Chapter 2

							                  Chapter 2



        Investments in Equity Securities
            (Overview of the course)




Chapter 2                                  1
                         Outline
• Broad overview of accounting options when
  one company buys shares of another
  company
• Review of 5 different types of investments
     –   Held-for-trading
     –   Available-for-sale
     –   Significant influence
     –   Control
     –   Joint venture



Chapter 2                                      2
            Learning Objectives

     – 2 main accounting methodologies:
        • Cost method
        • Equity method
     – Overview of purchase discrepancy and
       amortization of purchase discrepancy
     – Overview of the concepts involved with
       differential reporting



Chapter 2                                       3
The main question of the course
• How can a Canadian company report in its
  financial statements an investment in shares
  of another company?




Chapter 2                                        4
    5 types of share investments
•   Held for trading
•   Available for sale
•   Significant influence
•   Control
•   Joint venture




Chapter 2                          5
                     Definitions
• Subsidiaries (Sec. 1590)
     – If P controls S then P is the parent and S is the
       subsidiary
            – Eg. Pepsi & Pizza Hut


     – Control: exists if P has the continuing power to
       determine the strategic operating, investing, and
       financing policies of S without the cooperation of
       others (sec. 1590.03)




Chapter 2                                                   6
            Definitions (subsidiary)
• Control is assumed if P owns more than 50% of the
  shares but there are also other considerations
• “Business combination” (sec 1581) is the technical
  term where one company aquires another company
  either through:
     – Buying its assets directly
     – Buying voting shares
• Accounting method = Consolidation




Chapter 2                                              7
Definitions- Investments (sec 3051)
• Significant Influence:
     – An investment in another company which does not
       convey control and is not an investment in a joint
       venture but allows the investor to exercise
       significant influence over the strategic operating,
       investing, and financing policies of the investee
• Accounting method = Equity method




Chapter 2                                                8
        Definitions – Joint Ventures
                 (sec 3055)
• Each venturer shares the power to determine
  the strategic operating, financing, and
  investing policies and no single venturer is
  able to unilaterally control the venture

• Accounting method: proportionate
  consolidation



Chapter 2                                        9
       Other handbook sections
• Pages 37 – 40 list various other handbook
  sections and definitions for which we will look
  at the details later in the course




Chapter 2                                       10
Other Related Handbook Sections
•   Section 1300: “Differential Reporting”
•   Section 1530: “Comprehensive Income”
•   Section 1581: “Business Combinations”
•   Section 1600: “Consolidated Financial
                   Statements”
•   Section 1625: “Comprehensive Revaluation of
                   Assets and Liabilities”
•   Section 1650: “Foreign Currency Translation”
•   Section 1701: “Segment Disclosures”
•   Section 3062: “Goodwill and Other Intangible
                   Assets”
Chapter 2                                     11
Other Related Handbook Sections

• Section 3465: “Income Taxes”
• Section 3475: “Discontinued Operations”
• Section 3865: “Hedges”
• Accounting Guideline 15: “Consolidation of
  Variable Interest Entities”
• Related EIC Abstracts




Chapter 2                                      12
 Investments valued at Fair Value
• Investments held for trading:
     – Current assets
     – Investments that are actively traded and intended
       by mgmt to be sold within one year
     – Reported at cost and revalued at FMV every
       reporting date
     – Unrealized gains/losses reported in income




Chapter 2                                              13
            Investments at FMV
• Available-for-sale investments:
     – Can be current or non-current assets, depending on mgmt’s
       intentions as to how long they want to hold them for
     – Reported at cost and revalued to FMV every reporting period
     – Unrealized gains/losses reported in “other comprehensive
       income”
     – When investment is sold, unrealized gains/losses are
       removed from comp. income and realized gains/losses
       reported in regular income




Chapter 2                                                       14
            Comprehensive income
• Sec 1530 is a new handbook sections which requires
  companies to differentiate between net income and
  comprehensive income
• Comp. income includes:
     – Gains/losses on available-for-sale securities
     – Gains/losses on derivatives designated as cash flow hedges
     – Unrealized gains/losses on translating foreign financial
       statements
• Reporting of comp. income is not required for this
  course




Chapter 2                                                      15
Investments Not Valued at Fair Value

 • Sections 3855 and 3051 cover two types of
   investments which will not be valued at fair
   value at each reporting date and describe two
   methods of accounting for them
 • 1) Available-for-sale investments for which a
   quoted market price in an active market is not
   available
     - Accounting method is COST METHOD
 • 2) Significant influence investments
      – Accounting method is EQUITY METHOD
 Chapter 2                                      16
Investments Not Valued at Fair Value
 • Available-for-sale With No Quoted Market
   Value – if a quoted market price in an active
   market is not available for available-for-sale
   investments, then these investments are
   reported using the cost method

 • Dividends are recorded to dividend income
   account unless they are a liquidating dividend
   in which case the investment account is
   reduced (as in previous acct’g classes)


 Chapter 2                                          17
               EXAMPLE
• Jan 1, year 1, Jensatar puchases 10% of the
  outstanding common shares of Safebuy at
  $95,000.
                  Net income     dividends
Year 1            $100,000       $75,000
Year 2            $65,000        $75,000
Year 3            $30,000        $75,000




Chapter 2                                       18
Investments Not Valued at Fair Value
 • Significant Influence Investments – is an
   investment in the voting shares of a
   corporation that permits the investor to
   exercise significant influence over the
   strategic operating, financing, and investing
   policies of the investee, at the same time,
   however, it does not establish control or joint
   control over that investee




 Chapter 2                                           19
            Significant Influence
• The following conditions are possible
  indicators that significant influence is present:
     – The ability to elect members to the board of
       directors
     – The right to participate in the policy-making
       process
     – Significant intercompany transactions between the
       two companies
     – The size of ownership of the other shareholders of
       the investee
     – Exchange of management and technology
       between the two companies

Chapter 2                                              20
            Significant Influence
• Note: the fact that significant influence is possible is
  what is important. It doesn’t matter whether or not it is
  exercised.
• Section 3051 suggests that a holding between 20
  percent and 50 percent may indicate the presence of
  significant influence, but it also states that a holding
  of this size does not necessarily mean that such
  influence exists
• Ex: B might own 30% of shares and A owns 60% of
  shares but holds all seats on the board of directors
  therefore B does not have significant influence and
  shares are considered to be Available for Sale
• Ex: X owns 15% of shares but all other shares are
  held in very small blocks and therefore X has many
  seats on the Board of Directors
Chapter 2                                                21
            Significant Influence
• Significant influence investments be reported
  by the EQUITY METHOD
• The basic concept behind the equity method:
  the investor records its proportionate share of
  the investee’s income as its own income and
  reduces the investment account by its share
  of investee dividends received




Chapter 2                                       22
      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


Chapter 2                                       23
      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.


Chapter 2                                      24
       Equity Method Accounting

 •          Each investment has a unique account




             GENERAL JOURNAL                   Page           1
     Date             Description              Debit        Credit
     1-Jan. Investment in Newer Co.         $ 1,000,000
               Cash                                       $ 1,000,000
            to record investment in Newer




Chapter 2                                                            25
      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.

Chapter 2                                        26
      Equity Method Accounting
  New’s ownership percentage × Newer’s net
  income = 20% × $400,000 = $80,000




            GENERAL JOURNAL                 Page           100
    Date           Description              Debit         Credit
 31-Dec. Investment in Newer Co.        $    80,000
            Income on equity investment               $     80,000
         to record equity in Newer net
         income



Chapter 2                                                          27
      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.

Chapter 2                                               28
        Equity Method Accounting

 • New’s ownership percentage × Newer’s
   dividend = 20% × $70,000 = $14,000



             GENERAL JOURNAL                Page           100
 Date               Description             Debit         Credit
31-Dec. Cash                            $    14,000
           Investment in Newer Co.                    $     14,000
        to record receipt of dividend
        from Newer Co.



 Chapter 2                                                       29
     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
Chapter 2                                       30
Additional Features Associated with the CICA Equity Method


    • The previous example illustrated the basic
      concepts of the equity method

    • Besides these fundamentals, three other
      major features referred to in the Handbook
      must be considered:
         – The accounting for non-operating income
         – Acquisition costs grater than book value
         – Unrealized intercompany profits


    Chapter 2                                         31
Acquisition costs vs book value
• Usually, acquisition costs of shares are
  greater than book value
• Why? Market values reflect goodwill.
• Goodwill is not amortized (since June 30,
  2001) but if it is determined that specific
  assets are undervalued, then this difference
  is amortized.




Chapter 2                                        32
            Calculation of goodwill
• Harley pays $40 M to buy 30% of the shares of Ivan.
  Ivan’s net assets has a book value of $90M and
  specific plant assets are undervalued by $22M

• Investment cost                        $40M
• Book value of net assets                27M
  (90M x 30%)
  Difference                             $13M
  Due to undervalued assets              $6.6M
  (22M x 30%)
  Goodwill                               $6.4M
Note: The $6.6 will be amortized over the life of the
  assets
Chapter 2                                               33
               Unrealized Profits

                      Investor
    Downstream sale              Upstream sale




                    Investee
            Unrealized profits need to be removed
Chapter 2                                        34
                 Example
• Harrison owns 35% of Gunn and uses the
  equity method because it has significant
  influence.
• In year 1, it sells inventory to Gunn for $75M
  with a 60% gross profit on the transaction.
  The items are sold by Gunn to outsiders in
  year 2.
• The tax rate is 40%




Chapter 2                                          35
                      Continued…
• Unrealized profit before tax:
     = 75,000 x 60%
     = 45,000

• Unrealized profit after tax
     = 45,000 – (40%)(45,000)
     = 27,000

     Journal entry – yr 1:
     Investment income $27,000
        Investment in Gunn                         $27,000
     To eliminate unrealized profit from sales to Gunn
     (This entry would reverse in Year 2 when the external sales are
        made.)


Chapter 2                                                         36
                  Continued…
• Suppose the example is the same but Gunn
  sells to Harrison:
• Unrealized profit after tax = $27,000
• Harrison’s share = $27,000 x 30
                        = 9,450
     Journal entry – yr 1:
     Investment income       $9450
       Investment in Gunn                  $9450
     To eliminate unrealized profit from on Gunn’s sales
       to Harrison
     (This entry would reverse in Year 2 when the
       external sales are made.)

Chapter 2                                                  37
Miscellaneous Considerations

• When using the equity method, the following
  additional items must be considered:
     – Changes to and from the equity method: made on
       a prospective basis when situations change
        • ie. Share ownership changes from 10% to 40%
     – Loss in market value investment
        • Value decreases if decline is permanent




Chapter 2                                           38
            Differential Reporting
• The Handbook is rigourous and some of its
  requirements are costly for small companies.
• The question of whether the CICA Handbook’s
  sections on financial reporting should apply to all
  Canadian companies was revisited by a CICA task
  force in relation to public/non-public companies
• The task force considered two basic approaches:
     – A non-GAAP approach whereby non-public companies could
       use accounting policies completely separate from GAAP
     – A GAAP approach




Chapter 2                                                  39
            Differential Reporting

• This latter approach was the one eventually
  adopted when Section 1300 was issued and
  certain sections of the CICA Handbook were
  amended to allow optional treatments
• Section 1300 – this section on differential
  reporting was issued effective January 1,
  2002 and allows a qualifying enterprise to
  select which reporting options it will apply
  when it prepares its financial statements


Chapter 2                                        40
            Differential Reporting
• Qualifying enterprise:
     – Private company
     – All owners unanimously consent to the differential
       reporting options it adopts.




Chapter 2                                               41
            Differential Reporting
• Significant influence investments – the
  following paragraphs outline the option
  available:
     – An enterprise that qualifies under Differential
       Reporting, Section 1300, may elect to use the
       COST METHOD to account for its investments in
       companies subject to significant influence that
       would otherwise be accounted for by the equity
       method in accordance with Section 3051
        • All investments in companies subject to
          significant influence should be accounted for
          using the same method

Chapter 2                                                 42
            Differential Reporting
     – Investments in companies subject to significant
       influence accounted for using the cost method
       should be presented separately in the balance
       sheet
         • Income from those investments should be
           presented separately in the income statement
     – An enterprise that has applied the alternative
       method should disclose the basis of accounting
       used to account for investment in companies
       subject to significant influence



Chapter 2                                                 43