribution. Joint
operations and joint ventures are two types
of joint arrangements. In joint operations,
the venturers contribute the use of assets
but retain title to the assets. In joint
ventures, the venturers contribute assets
to a separate legal entity, which has title to
the assets. IAS28 requires the equity
method for joint ventures. IFRS 11 requires
proportionate consolidation for joint
operations (More on this in class 9).

ASPE 3056 IAS 28,IFRS


8
11
Equity Investments: The Big Picture
IFRS Description

IAS 39 – Financial Instruments – Deals with non-strategic equity investments


FVTPL (fair value through profit and loss)
Recognition and Measurement
and AFS (available for sale). FVTPL
(since now replaced by IFRS 9, we investments are initially reported at fair
will be brief) value and subsequently revalued at fair
value at each reporting date via the income
statement.
AFS investments are valued at fair value,
unrealized gains and losses are reported in
other comprehensive income. When the
investment is sold, the previously reported
unrealized gains and losses will be
removed from OCI into net income.
Exception: fair value not readily
determinable – cost method used.

9
Investments Valued at Fair Value (IFRS 9)
Fair Value Through Profit and Loss (FVTPL) investments
 Includes investments held for short-term trading.
 Also includes investments not held for short-term trading (called AFS
under IAS 39) if FVTOCI election not made.
 FVTPL investments held for short-term trading are classified as
current assets.
 Recorded at fair value. Unrealized gains and losses as well as
dividends received or receivable are reported in income.
Fair Value Through OCI (FVTOCI) investments
 Includes investments not held for short-term trading (called AFS
under IAS 39) if irrevocable FVTOCI election made.
 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, cumulative
unrealized gains/losses are cleared out of cumulative OCI and
transferred directly to retained earnings.

10
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.

11
The Cost Method
 Used for available-for-sale investments when market value is not
reliably measurable under IAS 39, but no longer permitted under
IFRS 9.
 Still permitted under ASPE so you must know how cost method
works.
 Can be used to report control investments in non-consolidated
separate entity financial statements (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.

12
Equity Method
 Equity method applies to investments in associates,
where the investor 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. 20% is not a hard and fast rule.

13
Equity Method
 When one investor has control, other investors may
or may not have significant influence depending on
representation on board, participation in decisions,
etc. Must look to facts, use judgement (IAS 28).
 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.

14
Equity Method
 Under the equity method, the timely recognition of losses (or profits)
in the investee facilitates both the stewardship and cash flow
prediction objectives. Since investor has some say, share of profits
or losses belong in investor’s income statement (stewardship
scorecard idea).
 With respect to prediction, the equity method reflects the accrual
method of income measurement. It is more predictive of future cash
flows than the cost method (ex/ investee losing money but declares
dividend, cost method and equity method provide very different
signals about future cash flows).
 We do not use fair value methods for SI investments because these
are long term operating assets. We do not use fair value accounting
under IFRS GAAP for operating assets.

15
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 share of the investee’s non-operating
income (e.g. discontinued operations) separately
 Amortizes acquisition costs greater than book value of
investee (“acquistion differential”) through either
amortization or, for goodwill, overall impairment losses
for equity account (see below for elabotarion)
 Eliminates after-tax unrealized intercompany profits

16
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.

17
Equity Method Accounting

• Each investment has a unique account

GENERAL JOURNAL Page 1


Date Description Debit Credit
1-Jan. Investment in Newer Co. $ 1,000,000
Cash $ 1,000,000
to record investment in Newer

18
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.

19
Equity Method Accounting

New’s ownership percentage × Newer’s net


income = 20% × $400,000 = $80,000

GENERAL JOURNAL Page 100


Date Description Debit Credit
31-Dec. Investment in Newer Co. $ 80,000
Income on equity investment $ 80,000
to record equity in Newer net
operating income

20
Equity Method Accounting

 Dividends paid by the investee are treated


as a reduction of the investor’s investment
account.

EXAMPLE
Also 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.
21
Equity Method Accounting

 New’s ownership percentage × Newer’s


dividend = 20% × $70,000 = $14,000

GENERAL JOURNAL Page 100


Date Description Debit Credit
31-Dec. Cash $ 14,000
Investment in Newer Co. $ 14,000
to record receipt of dividend
from Newer Co.

22
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
 The following equation may help understand the difference between equity and fv
methods. This is also further illustrated in tutorial problem 2-5.
 Initial investment:
 = share of net assets (i.e. NAV) at FV + share of GW
 = share of book owners equity (1) + FV increments (2) + share of GW (3)
 Equity method does not record gains related to (2) and (3), FV method does.

Investment in Newer
$ 1,000,000
80,000 $ 14,000
$ 1,066,000
23
Equity Method Accounting

 Investee records its share of investee’s


non-operating income/loss.

EXAMPLE
Also in 2010, Newer recorded a discontinued
operations loss of $100,000.
Prepare the journal entry to record New’s
portion of this discontinued operations loss.

24
Equity Method Accounting

 New’s ownership percentage × Newer’s


discontinued operations loss = 20% ×
$100,000 = $20,000

GENERAL JOURNAL Page 100


Date Description Debit Credit
31-Dec. Investment loss, discontinued ops $ 20,000
Investment in Newer Co. $ 20,000
to record loss on discontinued operations
from Newer Co.

25
Equity Method Accounting

 For finite life assets, investor amortizes acquisition costs paid in excess of
book value (“acquisition differential”)
 EXAMPLE
When 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 acquistion 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.

Using our formula:


Initial investment= share of book OE + share of FVI’s + share of GW
$1,000,000= $800,000 + $200,000 + $0

Prepare the journal entry to amortize the acquisition differential on New’s


books for 2010.

26
Equity Method Accounting

 New’s ownership percentage × acquisition


differential allocated to building / remaining
life = 20% × $1,000,000 / 20 = $10,000.
GENERAL JOURNAL Page 100
Date Description Debit Credit
31-Dec. Investment income $ 10,000
Investment in Newer Co. $ 10,000
to amortize purchase
discrepancy re Newer Co.

27
Equity Method Accounting

 Investor eliminates its share of unrealized profits


or losses on intercompany transactions until the
assets are sold to outsiders or consumed by the
purchaser.
EXAMPLE
In 2010 New sold inventory for proceeds of $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.
28
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
GENERAL JOURNAL Page 100
Date Description Debit Credit
31-Dec. Investment income $ 5,600
Investment in Newer Co. $ 5,600
to eliminate unrealized
downstream profit on sale to
Newer Co.

29
Equity Method Accounting

 Why do we eliminate investor share of unrealized profit?


 Ans: arm’s length concept within GAAP. Investor is
deemed to be dealing with unrelated investors at “arm’s
length” so investor can recognize their share of any
unrealized profits or losses on upstream or downstream
transactions (IAS 28 para 28). Later in the course, when
the investor has control, 100% of the unrealized gain on
upstream and downstream transactions are eliminated.
More of this in Chapters 6 and 7.

30
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 to its carrying amount and if recoverable < carrying then
write down to recoverable amount. Recoverable amount is the
higher of value in use (PV of future cash flows) and fair value less
costs to sell. Write down may in effect write down goodwill acquired.
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 or specific identification.

31
Changes To and From Equity Method
 Change From FVTPL to Equity When SI Obtained
 New equity method carrying value is fair value carrying value when
switch occurs.
 Illustrated later in course (step-by-step acquisitions). Also illustrated in
P2-2 .
 Change from Equity to FVTPL When No Longer Have SI
 This is illustrated in the King/Queen case assigned for Class 3.
 Difference between equity method carrying value and fair value at time
switch occurs goes to income. Thereafter, use FVTPL method.
 Investor’s share of investee’s cumulative OCI recycled to income at time
of switch.

32
Equity Method Requirements Under ASPE
 According to ASPE 3051.06,07 , investments in associates are
accounted for using either the cost method or the FVTPL method or
the equity method.

33
Summary Slide – FVTPL/FVTOCI/Cost/Equity

FVTPL FVTOCI Cost Equity

DR Investment (B/S DR Investment (B/S DR Investment (B/S DR Investment (B/S


Initial purchase account) CR Cash account) CR Cash account) CR Cash account) CR Cash

DR Investment (B/S
account) CR Investment
Earnings NONE NONE NONE Income

DR Cash CR Dividend DR Cash CR Dividend DR Cash CR Dividend DR Cash CR Investment


Dividends income income income (B/S account)

none; unless there is an none; unless there is an


impairment loss in which impairment loss in which
DR (CR) Investment (B/S case DR Impairment Loss case DR Impairment Loss
Change in fair value account) CR (DR) DR (CR) Investment (B/S CR Investment (B/S CR Investment (B/S
(year over year) Investment income account) CR (DR) OCI account) account)

34
For Next Week’s Tutorial

 Try:
 P 2-2
 P 2-4: equity and cost method accounting
 P 2-5: FVTPL/investment in associate/fair-value-
through-OCI

35
Tutorial (some things to consider)
 The concepts below are illustrated in Self-Study problem 2. Study it
before reading this slide or trying P2-5.
 accrual and “cash income” the same over entire life of an investment
 “cash income” = cash disposal proceeds plus cash dividends minus
initial cash paid
 Tell me why FVTPL income = cash income over entire life
 Tell me why cost method income = cash income over entire life
 Tell me why FVTOCI income incl. OCI income = cash income over
entire life
 Equity method income = share of NI + gain on disposal
 = share of NI + (cash disposal proceeds – initial cash paid – share of NI
+ cash dividends)
 = cash income over entire life

36