CHAPTER 2: Investments In Equity Securities

Learning Objectives LO1 To describe the broad relationship between all the relevant standards from Part I of the CICA Handbook that comprise the ‘big picture’ LO2 To distinguish between the various types of equity investments. LO3 To evaluate relevant factors to determine whether an investor has significant influence over an investee.

Learning Objectives LO4 To prepare journal entries to account for investments under the cost and equity methods. LO5 To state the disclosure requirements related to an investment in associate. LO6 Analyze and interpret financial statements involving investments in equity securities. LO7 Identify some of the differences between IFRSs and ASPE for investments in equity securities.

Equity Investments: The Big Picture LO1,LO2 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, 2015 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 Influences Fair value through profit and loss (FVTPL) Control _____________ Joint control through joint venture Other – elect FVTOCI Available for – sale investments (AFS) Category no longer exists

Equity Investments: The Big Picture (see Exhibit 2.1) LO1,LO2 Equity Investments: The Big Picture (see Exhibit 2.1) Reporting methods for investments in equity securities Type Reporting method Reporting Unrealized gains Significant influences Equity method Not applicable Control Full consolidation Joint control through Joint venture FVTPL Fair value method In net income Other – elect FVTOCI In OCI

Equity Investments: The Big Picture LO1 Equity Investments: The Big Picture When IFRS 9 becomes mandatory in 2015, 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 on other comprehensive income (OCI) This is the same treatment previously allowed for AFS investments Entities must group items presented in OCI in two categories (net of tax) - recycled through net income - not recycled through net income

Equity Investments: The Big Picture LO1, LO2 Equity Investments: The Big Picture Directly related IFRSs IFRS Description IFRS IO: Consolidate 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 to K to generate returns for J Refer to IAS 28, IFRS 1, and IFRS 9 if control does not exist.

Equity Investments: The Big Picture LO1, LO2 Equity Investments: The Big Picture IFRS Description IAS 28: Investments in Associates And Joint Ventures 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 participate in the strategic operating and financial policies of the investees 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. Joint ventures must use the equity method

Equity Investments: The Big Picture LO1, LO2 Equity Investments: The Big Picture IFRS Description IFRS11: 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. The equity method is required when the investor has joint control over a joint venture Some other types of joint arrangement report using proportionate consolidation. (Chapter 9)

Equity Investments: The Big Picture LO1, LO2 Equity Investments: The Big Picture IFRS Description IFRS 9: Financial Instruments -- Classification and Measurement Nonstrategic equity investments are valued at fair value with changes reported in net income. 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 LO1, LO2 Equity Investments: The Big Picture IFRS Description IFRS12: Disclosure of Interests in Other Entities Disclosure requirements for investments in associates, joint arrangements, non-controlled entities and subsidiaries. Disclosure objectives that help users: Understand the judgements and assumptions used for classifying investments Understand non-controlling interest in consolidated entities Assess the nature of risks associated with interests in other entities

Equity Investments: The Big Picture LO3 Equity Investments: The Big Picture Other Related IFRS IAS 27: Separate Financial Statements A parent company does not have to issue consolidated financial statements if its parent issues consolidated Financial Statements IFRS 3: Business Combinations A business can obtain control either by investing in voting shares or purchasing the net assets of another business. (Chapter 3) IFRS 8: Operating Segments Disclosure of operating segments within consolidated financial statements (Chapter 9) IAS 1: Presentation of 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

Equity Investments: The Big Picture LO1, LO2 Equity Investments: The Big Picture Other 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) IAS 38: Intangible Assets Provides additional guidelines to IFRS 3 IFRIC 16: Hedges of a Net Investment in a Foreign Operation Refer to Chapter 11

Investments Measured at Fair Value LO1, LO2 Investments Measured at Fair Value Fair Value Through Profit and Loss (FVTPL) Investments Include investment held for short-term trading and any other investments reporting entity wishes to designate 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

Investments Measured at Fair Value LO1, LO2 Investments Measured at Fair Value Fair Value Through OCI (FVTOCI) Investments Classified as current or noncurrent assets depending on how long management intends to hold 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 transferred directly to retained earnings. IAS 39 (replaced by IFRS 9 in 2009) allowed Available For Sale (AFS) investments to clear unrealized gains to net income.

Investments Measured At Fair Value LO1, LO2 Investments Measured 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 “Accumulated Other Comprehensive Income” which is a separate component of shareholders’ equity.

Investments Not Measured at Fair Value LO3 Investments Not Measured at Fair Value Reported using either the cost or equity method Cost method: Can be used to report control investments in non-consolidated separate entity financial statements (Chapter 3) Used for available-for-sale investments when market value is not reliably measurable until 2015 (old IAS 39) Can be used to record investments in controlled entities (Chapter 5) Impairment losses are reported in net income Dividends are reported in income Prior to 2009 Cumulative dividends received in excess of net income since acquisition (“liquidating dividends”) were reported in income IAS 27 requires all dividends be reported in income

Investments Not Measured at Fair Value LO3 Investments Not Measured 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.

Investments Not Measured at Fair Value LO3 Investments Not Measured 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.

Investments Not Measured at Fair Value LO4 Investments Not Measured at Fair Value 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, comprehensive income) separately Amortizes acquisition costs greater than book value of investee (“acquisition differential”) – discussed in later chapters Eliminates after-tax unrealized intercompany profits (Chapters 6 and 7)

Equity Method Accounting LO4 Equity Method Accounting Initial investment is recorded at cost EXAMPLE On January 1, 2013, New Inc. buys 30% of Newer Co for $1,500,000 cash. Prepare the journal entry to record the acquisition On New’s books

Equity Method Accounting LO4 Equity Method Accounting Each investment has a unique account GENERAL JOURNAL Page 1 Date Description Debit Credit 1- Jan Investment in Newer Co. $1,500,000 Cash To record investment in Newer

Equity Method Accounting LO4 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 2013, Newer’s net operating income was $400,000. Prepare the journal entry for New.

Equity Method Accounting LO4 Equity Method Accounting New’s ownership percentage x Newer’s net Income = 30% x $400,000 = $120,000 GENERAL JOURNAL Page 100 Date Description Debit Credit 31-Dec Investment in Newer Co. $120,000 Investment Income to record equity in Newer net operating income

Equity Method Accounting LO4 Equity Method Accounting Dividends paid by the investee are treated as a reduction of the investor’s investment account EXAMPLE Also in 2013, Newer paid $70,000 of dividends to Its shareholders Prepare the journal entry to record New’s receipt of its portion of the dividends from Newer.

Equity Method Accounting LO4 Equity Method Accounting New’s ownership percentage x Newer’s dividend = 30% x $70,000 = $21,000 GENERAL JOURNAL Page 100 Note: If Dividends are declared debit Dividends Receivable Date Description Debit Credit 31-Dec Cash $21,000 Investment in Newer Co to record receipt of dividend from Newer Co.

Equity Method Accounting LO4 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 account. The investor’s investment account is reduced by the amount of the dividends it receives from the investee. Investment in Newer $1,500,000 120,000 $21,000 $1,599,000

Equity Method Accounting LO4 Equity Method Accounting Investee records its share of investee’s non- operating income/loss EXAMPLE Also in 2013, Newer recorded a discounted operations loss of $100,000 (net of tax) and $10,000 other comprehensive income (net of tax) Prepare the journal entry to record New’s portion of this loss from discontinued operations and other comprehensive income.

Equity Method Accounting LO4 Equity Method Accounting New’s ownership percentage x Newer’s discontinued operations loss = 30% x $100,000 = $30,000 New’s share of other comprehensive income = 30% x $10,000 = $3,000 GENERAL JOURNAL Page 100 Date Description Debit Credit 31-Dec Investment in Newer Co $ 27,000 Discontinued operations -investment loss $30,000 Other comprehensive income $ 3,000 to record discontinued loss and other comprehensive income from Newer

Equity Method Accounting LO4 Equity Method Accounting Investor amortizes acquisition costs paid in excess of book value (“acquisition differential”) EXAMPLE When New paid $1,500,000 for Newer on January 1, 2013 Newer’s net book value was $5,000,000 (New’s 30%) share = $1,200,000). New’s $300,000 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 2013

Equity Method Accounting LO4 Equity Method Accounting New’s ownership percentage x acquisition differential allocated to building / remaining life = 30% x $1,000,000 / 20 years = $15,000 ($300,000 / 20 years) GENERAL JOURNAL Page 100 Description Debit Credit 31-Dec Investment Income $15,000 Investment in Newer Co. To amortize acquisition differential re Newer Co. this is further discussed in Chapter 5

Equity Method Accounting LO4 Equity Method Accounting Investor eliminates unrealized profits on intercompany transactions until the assets are sold to outsiders or consumed by the purchaser. EXAMPLE In 2013 New sold inventory for $100,000 to Newer and recorded a 40% gross profit on the transaction. Newer’s inventory still contains all of these items on December 31, 2013. New pays income tax at a rate of 30% Prepare the journal entry to eliminate the unrealized Intercompany profit on New’s books for 2013.

Equity Method Accounting LO4 Equity Method Accounting Downstream sale (investor selling to investee, investor’s books reflect profit) eliminate 30% x $100,000 x 40% gross profit x (1-30% tax rate) = $30,000 x 40% gross profit x 70% = $8,400 GENERAL JOURNAL Page 100 Date Description Debit Credit 31-Dec Investment income $ 8,400 Investment in Newer Co. to eliminate unrealized downstream profit on sale to Newer Co. this is further discussed in Chapters 6 and 7

Other Equity Accounting Considerations LO1, LO2 Change from FVTPL to equity method: once significant influence is achieved on an investment previously reflected as FVTPL, begin using equity method prospectively. 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 fair market value in profit and loss.

Other Equity Accounting Considerations LO4 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.

Other Equity Accounting Considerations LO4 Other Equity Accounting Considerations Impairment losses (IAS 36): Compare the investment’s recoverable amount (higher of value in use and fair value less costs of disposal) 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.

Analysis and Interpretation of Financial Statements LO6 Analysis and Interpretation of Financial Statements See Exhibit 2.3 -- Impact of Reporting Methods on Key Financial Ratios (see also Self-Study 2) The FVTPL investment must be shown as a current asset, whereas the other investments could be current or noncurrent depending on management’s intentions. The FVTPL investment shows the best liquidity and profitability.

IFRS versus ASPE CICA Handbook Part II Sections 3051 and 3856: LO7 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 -- report in net income. Prohibits use of the cost method to account for publicly traded investments, which must be reported at fair value with changes reflected in net income. Does not require amortization of the acquisition differential Other comprehensive income does not exist under ASPE.