Intermediate Accounting
Thomas H. Beechy
Schulich School of
Business,
York University
Joan E. D. Conrod
Faculty of Management
Dalhousie University
Powerpoint slides by:
Michael L. Hockenstein  Commerce Department • Vanier College
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Investments in Debt and Equity Securities
Chapter 12
12-2
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Introduction
 Investments usually are

purchased for cash and thus
have a known cost that is
recorded as an asset
The investment typically
produces an annual cash flow of
interest or dividends that can be
recorded as investment revenue
12-3
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Introduction (cont.)



What is the nature of an investment
in the securities of another
corporation?
How can the investment be reported
to reveal the economic impact of the
investment rather than just its legal
form?
Market value rather than cost of the
securities might be a lot more
important to the people who use the
financial statements
12-4
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Investment Objectives
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
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Temporary investment of idle cash
Long-term investments to generate earnings
Strategic alliances
Legal frameworks
Accounting for investments is dictated by how the
investment is classified, which in turn is dependent
on management’s intentions, and also on the
substance of the security itself
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Classification and Definition
 An investment in debt securities (whether
temporary or long term) is accounted for as a
passive investment
 passive investment: an inter-corporate
investment in which the investor cannot significantly
influence or control the operations of the investee
company
12-6
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Classification and Definition (cont.)
 An investment in the shares of another
company can be either a passive investment or
a strategic investment
 Passive investments:
 temporary or short-term investments
 long-term portfolio investments
12-7
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Classification and Definition (cont.)
 Strategic investments:
an investment that gives the investor control
over the subsidiary
an investment that gives the investor
significant influence over the affairs of the
investee corporation
a joint venture
12-8
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Exhibit 12-1
12-9
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Accounting For Investments
 There are four ways to account for
investments:
cost method
equity method
consolidation method
proportionate consolidation method
12-10
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Exhibit 12-2
12-11
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Classification of Investments
 An investment in debt securities is classified as a
temporary investment if both of the following
conditions are satisfied:
 the investment matures within the next year (or
operating cycle) or is capable of reasonably prompt
liquidation (either by sale on the open market or
sale to a financial institution)
 the investment is intended by management to be a
temporary use of cash
 If these two conditions are not satisfied, the
investment is classified as a long-term
investment
12-12
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The Nature of Portfolio Investments
 Portfolio investments: long-term investments in


debt or equity security
Long-term debt investments are always classified as
portfolio
Portfolio equity investments are long-term investments
that do not convey significant influence or control, and
are not joint ventures
12-13
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The Nature of Controlled Investments
 The CICA Handbook defines “control” as the
continuing power to determine…strategic
operating, investing and financing policies (of
the other enterprise) without the co-operation
of others [CICA 3050.04]
12-14
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The Nature of Significant Influence
Investments
 The CICA Handbook cites the following
possible indications of significant influence:
the ability to exercise significant influence may be
indicated by, for example, representation on the
board of directors, participation in policy-making
processes, material intercompany transactions,
interchange of managerial personnel or provision of
technical information [CICA 3050.04]
12-15
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The Nature of Joint Venture
Investments
 A joint venture:
an economic activity
resulting from a contractual arrangement
whereby two or more venturers jointly control
the economic activity [CICA 3055.03]
12-16
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Accounting by the Cost Method
 The investment is recorded at its acquisition
cost, including transaction costs such as
brokerage fees or service charges, but excluding
any accrued interest
 Interest revenue on interest-bearing debt
securities is recognized as it accrues, at the
nominal rate of interest; dividend income on
shares are recognized only when the issuing
corporation has declared the dividends
12-17
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Accounting by the Cost Method (cont.)
 At sale or maturity, any difference between
the proceeds received and the recorded cost
(plus accrued interest, if any) is recorded as
a gain or loss
 Interest-bearing debt securities that are
purchased between interest dates are
recorded at their market price, plus accrued
interest since the last interest payment date
12-18
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Accounting by the Cost Method (cont.)
 Amortization of premium or discount
 Basket purchases of securities
 Investments made in a foreign currency
12-19
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Amortization of Premium or Discount




What happens if debt securities are bought for
an amount other than face value, for example, at
98 or 104?
The investment is recorded at its cost, which is
greater or less than the face amount of the debt
Temporary investment---carrying value stays at the
acquisition cost
Portfolio investment, “it would be appropriate to
amortize any discount or premium arising on
purchase over the period to maturity” [CICA
3050.19]
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Amortization of Premium or Discount (cont.)
 General practice is to amortize the acquisition
premium or discount on a fixed-term debt
instrument over the remaining life of the
instrument if:
 it is the intent of management to hold a marketable
financial instrument to maturity
 the instrument is not marketable, and therefore the
investor must hold it to maturity
 the instrument is intentionally structured with a zero
or token interest rate and is intended by the issuer
to be sold at a deep discount
12-21
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Basket Purchases of Securities
 Basket purchase:

a purchase of two or more
classes of securities for a single lump sum
The total purchase price must be allocated to the
different types of securities, the general principles
being:
 when the market price of each class of security is
known, the proportional method of allocation is
used
 if the market price is not known for a class of
security, the incremental method is used
12-22
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Basket Purchases of Securities (cont.)
 Proportional method:
the total cost is allocated
in proportion to the market values of the various
securities in the basket
 Incremental method:
the purchase price is
allocated first to the securities with known prices, and
then the remainder of the lump-sum purchase
price is attributed to the class of investment
that does not have a market price
12-23
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Investments Made in a Foreign Currency
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

The purchase price must be converted into Canadian
dollars for recording on the Canadian investor’s books
and reporting in the investor’s financial statements
To record the purchase, the exchange rate, on or
about the date of purchase, is used
Investments in debt instruments that are denominated
in a foreign currency must be restated to their current
equivalent amount in Canadian dollars at each
balance sheet date
12-24
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Disclosure for Passive Investments
 For both temporary investments and portfolio
investments the CICA Handbook has
recommended disclosure only of the following:
the basis of valuation (e.g., cost), and
the quoted market value of any marketable
securities that are included in temporary
investments or portfolio investments
12-25
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Disclosure For Passive Investments (cont.)
 Recommended disclosure is expanded to
include extensive disclosures for financial
assets, by class:
significant terms and conditions
interest rate risk
credit risk
fair value
12-26
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Lower of Cost or Market
 When the value of an investment falls below
its acquisition cost, an economic loss has
occurred
 Accounting practice on recognition of the loss
varies, however, depending on whether the
investment is classified as temporary or longterm
12-27
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Lower of Cost or Market (cont.)
 If the investment is temporary, the loss is

recognized by applying the lower of cost or
market (LCM) rule to the temporary investment
portfolio as a whole
If the investment is long-term, the loss will be
recognized (through a write-down of the
investment’s carrying value) only if
management judges the loss in value to be
other than a temporary decline
[CICA 3050.20]
12-28
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Lower of Cost or Market for
Temporary Investments
 The CICA Handbook recommends that “When

the market value of temporary investments
has declined below the carrying value, they
should be carried at market” [CICA 3010.06]
There are two approaches to applying the
lower of cost or market (LCM) rule:
the allowance method
the direct write-down method
12-29
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Lower of Cost or Market for
Temporary Investments (cont.)
 Under the allowance method, the allowance


can be reduced if market values recover
In the direct write-off method, the written-down
amount becomes the new carrying value and
the write-down
The direct write-down method is the method
that is used for long-term portfolio investments
12-30
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Lower of Cost or Market for Portfolio
Investments
 There are three characteristics of LCM when
applied to long-term portfolio investments that
are different from LCM as applied to temporary
investments:
 the market value test is applied individually to each
investment rather than to the portfolio as a whole
 a write-down is made only “when there has been a
loss in value of an investment that is other than a
temporary decline” [CICA 3050.20]
12-31
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Lower of Cost or Market for
Portfolio Investments (cont.)
 if an investment is written down, the write-down is
recorded directly as a reduction in the carrying value
of the investment, which then becomes the new
carrying value; the allowance method is not used
 The write-down cannot be reversed later if the
market value increases in years subsequent to
the write-down
12-32
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Permanent Impairment of Value
 The CICA Handbook lists several guidelines
for determining whether a permanent
impairment of value has occurred:
 a prolonged period during which the quoted
market value of the investment is less than its
carrying value
 severe losses by the investee in the current
period, or current and prior periods
 continued losses by the investee for a period
of years
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Permanent Impairment of Value (cont.)
 suspension of trading in the securities
 liquidity or going concern problems of the
investee
 the current appraised value of the investee’s
assets is less than its book value
12-34
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Equity Method
 The equity method is used for recording
strategic investments in equity securities
 May also be used for controlled investments
and joint ventures if differential reporting is
adopted
12-35
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Equity Method (cont.)


Conceptually, the equity method treats the investee
company as if it were condensed into one balance
sheet item and one income statement item and then
merged into the investor company at the proportion
owned by the investor
The equity method requires that the investment
account represent the investor’s proportionate share
of the book value of the investee and that the
investment income represent the investor’s
proportionate share of the investee’s income
12-36
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Consolidation
 A parent company is required to consolidate its
financial statements with those of its subsidiaries
when it issues general purpose financial
statements
 The parent company uses the cost or equity
method to account for its investment during the
year, but, at the end of the reporting period, must
prepare consolidated financial statements for
reporting to its shareholders and other financial
statement users
12-37
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Consolidation (cont.)
 Consolidated statements are prepared by
combining the sets of financial statements into
one, which is intended to portray the activities
of the whole enterprise
 This is an application of substance over form, as
consolidated statements portray the economic
entity that exists in substance, rather than relying
on the legal form that has been used to organize
the activities of an enterprise
12-38
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Common Consolidation Adjustments
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
The investment account must be eliminated from the
parent company’s financial statements, and the
corresponding equity accounts must be eliminated
from the subsidiary’s financial statements
If net assets’ book values reflected on the subsidiary’s
books on the date of acquisition are different from their
market values on that date, the difference, called a fair
value increment, must be recognized on the
consolidated financial statements, along with any
goodwill inherent in the purchase price
12-39
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Common Consolidation Adjustments (cont.)
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

If fair values (i.e., market values) were recognized,
they must be amortized in subsequent years, as must
goodwill
Goodwill is not amortized, but written down if
impaired---the impairment test must be done on an
annual basis
Any portion of the subsidiary that is consolidated but
is owned by non-controlling, or minority, subsidiary
shareholders must be recognized
12-40
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Common Consolidation Adjustments (cont.)
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
Inter-company receivables and payables, gains and
losses, and revenues and expenses must be
eliminated so that the financial statements will only
reflect transactions with outsiders
If there are any inter-company unrealized profits at
year-end, these must be eliminated so that income is
not misstated
12-41
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Cash Flow Statement
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

Financial instruments are considered to be cash
equivalents, and they are included in the definition of
cash when the cash flow statement is prepared
Investments in cash equivalents do not appear in the
cash flow statement, but instead are included in the
cash balance
For all other investments in debt and equity securities,
the cash flow impacts occur in three ways:
 there is a cash outflow when an investment is
purchased
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Cash Flow Statement (cont.)
 cash payments are received by the investor
(dividends or interest)
 cash is received when the investment is sold or is
redeemed at maturity
 Investment income can be reported in either the
operating section or the investing section, but
the presentation should be consistent from
period to period
12-43
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Market Value Method


The market value method is a different method of
accounting for marketable securities, both debt and
equity
This method is used by companies whose primary
business involves investing in the securities of others,
mutual funds (technically known as open-ended
investment funds), insurance companies, and
securities dealers and brokers
12-44
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Market Value Method (cont.)
 The market value method is summarized as
follows:
 at date of acquisition, investments are recorded at
cost
 after acquisition, each individual investment
account balance is adjusted at the end of the
accounting year to the current market value of the
securities held---the adjusted amount then
becomes the new carrying value for subsequent
accounting
12-45
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Market Value Method (cont.)
 interest earned and dividends declared are
recognized by the investor as investment revenue
 increases or decreases in the market value of the
securities are recognized at the end of each
accounting period using one of the following
approaches
- current approach
- deferral approach
 on disposal of the investment, the difference
between the carrying value at that date and the
sale price is recognized as a gain or sale on
disposal
12-46
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Market Value Approach
 Objections to the market value
approach
 it departs from conservatism, they
claim, because gains are recognized
before they are realized
 market valuation departs from
objectivity because it uses a
subjective market valuation on the
balance sheet date that will change
the very next day
12-47
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Market Value Approach (cont.)
 Supporters cite relevance and
freedom from bias
 earnings process has satisfied the
requirements for revenue recognition
 to realize the gains and losses, all
management has to do is pick up the
telephone and call the company’s
broker
12-48
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