1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Peter Secord Saint Mary’s University © 2003 McGraw-Hill Ryerson Limited

2. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 2 Chapter 2 Temporary, Portfolio, and Significant Influence Investments

3. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 3 Where we are going: The Big Picture Companies invest in the shares of other companies for many reasons; the relationships between companies lead to several reporting alternatives: –Temporary investments, transitory in nature –Portfolio investments, longer term, but no influence –Significant Influence investments known as “affiliates” –Controlled intercorporate investments, “subsidiaries” –Joint ventures with control shared with other companies Each of these classifications raises a series of accounting and reporting issues, and may lead to unique aspects of financial reporting

4. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 4 Where we are going: The Big Picture These unique aspects of financial reporting are the principal subject matter of the next several chapters of your text and this course. Key among the issues are: –Determination of which accounting approach(es) apply in a particular case –Understanding the terminology in use, and the impact on earnings and financial position of the various methods –Learning how to apply the various methods of accounting for intercorporate investments to both simple and complex cases

5. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 5 Temporary Investments Investments may be short term or long term –This is in part a question of management intention, and in part based on the characteristics of the investment Investments should be classified as current assets only if capable of reasonably prompt liquidation. –This ensures that only “liquid” assets are reported as current assets on the balance sheet Includes marketable equity securities, bonds, treasury bills, investment certificates, and others –Notes disclosure as to the nature and characteristics of investments, as well as their valuation, aids the users of the financial statements in assessment of the reporting company

6. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 6 Temporary Investments There are a variety of provisions which govern the accounting for, and disclosure of, temporary investments –Securities issued by affiliates should be set out separately. –The basis of valuation should be disclosed. –For marketable securities, both quoted market value and carrying value should be disclosed. –When the market value of temporary investments has declined below the carrying value, they should be carried at market value (i.e. LCM Rule is applied).

7. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 7 Temporary Investments in Annual Reports 5. CASH, CASH EQUIVALENTS AND SHORT TERM INVESTMENTS Cash, cash equivalents, short term investments, bank indebtedness and the Company’s commercial paper program form an integral part of the Company’s cash management. The Company had $1,257 (1999 – $990) in cash, cash equivalents and short term investments held by its non-Canadian subsidiaries. Short term investments are carried at the lower of cost or quoted market value and consist primarily of United States government securities, commercial paper, bank deposits and repurchase agreements. The income from these investments of $71 (1999 – $48) was included as a reduction of other interest expense. Cash and cash equivalents of $852 (1999 – $699) include short term investments with a maturity of less than 90 days, and short term investments of $418 (1999 – $312) with a maturity of greater than 90 days. Example: from the Notes for George Weston Limited, 2000

8. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 8 Temporary Investments: International View Under International Accounting Standards –Temporary investments are considered financial instruments (whether debt or equity in nature) –A distinction is made between equity instruments and monetary financial assets –Temporary investments are generally, but not always, carried at lower of cost or market value –In all cases, both carrying value and fair market value must be disclosed –Interest and dividends are reported when earned

9. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 9 Temporary Investments: International View Under US GAAP, investments are classified and accounted for as follows: –Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. –Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. –Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

10. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 10 Long-Term Investments A clear distinction is made between Temporary and Long-term investments in Canada Long-term investments are carried as non- current assets on the balance sheet The investor can own any amount of shares in the investee. –Influence varies directly with the amount of shares owned - the greater the number of shares, the greater the potential for influence

11. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 11 Long-Term Investments When only a few shares are owned (low percentage), there is unlikely to be any influence of the investor on the “investee” –Such investments are referred to as “long-term portfolio investments” and are carried at cost by the investor –Dividends are recognized as investment revenue –The carrying value of the investment is not adjusted for market fluctuations - similar to most non-current items

12. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 12 The Size of the Investment 0% ~20%~50%100% Cost Method Equity accounting Consolidation accounting Investor Ownership of Investee Common Shares

13. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 13 Long-Term Investments The cost method has wrinkles: –If there is a decline in market value of an investment, the carrying value should be written down if this decline is considered a “permanent impairment” –If the investee company pays dividends in excess of earnings (both computed on a cumulative basis since acquisition of the investment), the excess is considered a return of invested capital and the investment account will be reduced accordingly. These excess dividends received are not considered investment income; they are referred to as liquidating dividends.

14. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 14 Cost Method: Handbook Provisions The cost method should be used in accounting for portfolio investments. In the case of fixed term securities, it would be appropriate to amortize any discount or premium arising on purchase over the period to maturity. When there has been a loss in value of an investment that is other than a temporary decline, the investment should be written down to recognize the loss. The write-down would be included in the determination of income and may or may not be an extraordinary item. A write-down of an investment to reflect a loss in value should not be reversed if there is a subsequent increase in value.

15. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 15 Long-Term Investments: Equity The investor can own any amount of shares: –Influence varies directly with the amount of shares owned. significant influence controlWhen there is significant influence, but not control –The investee is referred to as an affiliate and the investment is accounted for by the equity method –The presence of influence is determined by the facts of the relationship, not by the exact percentage ownership –Transactions between the companies, interchange of knowledge management personnel, membership on boards are among the factors to be considered in establishment of the relationship

16. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 16 Long-Term Investments: Equity –Generally, small shareholdings do not lead to any significant influence and the cost method is used. In a few cases, an investor has influence over the policies of an investee even when the investor holds less than 20% of the investee’s common stock. In such cases, the equity method must be used. –Occasionally, a shareholding greater than 20% would not lead to significant influence. In such cases, the cost method must be used.

17. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 17 Long-Term Investments: Control The investor can own any amount of shares: –Influence varies directly with the amount of shares owned. controlWhen there is control, the investor and investee are referred to as parent and subsidiary –Control is determined by the facts of the relationship, not by the exact percentage shareholding - this is referred to as de facto control –“American” approach is de jure (legal) control, based on exactly 50%, and can result in very different results than Canadian practice

18. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 18 Cost Method Accounting Initial investment is recorded at cost. Investor recognizes its share of investee’s earnings distributions (dividends) as income from the investment. Dividends paid in excess of earnings reported are a reduction of the investor’s investment account (liquidating dividend) –The reduction for a liquidating dividend is based on cumulative earnings since the date of acquisition of the intercorporate investment, not just the earnings of the current year –This is to prevent companies from overstating their revenue through buying “instant earnings”

19. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 19 Equity Method Accounting Initial investment is recorded at cost. Investor recognizes its share of investee’s net income (loss) on the income statement. –Based on percentage ownership. Dividends paid by the investee are treated as a reduction of the investor’s investment account.

20. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 20 Equity Method Accounting Initial investment is recorded at cost. EXAMPLE On January 1, 2004, New Inc. buys 20% of Newer Co. for $1,000,000 cash. Prepare the journal entry to record the acquisition on New’s books.

21. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 21 Equity Method Accounting Each investment has a unique account

22. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 22 Equity Method Accounting Investor recognizes its share of investee’s net income (loss) on the income statement. –Based on percentage ownership. EXAMPLE For all of 2004, Newer’s net income was $400,000. Prepare the journal entry for New.

23. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 23 Equity Method Accounting New’s ownership percentage × Newer’s net income = 20% × $400,000 = $80,000

24. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 24 Equity Method Accounting Dividends paid by the investee are treated as a reduction of the investor’s investment account. EXAMPLE Also in 2004, Newer paid a $70,000 dividend to its shareholders. Prepare the journal entry to record New’s receipt of the dividend from Newer.

25. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 25 Equity Method Accounting New’s ownership percentage × Newer’s dividend = 20% × $70,000 = $14,000

26. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 26 Equity Method Accounting: Summary of the Investment Account The initial investment is recorded at cost. The subsidiary’s net income (loss) results in a proportional increase (decrease) in the parent’s investment account. The parent’s investment account is reduced by the amount of the dividends it receives from the subsidiary. Investment in Newer $ 1,000,000 80,000 $ 14,000 $ 1,066,000

27. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 27 Equity Method: Handbook Provisions An investor that is able to exercise significant influence over an investee that is neither a subsidiary as defined in SUBSIDIARIES, Section 1590, nor a joint venture as defined in INTERESTS IN JOINT VENTURES, Section 3055, should account for the investment by the equity method. When an investor ceases to be able to exercise significant influence over an investee, the investment should be accounted for by the cost method.

28. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 28 Equity Method: Handbook Provisions Investment income as calculated by the equity method should be that amount necessary to increase or decrease the investor's income to that which would have been recognized if the results of the investee's operations had been consolidated with those of the investor. In accounting for an investment by the equity method, the investor's proportionate share of the investee's discontinued operations, extraordinary items, changes in accounting policy, corrections of errors relating to prior period financial statements and capital transactions should be disclosed in the investor's financial statements according to their nature.

29. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 29 Equity Method: Handbook Provisions When the fiscal periods of an investor and an investee, the investment in which is accounted for by the equity method, are not coterminous, events relating to, or transactions of, the investee that have occurred during the intervening period and significantly affect the financial position or results of operations of the investor should be recorded or disclosed, as appropriate.

30. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 30 Reporting Long-Term Investments Example: Aliant Telecom –Aliant is engaged in four core lines of business: telecommunications, information technology, remote communications and emerging businesses. –Much of this business is carried out through long-term investments in subsidiaries and affiliated companies –Long-term investments in affiliate and portfolio investments (December 31, 2000), totaled over $80 million –For example, Aliant owns 29.3% of iMajicTV Inc.

31. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 31 Aliant Telecom Annual Report 2000 How should these investments be reported? Investments subject to significant Influence should be accounted for by the equity method Portfolio investments are reported by the cost method

32. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 32 Aliant Telecom Annual Report 2000 Investments –The Company accounts for its investments in affiliated companies over which it has significant influence on the equity basis of accounting, whereby the investments are initially recorded at cost, and subsequently adjusted to recognize the Company’s share of earnings or losses of the investee companies and reduced by dividends received. The excess of the cost of equity investments over the underlying book value at the date of acquisition is amortized over the estimated useful lives of the underlying assets to which it is attributed. –Portfolio investments are accounted for on the cost basis. Declines in market value below cost are recognized when such declines are considered to be other than temporary.

33. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 33 Reporting Long-Term Investments Example: Extensive disclosure is provided for portfolio and significant influence investments in both public and private companies. This disclosure includes –Descriptions of the securities held, including their cost and market value at the balance sheet date –A description of several acquisitions and dispositions which occurred in long-term investments during the year –Details of the gains involved with these dispositions, totaling $112,472,000 during the year 2000.

34. Chapter 2 © 2003 McGraw-Hill Ryerson Limited 34 Long-Term Investments: International View There are subtle difference internationally in the manner in which the equity method and the cost method are applied, and also in the determination as to when to apply one or the other of these methods The principal distinction is whether “significant influence” is the guiding factor, or whether a cut off is strictly enforced at 20% (or at some other shareholding percentage)