Advanced Financial Accounting I
ADMS 4520 – Winter 2012 – Patrice Gelinas
Lecture 1 Part 2 – Investments in Equity Securities – Jan 6
Equity Investments: The Big Picture
- Companies invest in the shares of other companies for:
o Strategic reasons: intending to maintain a long-term relationship, and
o Non-strategic reasons: intending to hold for profit.
- Starting January 1, 2013 IFRS 9 requires all nonstrategic investments to be reported
at fair value including private companies which do not have a quoted market value.
o IFRS is developing a standard for fair value measurement.
Strategic Investments
Non-Strategic Investments
Significant influence
Fair value through profit and loss
(FVTPL)
Control
Available-for-sale (AFS)
Market value available
Joint control
- market value not available
- Reporting methods for investments in equity securities.
Type
Reporting Method
Reporting Unrealized
Gains
Significant influence
Equity method
Not applicable
Control
Full consolidation
Not applicable
Joint control
Proportionate
Not applicable
consolidation or equity
FVTPL
Fair value method
In net income
Available-for-sale
-FMV available.
-Fair value method.
-In OCI.
-FMV not available.
-Cost method.
-Not applicable.
- When IFRS 9 becomes mandatory in 2013, 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 in other comprehensive income
(OCI).
o This is the same treatment presently allowed for AFS investments.
o However, unlike current treatment, when such investments are sold
accumulated gains or losses in OCI are cleared directly to retained earnings,
not net income.
- Directly related IFRSs:
o IAS 27 – Consolidated and Separate 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 of K to
generate returns for J.
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 Refer to IAS 28, IAS 31 and IAS 39 if control does not exist.
o IAS 28 – Investment in Associates
 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 affect the strategic
operating and financing policies of the investee 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.
o IAS 31 – Joint Arrangements
 Joint arrangements (‘ventures’) have two or more owners (‘ventures’)
that have a contractual arrangement among themselves to exercise
joint control over the venture and therefore no venture can exercise
unilateral control. Report using either proportionate consolidation or
the equity method.
o IFRS 9 – Financial Instruments – Classification and Measurement
 Nonstrategic equity investments are valued at fair value with changes
reported in profit or loss.
 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.
Other related IFRSs:
o IAS 39 – Financial Instruments – Recognition and Measurement
 Indicates how and when hedge accounting standards can be applied
to report gains and losses on hedged and hedging items in the same
period.
o IFRS 3 – Business Combinations
 A business can obtain control either by investing in voting shares or
purchasing the net assets of another business.
o IFRS 8 – Operating Segments
 Disclosure of operating segments within consolidated financial
statements.
o IAS 1 – Presentation of Financial Statements
 Financial statements include balance sheet (statement of financial
position), and statements of comprehensive income, changes in
equity, and cash flows.
o IFRS 12 – Income Taxes
 Refer to chapter 6 and 9.
o IAS 21 – The Effects of Changes in Foreign Exchange Rates
 Addresses translation of the financial statements of foreign investees,
subsidiaries, and joint arrangements. [Chapter 10 and 11]
o IAS 36 – Impairment of Assets
 Applies impairment tests to all assets including investments in
associates, goodwill, and intangibles. [Chapter 5]
o IFRIC 16 – Hedges of a Net Investment in a Foreign Operation
 Refer to Chapter 11.
o SIC 12 – Consolidation – Special Purpose Entities
 Refer to Chapter 9.
o SIC 13 – Jointly Controlled Entities – Non-monetary Contributions by
Venturers
 Guidance in determining the gain that a venture can recognize when
contributing non-monetary assets to a joint arrangement [Chapter 9].
Investments Valued at Fair Value
- Fair value through profit and loss (FVTPL) investments
o Include investment held for short-term trading and any other investments
the reporting entity wishes to designate as FVTPL.
o Classified as current assets since they actively trade and are intended to be
sold within one year.
o Recorded at fair value. Unrealized gains and losses as well as dividends
received or receivable are reported in income.
- Available for sale investments
o Classified as current or noncurrent assets depending on how long
management intends to hold on to these shares.
o Unrealized gains/losses are recorded in other comprehensive income (OCI).
Dividends are recorded in income.
o When sold, previously unrealized gains and losses are removed from OCI and
reported in net income.
o Account at cost if market value is not available.
- 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).
o 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 ‘Cumulative Other
Comprehensive Income’ which is a separate component of shareholders’ equity.
Investments Not Valued at Fair Value
- Reported using either the cost or equity method.
- Cost method:
o Used for available-for-sale investments when market value is not reliably
measureable.
o Can be used to report control investments in non-consolidated separate
entity financial statements [Chapter 5].
o Can be used to record control investments [Chapter 5].
o Impairment losses are reported in net income.
o Dividends are reported in income.
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-
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o Cumulative dividends received in excess of net income since acquisition
(‘liquidating dividends’) are reported in income.
Equity method applies to investments in associates, where the investee has the
ability to exercise significant influence. Indications of significant influence include:
o Representation on board of directors.
o Participation in policy-making processes or decisions about dividends and
distributions.
o Material transactions between investor and investee.
o Exchange of management personnel.
o 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 judgement.
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.
o 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.
Using the equity method, the investor:
o Records its proportionate share of the investee’s operating income as its own
operating income.
o Reduces the investment account by its share of investee dividends received.
o Records its proportionate share of the investee’s non-operating income (e.g.
discontinued operations, extraordinary items) separately.
o Amortizes acquisition costs greater than book value of investee (‘acquisition
differential’).
o Eliminates after-tax unrealized intercompany profits.
Equity Method Accounting
- Investor recognizes its share of investee’s net operating income (loss) on the income
statement.
o Based on percentage ownership.
- Dividends paid by the investee are treated as a reduction of the investor’s
investment account.
- The initial investment is recorded at cost.
- The investee’s net income (loss) results in a proportional increase (Decrease) in the
investor’s investment account.
- The investor’s investment account is reduced by the amount of the dividends it
receives from the investee.
- Investee records its share of investee’s non-operating income/loss.
- Investor amortizes acquisition costs paid in excess of book value (‘acquisition
differential’).
- Investor eliminates unrealized profits on intercompany transactions until the assets
are sold to outsiders or consumed by the purchaser.
Other Equity Accounting Considerations
- Change from FVTPL to equity method: once significant influence is achieved on an
investment previously reflected as FVTPL, begin using equity method.
- 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 market value in profit and
loss.
- Losses exceeding investment account balance (IAS 28):
o 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.
o 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.
- Impairment losses (IAS 36): Compare the investment’s recoverable amount (higher
of fair value less costs of selling and value in use) to its carrying amount and if
recoverable amount < carrying amount, then write down to recoverable amount.
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
and loss is calculated based on average cost of shares sold, not FIFO, LIFO or specific
identification.
GAAP for Private Enterprises
- CICA handbook Part II Sections 3051 and 3856:
o Permits use of either equity or cost method to account for all significant
influence investments that are not publicly traded on the same basis.
o Investments in and income from cost-accounted investments should be
reported separately, net of any impairment losses which are reported in net
income.
o Allows investors to elect to report any equity investment at fair value.
o Prohibits use of the cost method to account for publicly traded investments,
which must be reported at fair value with changes reflected in profit and loss.
o Does not require amortization of the acquisition differential.