AA Hamlen 4e - PPT - Ch01 Final PPT Slides 082918

ADVANCED ACCOUNTING
4th Edition
Susan S. Hamlen
University at Buffalo, The State University
of New York
Cambridge Business Publishers

CHAPTER 1
Intercorporate Investments:
An Overview
Cambridge Business Publishers, ©2019

Motivations for Intercorporate Investments
 As a temporary investment of excess cash or part of a

longer-term portfolio
 Expectations of interest income, dividends and gains
 As a strategic investment
 Develop relationships with suppliers and customers
 Gain access to new product or geographic markets
 To facilitate activity along the supply chain

The Coca-Cola Company’s Investments
 December 31, 2016 balance sheet

 Debt securities of nearly $5 trillion
 Equity securities over $2 trillion
 Investments with significant influence
 Investments in bottling companies
 29% interest in Coca-Cola Amatil
 Joint ventures
 50/50 venture with Nestlé
 Controlling interests
 Nearly 60 companies worldwide

Types of Investments
for Reporting Purposes
Trading
Controlling Available-
interest for-sale
Derivatives Held-to-maturity
(hedges)
Equity No significant
influence equity
method securities

Fair Value Option
 ASC Topic 825 allows companies to elect the fair value

option for eligible intercorporate investments
 Investments reported at fair value
 Value changes reported as part of income
 Option available only for noncontrolling investments
This chapter assumes the company

did not elect the fair value option.

Learning Objective 1
Describe the reporting for

intercorporate debt investments and
intercorporate equity investments
with no significant influence.

Examples of Debt and Equity Investments
with No Significant Influence
Debt Securities Equity Securities
Commercial
Common stock
paper
Corporate
Preferred stock
bonds
Redeemable Put and Call

preferred stock options

Debt Securities (ASC Topic 320)
 Divides debt investments with readily determinable

market values into three categories:
Trading Available-for-Sale Held-to-Maturity

Investments Investments Investments

Trading Investments
 Reported on balance sheet as current assets at fair

value
 Income statement reports:
 Gains/losses as market prices change
 Interest income as earned

Accounting for Trading Investments
Securities owned:
Total cost = $800,000
To record purchase of trading securities costing $800,000—

2018
Oct. 15 Investment in trading securities 800,000
Cash 800,000

To record the sale of trading security C for $214,000—

2018
Dec. 5 Cash 214,000
Investment in trading securities 200,000
Gain on sale of trading securities (income) 14,000
To record the unrealized value change for securities A and B—

Security Cost Year-End Value Unrealized Gain (Loss)
A $100,000 $125,000 $25,000 gain
B 500,000 485,000 $15,000 loss
2018
Dec. 31 Investment in trading securities 25,000
Unrealized gain on trading securities (income) 25,000
Dec. 31 Unrealized loss on trading securities (income) 15,000

To record the sale of trading securities A and B—

Security Cost Year-End Value Date Sold Selling Price Realized Gain (Loss)
A $100,000 $125,000 1/15/19 $120,000 $(5,000)
B 500,000 485,000 1/15/19 496,000 $11,000.
Security A—
2019
Jan 15 Cash 120,000
Loss on sale of trading securities (income) 5,000
Security B—
2019
Jan 15 Cash 496,000
Gain on sale of trading securities (income) 11,000
 Gains and losses are reported in income as the value of

the securities changes
 No impairment testing is necessary since all changes in
value flow through income
 No difference in accounting between a “normal” decline in
value and a decline characterized as “impairment”

Available-for-Sale Investments
 Balance sheet
 Reported as current or noncurrent assets at fair value
 Unrealized gains/losses reported in accumulated other
comprehensive income
 Income statement reporting
 Realized gains/losses
 Interest income

Journal Entries for
AFS investments:
Total cost = $800,000
To record purchase of investments costing $800,000—

2018
Oct. 15 Investment in AFS securities 800,000
Cash 800,000

Journal Entries for
To record the sale of AFS security C for $214,000—

2018
Dec. 5 Cash 214,000
Investment in AFS securities 200,000
Gain on sale of AFS securities (income) 14,000
To record the unrealized value change for securities A and B—

Security Cost Year-End Value Unrealized Gain (Loss)
A $100,000 $125,000 $25,000 gain
B 500,000 485,000 $15,000 loss
2018
Dec. 31 Investment in AFS securities 25,000
Unrealized gain on AFS securities (OCI) 25,000
Dec. 31 Unrealized loss on AFS securities (OCI) 15,000
Journal Entries for
2018 Year-End Date Selling Realized

Security Cost Value Sold Price Gain (Loss)
A $100,000 $125,000 1/15/19 $120,000 $20,000.
B 500,000 485,000 1/15/19 496,000 $(4,000)
To record the sale of AFS security A—

2019
Jan 15 Cash 120,000
Reclassification of gain on AFS securities (OCI) 25,000
Gain on sale (income) 20,000
To record the sale of AFS security B—

2019
Jan 15 Cash 496,000
Loss on sale (income) 4,000
Reclassification of loss on AFS securities (OCI) 15,000

Impairment Testing for AFS Securities
 Required because impairment losses are reported

differently from “normal” losses.
 ASC 326: debt security is impaired if its fair value is below
its cost.
 Loss is reported in income and as a direct reduction in the
investment balance if not recoverable
 Investor plans to sell security before loss recovered
To record $15,000 decline in value of AFS security B at December 31,
2018—
2018
Dec. 31 Impairment loss on security B (income) 15,000
Impairment Testing of AFS Securities
 If the investor plans to hold security and not sell it before

loss is recovered, impairment loss is divided in two parts:
 Credit losses are reported in income and reduce investment
through an allowance account and are reversible through
income
 Market-related losses are reported in OCI and direct reduction
in investment balance
 Credit losses relate to a decline in investee’s ability to
pay principal and interest
 Market-related losses are caused by rising market
interest rates
 Suppose $15,000 decline in value of AFS security B at

December 31, 2018 is a credit loss
 Loss is reported in income
 Allowance is set up as a contra to the investment account
Impairment loss on AFS securities (income) 15,000

Allowance for credit losses (Security B) 15,000

 Credit loss impairment is the difference between cost and market

value
 Unrealized gains and losses previously reported in OCI are
reclassified to income
 Suppose have AFS investment originally purchased for $160,000,
now carried at $200,000. Value declines to $90,000 due to credit
losses.
 Impairment loss of $70,000 reported in income
 $40,000 gain reclassified from AOCI
 Investment adjusted to cost of $160,000
 Allowance of of
Reclassification $70,000 setsecurities
gain on AFS up as contra
(OCI) to investment account
40,000
Impairment loss on AFS securities (income) 70,000
Allowance for credit losses 70,000

Held-to-Maturity Investments
 Reported at amortized cost

 Discount or premium amortized over time
 No gains or losses unless sold prior to maturity
 Early sale requires extreme circumstances
 Only interest income appears on income statement
Income Statement
Other income/losses:
Interest income $ xx

Journal Entries for HTM Investments
Example
A company purchased a $1 million face value, 5% corporate bond

on January 1, 2018 for $965,349, yielding 6%. Interest is paid
annually on December 31. Maturity is December 31, 2021.
To record the purchase of HTM securities—

2018
Jan. 1 Investment in HTM securities 965,349
Cash 965,349
To record the receipt of interest income for 2018—

2018
Dec. 31 Cash $1,000,000 x 5% 50,000
Investment in HTM securities $57,921 ̶ $50,000 7,921
Interest income 57,921
$965,349 x 6%

Example
$1 million, 5% face value corporate bond for $965,349, yielding 6%.

Carrying value at December 31, 2018: $965,349 + $7,921 = $973,270
2019
$1,000,000 x 5%
Dec. 31 Cash 50,000
$973,270 x 6%

2020
Dec. 31 Cash $1,000,000 x 5% 50,000
$981,666 x 6%
Example
$1 million, 5% face value corporate bond for $965,349, yielding 6%.

2021
$1,000,000 x 5%
Dec. 31 Cash 50,000
$990,566 x 6%
Carrying value at December 31, 2021; $990,566 + $9,434 = $1,000,000

To record the receipt of face value bonds at maturity—
2021
Dec. 31 Cash 1,000,000
Investment in HTM securities 1,000,000
Impairment Testing for HTM Investments
 Required because normally HTM investments are

carried at amortized cost
 Allowance account measures expected credit losses
over life of investment (CECL model)
 Changes in expected credit losses (increases or
decreases) are reported in income

Recording an Impairment Loss
Example
An investor owns an HTM security carried at amortized cost. At

the end of 2019, the investor determines that it is probable that
all amounts due according to the contractual terms of the security
will not be collected. The credit loss is estimated to be $300,000.
To record the impairment—

2019
Dec. 31 Impairment loss on HTM securities (income) 300,000
Allowance for credit losses 300,000

Equity Securities (ASC Topic 321)
 No significant influence over the investee

 Investments with readily determinable fair values
follow same reporting as trading debt securities
 Reported at fair value on balance sheet
 Changes in value reported in income as incurred
 No need for impairment testing

Explain the reporting for equity method

intercorporate investments.

Investments with Significant Influence
 Two accounting options exist

 Elect to use the ASC Topic 825 fair value option, or
 Apply the equity method (ASC Topic 323)
 Investor must exert significant influence over operating
and financing decisions of the investee

When is Significant Influence Present?
 Representation on the investee’s board

 Involvement in investee operating and financial policies
 Significant transactions between investor and investee
 Guideline: 20% to 50% ownership
 BUT significant influence can exist with less than 20%
ownership
 AND significant influence may not exist even with 20%-50%
ownership
 Key issue: Significant influence

Accounting Using the Equity Method
Investment performance reflects the investee’s

performance.
Equity Method Investment
Increases
Cost of investment
Investor's share of investee's Investor's share of investee's

income and OCI gains losses and OCI losses
Decreases
Dividends declared
by investee
Ending balance
Investment changes in proportion to the investee’s

retained earnings and AOCI accounts.
Equity Method
Example
Suppose Coca-Cola acquires 30% of Rocky Mountain Bottler’s stock
(300,000 shares) for $12 million. During the first year, the investee
reports net income of $2 million and declares and pays dividends of
$0.50/share.
To record the purchase of equity investment—
Investment in Rocky Mountain Bottlers 12,000,000
Cash 12,000,000
To record dividends declared; $0.50 x 300,000—

Dividends receivable 150,000
Investment in Rocky Mountain Bottlers 150,000
To record dividends paid—

Cash 150,000
Dividends receivable 150,000
To accrue earnings of investee; 30% x $2,000,000 = $600,000—

Equity in net income of Rocky Mountain Bottlers (Income) 600,000
Equity Method
Example
Suppose Rocky Mountain Bottlers (the investee) reported $200,000

in unrealized gains on AFS securities, its only OCI item.
To record share of investee’s OCI (unrealized gains on AFS securities);

30% x $200,000 = $60,000—
Unrealized gains on AFS investments (OCI) 60,000
Change in investee’s equity = $2,000,000 ̶ $500,000 + $200,000

= $1,700,000
Change in equity method investment = $600,000 ̶ $150,000 +
$60,000 = $510,000, or 30% of the change in the investee’s equity.
Equity Method
Example
Coca-Cola (investor) acquired 30% of Rocky Mountain Bottler’s

(investee) stock (300,000 shares) for $12 million. During the first
year, Rocky Mountain reported net income of $2 million, declared
and paid dividends of $0.50/share, and reported $200,000 in
unrealized gains on AFS securities.
Investment in Equity in Net Income of
Rocky Mountain Bottlers Rocky Mountain Bottlers
12,000,000 600,000
600,000 150,000
60,000
12,510,000 600,000
Balance Sheet as Income Statement

long-term asset
Equity in Net Income
 Adjustments to reported net income may be required

 If investment cost differs from investee’s book value:
 Adjustment required: Amortize investment cost in excess of book
value acquired
 If investor and investee transact business with each other:
 Adjustment required: Remove intercompany profit that is not yet
earned

Adjustments to Equity in Net Income
 Adjustments should be made for depreciation and

amortization on revaluations of:
 Tangible assets, and
 Limited life intangible assets
EXCEPTIONS
No adjustments for goodwill impairment or
impairment of other indefinite life intangibles.

Inventory Sales
Between Investee and Investor
Downstream Sales
Investor sells inventory to investee
Upstream Sales
Investee sells inventory to investor
Both companies record sales Both companies report

as if selling to outside Results in gross margin as part
customers. of income.
If inventory not sold to Investor must remove

unrelated outside party when calculating equity
at year-end, gross margin in net income
is not yet earned. of investee.
Revaluations
Example
Suppose on January 1, 2019, Rocky Mountain Bottlers reports total

assets of $80 million and total liabilities of $50 million, for a net
book value of $30 million. Coca-Cola paid $12 million for 30% of
Rocky Mountain’s shares. Analysis indicates that Rocky Mountain
has unreported technology valued at $5 million and its plant and
equipment is undervalued by $1 million. Plant and equipment has a
remaining life of 10 years as of January 2, 2019 and uses straight-line
depreciation. The previously unreported technology is a limited life
intangible asset with a 5-year life.
Price paid $12,000,000
Share of Rocky Mountain’s net assets acquired:
Book value (30% x $30,000,000) $9,000,000
Revaluation of plant & equipment (30% x $1,000,000) 300,000
Unreported technology (30% x $5,000,000) 1,500,000 10,800,000
Additional investment cost (goodwill) $ 1,200,000

Unconfirmed Inventory Profits
Example
Suppose Rocky Mountain Bottlers sells canned beverages to Coca-

Cola upstream at a 20% markup on cost. Coca-Cola holds $210,000
of this inventory at year-end. Coca-Cola sells finished products to
Rocky Mountain downstream at a 25% markup on cost. Rocky
Mountain holds $100,000 of this inventory at year-end.
How much is unconfirmed profit?
Unconfirmed gross profit on $210,000 upstream sales:

$210,000 ̶ ($210,000 / 1.20) = $35,000
Unconfirmed gross profit on $100,000 downstream sales:
$100,000 ̶ ($100,000 / 1.25) = $20,000
Recognition of Adjusted Equity
in Net Income for 2019
Coca-Cola’s share of Rocky Mountain’s reported

2019 income (30% x $2,000,000) $600,000.
Adjustments for revaluation write-offs:
Plant and equipment (30,000) $300,000 / 10
Previously unreported technology (300,000)
Adjustments for unconfirmed inventory profits: $1,500,000 / 5
Upstream sales (10,500)
Downstream sales (6,000) 30% x $35,000
Equity in net income of Rocky Mountain $253,500.
30% x $20,000
2019
Dec. 31 Investment in Rocky Mountain Bottlers 253,500
Equity in net income of Rocky Mountain Bottlers 253,500

Investee Losses
Equity Method Investments
 Equity in losses may exceed the carrying value of the

investment
 If losses are considered temporary, they are recorded
even though investment account balance becomes
negative
 If losses are not considered temporary
 Use of equity method suspended when investment account
balance reaches zero
 If investee reports future profits, equity method applied
once investor’s share of profits equals its share of losses
during the suspension period
Impairment Testing
 Impairment testing required for equity method

investments (ASC Topic 323)
 Criteria
 Fair value of the investment declines below its carrying
value, and
 The decline is other than temporary
 Accounting requirements
 Investment is written down and a loss is recognized on the
investor’s income statement
 Subsequent increases are ignored

Change to Significant Influence
 An investor may acquire significant influence in an

equity investment currently reported as having no
significant influence
 Change to equity method handled prospectively
 When significant influence obtained, cost of transaction
leading to significant influence added to current balance of
investment account
 Investor applies equity method going forward

Joint Ventures
 An entity formed by a group of individuals or firms

that contributes resources and jointly shares in
managing and controlling the venture
 Often established for a short-term, single business
transaction or activity
 Enables expertise, special technology, capital, access to
markets to be combined
U.S. companies use the equity method

for joint ventures.

Describe the reporting for

controlling interests in other companies.

Controlling Investments
 Investor has control over the operating and financial

decisions of the investee
 Three investment structures
 Merger, consolidation, or asset acquisition
 Stock acquisition
 Variable interest entity
 Assets, liabilities, revenues, and expenses are combined
with those of the investor for financial statement
reporting

Mergers, Consolidations,
and Asset Acquisitions
 Investor directly acquires the assets and liabilities of

the investee
 Assets and liabilities recorded directly on investor’s
balance sheet at fair value
Merger Consolidation
Occurs when the investor acquires Occurs when a new entity is
the investee and becomes the formed to acquire both the
remaining legal entity. investor and the investee.
Asset Acquisition
Occurs when an investor acquires
a subset of the investee’s assets.
Merger
Example
Coca-Cola acquires all of Rocky Mountain Bottler’s assets and

liabilities in a merger by paying $40 million in cash on Jan. 2, 2019.
Fair values are: Current assets, $20 million; plant and equipment,
$61 million; current liabilities, $15 million; and long-term debt, $35
million. Coca-Cola identified and valued Rocky Mountain’s
previously unreported intangibles asset, technology, at $5 million.
Price paid $40,000,000
Fair value of identifiable net assets acquired:
Current assets $20,000,000.
Plant and equipment 61,000,000.
Technology 5,000,000.
Current liabilities (15,000,000)
Long-term debt (35,000,000) 36,000,000
Goodwill $ 4,000,000

Merger
Example
To record the acquisition of Rocky Mountain Bottlers—

Current assets 20,000,000
Plant and equipment 61,000,000
Technology 5,000,000
Goodwill 4,000,000
Current liabilities 15,000,000
Long-term debt 35,000,000
Cash 40,000,000

Stock Acquisitions
 Occurs when an investor obtains control over another

company by investing in its voting stock
 Investee remains a separate legal entity
The separate
financial records
are consolidated
at the end of
PARENT each reporting
The investor SUBSIDIARY period.
The acquired company
(investee)
Stock Acquisition
Example
Assume Coca-Cola acquires and holds all of the voting stock of

Rocky Mountain Bottlers, paying the former stockholders of Rocky
Mountain $40 million cash.
Investment in Rocky Mountain Bottlers 40,000,000

Cash 40,000,000
This is the entry Coca-Cola makes on its own books,

but its annual report shows Coca-Cola and
Rocky Mountain’s combined accounts as if Coca-Cola
recorded the acquisition as a merger.

Change to Controlling Interest
 Investor may hold a significant interest equity investment and

then purchase more shares to obtain control.
 Example: Coca-Cola holds a 25% interest in ABC Bottler’s stock,
reported at $1,000,000 using the equity method.
 Fair value of investment is $1,500,000
 Coca-Cola purchases the remaining 75% interest for $5,000,000
 Accounting:
 Revalue equity method investment to fair value, report gain/loss in income
 Acquisition cost of 100% interest = fair value of 25% interest + cash paid
for additional 75% interest
Investment in ABC Bottler (Equity method) 500,000
Gain in equity method investment (Income) 500,000
Investment in ABC Bottler 6,500,000

Cash 5,000,000
Investment in ABC Bottler (Equity method) 1,500,000
Variable Interest Entities (VIEs)
 Investee is a separate legal entity controlled by another

company
 Control occurs through legal relationships rather than
stock ownership
 Entity is considered to be a VIE if:
 The entity must obtain guarantees from other parties in
order to obtain financing, or
 The equity holders do not have the usual rights and
responsibilities of equity ownership, such as voting and
residual return rights
Issue of Control with VIEs
 Consequences of control
 Must have the power to direct the VIE’s activities
 Must absorb the majority of the VIE’s risks and rewards
 Reporting is the same as for stock investments
Voting rights are not an indicator

of controlling a VIE.

Discuss International Financial

Reporting Standards (IFRS)
for intercorporate investments.

IFRS for Debt Investments and Equity
Investments with No Significant Influence
 Requirements for classification/measurement,

impairment and hedging found in IFRS 9 (effective in
2018)
 Significant differences between IFRS 9 and US GAAP:
 Credit losses on debt instruments reported at FV-OCI and
amortized cost are calculated differently
 Under IFRS, loss is based on expected credit losses over next 12
months (unless there is “significant deterioration” of credit quality)
 IFRS allows FV-OCI treatment for equity investments with no
significant influence
 Gains (losses) not reclassified to income when security sold
IFRS for Significant Influence Investments
 Investee is defined as an associate

 Principles-oriented view to significant influence
 Representation on the investee’s board
 Participation in policy-making process
 Material transactions between the investor and the investee
 Interchange of managerial personnel
 Provision of essential technical information

IFRS for Significant Influence Investments
 Equity method required

 Similar to U.S. GAAP procedures
 Impairment testing
 Test for impairment if significant events indicate possible
impairment
 Compare the investment carrying value with the higher of its
market value or value-in-use
 Value-in-use is the present value of the investment’s future
expected cash flows
Possible differences in impairment loss recognition
between IFRS and U.S. GAAP.
IFRS for Joint Ventures
 IFRS 11
 Two kinds of joint arrangements:
 Joint operations (rights to entity’s assets and liabilities)
 Joint ventures (rights to entity’s returns and disposal value)
 Joint ventures are most common
 Reported using the equity method

IFRS for Controlling Investments
 IFRS 3(R) describes IFRS for valuing acquired assets and

liabilities, and consolidation procedures
 Similar to U.S. GAAP
 IFRS 10: When should an entity be consolidated?
Control occurs when investor has all of the following:
 Power to direct the activities that significantly affect the
investee’s returns
 Exposure to variable returns from investee
 Ability to use power to affect the amount of investor’s
returns
IFRS for Controlling Investments
 IFRS 10 applies to all control relationships

 Investments in stock of a company
 Control achieved through contractual relationships
Should an entity controlled through a financial

relationship be consolidated?
Possible differences between IFRS and U.S. GAAP.

Cambridge Business Publishers
www.cambridgepub.com

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ADVANCED ACCOUNTING

Cambridge Business Publishers

Cambridge Business Publishers, ©2019

 As a temporary investment of excess cash or part of a

Cambridge Business Publishers, ©2019

 December 31, 2016 balance sheet

Cambridge Business Publishers, ©2019

Cambridge Business Publishers, ©2019

 ASC Topic 825 allows companies to elect the fair value

This chapter assumes the company

Cambridge Business Publishers, ©2019

Describe the reporting for

Cambridge Business Publishers, ©2019

Debt Securities Equity Securities

Redeemable Put and Call

Cambridge Business Publishers, ©2019

 Divides debt investments with readily determinable

Trading Available-for-Sale Held-to-Maturity

Cambridge Business Publishers, ©2019

 Reported on balance sheet as current assets at fair

Cambridge Business Publishers, ©2019

Total cost = $800,000

To record purchase of trading securities costing $800,000—

Cambridge Business Publishers, ©2019

To record the sale of trading security C for $214,000—

To record the unrealized value change for securities A and B—

Dec. 31 Unrealized loss on trading securities (income) 15,000

To record the sale of trading securities A and B—

 Gains and losses are reported in income as the value of

Cambridge Business Publishers, ©2019

Cambridge Business Publishers, ©2019

Total cost = $800,000

To record purchase of investments costing $800,000—

Cambridge Business Publishers, ©2019

To record the sale of AFS security C for $214,000—

To record the unrealized value change for securities A and B—

2018 Year-End Date Selling Realized

To record the sale of AFS security A—

To record the sale of AFS security B—

Cambridge Business Publishers, ©2019

 Required because impairment losses are reported

 If the investor plans to hold security and not sell it before

 Suppose $15,000 decline in value of AFS security B at

Impairment loss on AFS securities (income) 15,000

Cambridge Business Publishers, ©2019

 Credit loss impairment is the difference between cost and market

Cambridge Business Publishers, ©2019

 Reported at amortized cost

Cambridge Business Publishers, ©2019

A company purchased a $1 million face value, 5% corporate bond

To record the purchase of HTM securities—

To record the receipt of interest income for 2018—

Cambridge Business Publishers, ©2019

$1 million, 5% face value corporate bond for $965,349, yielding 6%.

Carrying value at December 31, 2019: $973,270 + $8,396 = $981,666

$1 million, 5% face value corporate bond for $965,349, yielding 6%.

Carrying value at December 31, 2021; $990,566 + $9,434 = $1,000,000

 Required because normally HTM investments are

Cambridge Business Publishers, ©2019

An investor owns an HTM security carried at amortized cost. At

To record the impairment—

Cambridge Business Publishers, ©2019

 No significant influence over the investee