Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 10 Investments

Learning Objectives 1.Identify the different types of categories of investments and describe how the investments are classified. 2.Explain the nature of temporary investments and describe the accounting and reporting treatment for temporary investments. 3.Explain the nature of long-term investments and describe the accounting and financial reporting for these investments.

Learning Objectives 4.Explain the equity method of accounting and compare it to the cost method for equity securities. 5.Describe the disclosure requirements for long-term investments in debt and equity securities.

Investments Temporary Investments Classification Measurement Presentation and disclosure Long-term Investments Debt securities Equity instruments Measurement – impairment Presentation and disclosure Fair Value Controversy Liabilities Subjectivity Gains trading

Types of Investments Debt Gov’t. Bonds Corp. Bonds Equity Preferred Shares Common Shares Options Warrants Short-term Paper CDs T-bills Commercial Paper Long-TermTemporary

Temporary Investments - Classification Two criteria must be met to qualify as a temporary investment: 1.Must be capable of reasonably prompt liquidation 2.Must be management intent to convert them to cash, within one year (or operating cycle) Temporary investments are defined as financial instruments; details: a)Cash b)Contractual right to receive cash or other financial asset c)Contractual right to exchange financial instruments d)An equity instrument of another entity

Measurement Recorded at historical cost –Cost includes purchase price and incidental direct costs Cost is more difficult to define when investments acquired for non-cash consideration –Record at fair value of consideration given; or –Fair value of consideration received

Valuation of Temporary Investments Valued using LCM (Lower of Cost or Market) Applied to: –portfolio as a whole; or –individual item basis Application of LCM must then be consistently applied Investment Allowance account used to capture valuation write-downs Reported net balance cannot be below cost

Application of LCM Given for Western Publishing Corp. on December 31, 2002: InvestmentsCostFair Value Air Canada shares$ 43,860$ 51,500 CIBC shares184,230175,200 Magna shares86,36091,500 Portfolio Total$314,450$318,200 Apply LCM on an Individual Security Basis.

Application of LCM Note: Gains will not be recorded. $318,200 91, ,200 $ 51,500 Fair Value $ 9,030$314,450Portfolio Total 5,14086,360Magna shares (9,030)184,230CIBC shares $ 7,640$ 43,860Air Canada shares Unrealized Gain (Loss) CostInvestments Western Publishing Corporation Security Portfolio December 31, 2001

Application of LCM To record the the LCM rule, the journal entry at December 31, 2002 will be: Loss on Investment9,030 Investment Allowance9,030 We will now apply the LCM valuation based on the portfolio as a whole.

Application of LCM Note: The total historical cost is lower than total fair value. No Loss is recorded. $318,200 91, ,200 $ 51,500 Fair Value $ 3,750$314,450Portfolio Total 5,14086,360Magna shares (9,030)184,230CIBC shares $ 7,640$ 43,860Air Canada shares Unrealized Gain (Loss) CostInvestments Western Publishing Corporation Security Portfolio December 31, 2001

Temporary Investments: Final Notes If management intent changes and does not plan to hold the investment for temporary purposes, the investment is to be reclassified as a long-term investment When an investment is sold, related balance in the Investment Allowance account is to be written-off

Temporary Investments: Bonds Bonds are carried at the present value of the future cash flows: –PV of the face value, plus –PV of the interest annuity When purchased between interest payment dates, the accrued interest is recorded at the date of purchase

Presentation and Disclosure CICA Handbook, Section 3010: –Separate presentation of investments in affiliated companies –Valuation basis is disclosed –Market and carrying value is disclosed –Disclosure required for information related to: terms and conditions interest rate risk credit risk concentrations

Long-term Investments Management intent is to hold the investment for longer than one year CICA Handbook, Section 3860 governs long- term investments in: –bonds –most preferred shares Long-term investments in common shares are not governed by Section 3860 –Sections 3050 and 1590 govern common share investments

Long-term Investments: Bonds Recorded at historical cost Bond premium or discount used to amortize the difference between the bond face value and market value Consider the following example of the Chan Corporation.

Long-term Investments: Bonds Given: Face amount:$100,000 Purchase date:January 1, 2001 Maturity date:January 1, 2006 Interest paid:July 1 st and January 1 st Coupon (stated) rate of interest:8% Market (effective) rate of interest:10% What is the approximate purchase price? PV of $100,000 (n=10, i=5%) + PV A of ($100,000 X 4%) where n=10, i = 5% PV is approximately equal to $92,278

Long-term Investments: Bonds The entry to record this purchase is: Long-term investments92,278 Cash92,278 Note that the discount of ($100,000 – 92,278) $7,722 is not recorded. It is amortized over the life of the bond. The effective interest method is used to amortize a bond premium or discount.

Bond Discount Amortization

Discount/Premium Amortization Interest revenue is always calculated using the market (effective) rate at the time of purchase With a premium, add the difference between Cash Received and Interest Revenue to the carrying amount of bonds On disposition of a bond, the related portion of the discount or premium is removed from the books at the time of disposition

Equity Investments: Common Shares As common shares carry voting rights, influence becomes a factor in determining the appropriate accounting treatment There are three levels of influence, each with their own accounting treatment

Equity Investments: Common Shares Level of Influence Little or None Significant Control Type of Investment Portfolio Significant Subsidiary Influence Accounting Method Cost MethodEquity Consolidation Method Percentage Ownership 0%

Equity Method Applies to equity investments of significant influence Significant influence deemed using the following criteria: –Quantitative test: 20% to 50% ownership –Qualitative test: Representation on Board of Directors Participation in policy-making Material intercompany transactions Exchange of management personnel Provision of technical information –Professional judgement

Equity Method Investment recorded at cost Any dividends received are credited to the Investment account Investor takes into income their respective share of the Investee Net Income for the year LCM Valuation does not apply Consider the following example of Maxi Limited.

Equity Method Given: Maxi Limited purchases 20% of Mini Limited, and exercises significant influence January 2, 2002 Maxi purchases 48,000 $10 per share For the year 2002 Mini Limited reports a Net Income of $200,000 December 31, 2002 shares of Mini Limited have a market price of $12 per share January 28, 2003 Mini declared and paid a total cash dividend of $100,000 For the year 2003 Mini reports a Net Loss of $50,000 Prepare all necessary journal entries, using the Equity Method.

Equity Method January 2, 2002 Long-term Investments 480,000 Cash 480,000 (48,000 shares X $10) December 31, 2002 Long-term Investments 40,000 Investment Income 40,000 ($200,000 Net Income X 20%) December 31, 2002 No entry required to reflect market price (or fair value) January 28, 2003 Cash 20,000 Long-term Investments 20,000 ($100,000 Dividend X 20%) December 31, 2003 Investment Loss 10,000 Long-term Investment 10,000 ($50,000 Net Loss X 20%)

Recording Under Cost vs. Equity Maxi Limited Cost MethodEquity Method No Entry RequiredInvestment Loss10,000 Long-term Investments 10,000 Cash20,000Cash20,000 Investment Income 20,000 Long-term Investments 20,000 No Entry Required No Entry RequiredLong-term Investments40,000 Investment Income 40,000 Long-term Investments 480,000Long-term Investments 480,000 Cash 480,000 Cash 480,000

Equity Method: Final Notes Discontinued Operations and Extraordinary Items of investee are reported as discontinued and extraordinary items by investor Amounts paid in excess of (or less than) investee’s book value are amortized and reported by investor If ownership falls below the level of significant influence, investment is then accounted for using cost method

Impairment of Value To apply LCM, decline in value must be other than temporary or short-term –Extended period where market value < carrying value –Severe or continued investee losses –Investee share trading is suspended –Liquidity or going concern problems with investee –Appraised fair value < carrying value Amount of write-down reported as loss by investor Long-term debt investments generally not subject to market write-downs

Long-term Investment Disclosure Requirements CICA Handbook, Section 3050 Basis of valuation Separate reporting for investments –Significant influence –Other affiliated companies –Other long-term investments Income from each of the above investment categories reported separately Equity method: any difference between cost of investment and net book value of investee Disclose fair value and carrying value of portfolio investments (e.g. preferred shares)

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