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in Microsoft®
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Prepared by
Peter Secord
Saint Mary’s
University
© 2003 McGraw-Hill
Ryerson Limited
Chapter 2
Temporary, Portfolio,
and
Significant Influence Investments
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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
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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
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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
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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).
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Temporary Investments in Annual Reports
Example: from the Notes for
George Weston Limited, 2000
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.
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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
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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.
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Long-Term Investments
• A clear distinction is made between
Temporary and Long-term investments in
Canada
• Long-term investments are carried as noncurrent 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
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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
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The Size of the Investment
Investor Ownership
of Investee Common Shares
Cost
Method
Equity
accounting
~20%
0%
Consolidation
accounting
~50%
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100%
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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.
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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.
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Long-Term Investments: Equity
• The investor can own any amount of shares:
– Influence varies directly with the amount of shares
owned.
• When 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
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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.
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Long-Term Investments: Control
• The investor can own any amount of shares:
– Influence varies directly with the amount of shares
owned.
• When 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
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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”
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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.
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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.
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Equity Method Accounting
•
Each investment has a unique account
GENERAL JOURNAL
Date
Description
1-Jan. Investment in Newer Co.
Cash
to record investment in Newer
Page
1
Debit
Credit
$ 1,000,000
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$ 1,000,000
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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.
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Equity Method Accounting
New’s ownership percentage × Newer’s net
income = 20% × $400,000 = $80,000
GENERAL JOURNAL
Date
Description
31-Dec. Investment in Newer Co.
$
Income on equity investment
to record equity in Newer net
income
Page
100
Debit
Credit
80,000
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$
80,000
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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.
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Equity Method Accounting
• New’s ownership percentage × Newer’s
dividend = 20% × $70,000 = $14,000
GENERAL JOURNAL
Date
Description
31-Dec. Cash
Investment in Newer Co.
to record receipt of dividend
from Newer Co.
Page
100
Debit
Credit
$
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14,000
$
14,000
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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
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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)
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