Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 9 Investments

2 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

3 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

4 Investments – Recent Changes Due to the complexity of accounting for investments, there are currently a number of projects by IASB and FASB in this area: 1.Simplification of existing accounting standards 2.Improved guidance on “fair value” measurement

5 Financial Assets and Investments Debt investments include investments in government debt, corporate bonds, convertible debt, and commercial paper Equity instruments represent ownership interests in companies (e.g., common stock, preferred stock) Motivations for investments include: to obtain short-term returns or long-term returns on investments, and for corporate strategy

6 Financial Assets and Investments Method of accounting for a particular investment can depend on: –Type of instrument (debt vs. equity) –Management’s intent –Ability to reliably measure instrument’s fair value, or –Extent of influence over the investee company

7 Fair Value Issues Investments generally recognized at their fair value at acquisition (usually purchase price) Also, many investments are adjusted to fair value at the balance sheet date Unrealized holding gains or losses occur when a financial instrument is adjusted to its fair value

8 Accounting Models There are three main models of accounting for investments: –Cost/amortized cost model –Fair value through net income model (FV-NI) –Fair value through other comprehensive income model (FV-OCI)

Accounting Models: Summary Cost/Amortized Cost ModelFV-NIFV-OCI At acquisition, measure at: Cost (fair value + transaction costs)Fair value At each reporting date, measure at: Cost or amortized costFair value Unrealized holding gains/losses reported in:Not applicableNet incomeOCI Realized holding gains/losses reported in:Net income Transfer total realized to net income (recycling), or to retained earnings 9

10 Cost/Amortized Cost Model: Investments in Shares Cost model for investments in shares of another entity: 1.Recognize cost of investment at fair value (plus direct transaction costs) 2.Report at cost (unless impaired) 3.Recognize dividend income when have claim to dividend 4.When dispose of investment, derecognize and report a gain/loss on disposal in net income.

11 Cost/Amortized Cost Model: Investments in Debt Securities Amortized cost model for investments in debt securities of another entity: 1.Recognize cost of investment at fair value (plus direct transaction costs) 2.Report at amortized cost as well as interest receivable (unless impaired) 3.Recognize interest income as earned, and also amortize any discount/premium by adjusting carrying amount of investment 4.When dispose of investment, first bring accrued interest and discount/premium amortization up to date. Derecognize investment and report a gain/loss on disposal in net income.

12 Given: Face amount:$100,000 Purchase date:January 1, 2011 Maturity date:January 1, 2016 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 Amortized Cost Model: Example

13 Amortized Cost Model: Example The entry to record this purchase is: Investment in Bonds92,278 Cash92,278 Note the discount of $7,722 ($100,000 – 92,278) is not recorded separately; it is amortized over the life of the bond The effective interest method is used to amortize the premium or discount (required under IFRS) Private entity GAAP also allows straight-line method of amortizing premium or discount

14 Bond Discount Amortization

15 Reporting under Amortized Cost Model Balance Sheet Current assets Interest receivable (accrued interest from investment) $xx,xxx Long-term investments Investment, at amortized cost$xx,xxx Income Statement Other revenue and gains Interest income$x,xxx

16 Sale of Investments Discount (or premium) is amortized from last date of amortization to the date of sale New carrying amount calculated, which is the amortized cost balance plus the discount (or minus the premium) amortized from last date of amortization Gain (or loss) calculated as the difference between selling price and carrying amount Any accrued interest income is calculated (and received) over and above the selling price of the investment

17 Fair Value through Net Income (FV-NI) Model Fair value through net income (FV-NI) also referred to as fair value through profit or loss (FVTPL) in IFRS At acquisition, investment recorded at fair value Transactions costs are expensed At each reporting date, FV-NI investments are adjusted to current fair value and any holding gain or loss is reported in net income Any earned interest/dividend income and any holding gain or loss on the investment may be reported together as “Investment Income”

18 FV-NI: An example For non-interest bearing Treasury bill: Purchase date: March 15 Maturity date: September 15 Pay = $19,231 for $20,000 six-month T-bill (8% yield) Entry on March 15: Temporary Investment in T-Bill19,231 Cash19,231 Entry on Sept 15: Cash20,000 Temporary Investment in T-Bill19,231 Investment Income/Loss 769

19 FV-NI: An example A company reported on December 31, 2012: InvestmentsCarrying Amount Fair Value In various shares $192,990 $191,200 Adjustment to fair value (192, ,200= $1,790) Entry to record adjustment at year end: Investment Income/Loss 1,790 Investments 1, Current assets: Temporary investments, at fair value$191,200

20 Fair Value through Other Comprehensive Income (FV-OCI) At acquisition, investments are recorded at fair value Transaction costs tend to be added to investment’s carrying amount At each reporting date, FV-OCI investments are adjusted to current fair value and any holding gain or loss is reported in other comprehensive income (OCI) Accumulated holding gains/losses are reported in AOCI, which is a separate item under Shareholders’ Equity

21 Fair Value through Other Comprehensive Income (FV-OCI) When investments are disposed, previously unrealized holding gains or losses need to be transferred out of OCI/AOCI Under FV-OCI with recycling, unrealized holding gains or losses are transferred (i.e. “recycled”) into net income (and as part of net income, closed into retained earnings) Under FV-OCI without recycling, unrealized holding gains or losses are transferred directly into retained earnings (bypassing net income)

22 FV-OCI: An Example Given share investment accounted for at FV-OCI: Fair value at Dec. 31, 2010$275,000 Carrying amt. at Dec. 31, ,700 Unrealized Holding Gain$ 15,300 Entry to Record: Investment15,300 Holding Gain (OCI)15,300 Long-term investments (assumed) Investment, at fair value with gains/losses in OCI $ 275,000 Shareholders’ Equity Accumulated other comprehensive income (loss) $ 15,300

23 FV-OCI: An example On January 23, 2011 sell investment for $287,220 Entry to record adjustment to fair value: Investment ($287, ,000)12,220 Holding Gain on Investment (OCI) 12,220 Entry to record sale and proceeds: Cash287,220 Investment 287,220 Entry to transfer holding gains: Holding Gain on Investment (OCI) (15,300+12,220)27,520 Gain on Sale of Investment27,520 OR (if FV-OCI without recycling) Retained Earnings27,520

24 GAAP Classifications: PE GAAP Private entity GAAP generally relies on cost- based model for equity investments, unless active market prices are available FV-NI model is allowed as an option for any financial instrument Under all models, interest earned and dividends received are recognized in net income

25 GAAP Classifications: IFRS Amortized cost used only if both of following conditions are satisfied: –Business model: investment managed on contractual yield basis (and cash flows best assessed relative to contractual cash flows specified by instrument) –Contractual cash flow characteristics: cash flows represent only payments of principal and interest on principal outstanding, and occur at specified dates If criteria for amortized cost do not apply, then FV-NI is used.

26 GAAP Classifications: IFRS IFRS proposed draft standard includes two additional options: –Investments held for longer term strategic reasons (without control or significant influence) may be accounted for under FV- OCI without recycling if such choice is made on acquisition –Fair value option provides an opportunity to use FV-NI accounting from acquisition if it corrects an “accounting mismatch”

27 GAAP Classifications: IFRS Reclassification from one category to another is not allowed, except when there is a change in business model in relation to investments If reclassify to FV-based model, then revalue at FV and recognize gain/loss in income If reclassify from FV-based model to another, then FV at time of reclassification becomes the new carrying amount

28 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

29 Impairment Investments must be reviewed for possible impairment to ensure that future benefit justifies the valuation on the balance sheet There are three different impairment models: 1.Incurred loss model 2.Expected loss model 3.Full fair value model

30 Impairment: Incurred Loss Model Impairment test carried out only if there is evidence of possible impairment Indicators of possible impairment include: –Significant financial difficulties –Defaulting on interest/principal payments –Major financial reorganization or bankruptcy Impairment loss is recognized in net income as difference between carrying amount and revised present value of expected cash flows Revised present value is calculated using discounted cash flow (DCF) model (using either historic or current market rate as discount rate)

31 Impairment: Expected Loss Model Impairment test carried out continuously Impairment loss is recognized in net income as difference between carrying amount and revised present value of expected cash flows Revised present value is calculated using discounted cash flow (DCF) model (using effective interest rate from time of acquisition)

32 Impairment: Fair Value Loss Model Impairment loss is recognized in net income as difference between carrying amount and fair value Where fair value is determined using the discounted cash flow (DCF) model, using the current interest rate at time of impairment test

33 Impairment: Fair Value Loss Model Impairment loss is recognized in net income as difference between carrying amount and fair value Where fair value is determined using the discounted cash flow (DCF) model, using the current interest rate at time of impairment test

34 Impairment: Accounting Standards IFRS currently uses the following models: –For all financial asset investments accounted for at cost or amortized cost: incurred loss model (with original discount rate) –For FV-OCI instruments: full fair value model (with no reversals of impairments on equity instruments recognized in net income; such reversals are recognized in OCI) IFRS proposals include: –For instruments at amortized cost: expected loss model –For instruments at fair value: always adjust to FV

35 Impairment: Accounting Standards Private entity GAAP has following requirement: –For financial asset investments accounted for at cost or amortized cost: incurred loss model (using current market rate)

36 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

37 Strategic Investments As common shares carry voting rights, extent of influence becomes a factor in determining the appropriate accounting treatment There are three levels of influence, each with its own accounting treatment: 1.Little or no influence 2.Significant influence 3.Control

38 Level ofLittle or Significant Control Influencenone Type of Less than Associate, or Subsidiary Investment significant significantinfluence % Ownership 0%20%50%100% Equity Investments: Common Shares

39 Investment in Associates: Significant Influence Applies to equity investments of significant influence (not control) Significant influence deemed using the following criteria: 1.Quantitative test: 20% to 50% ownership 2.Qualitative test: Representation on Board of Directors Participation in policy-making Material intercompany transactions Exchange of management personnel Provision of technical information

40 Investment in Associates Under IFRS, investments in associates (i.e. “significant influence”) are accounted for using the equity method of accounting Under private entity GAAP, investors can choose from following options for all “significant influence” investments: –Equity method, or –Cost method (unless associate shares are quoted in active market, in which case FV-NI model is used)

41 Equity Method Investment recorded at cost of acquisition Investor takes into income its respective share of the investee net income for the year by debiting the Investment account and crediting Investment Income Any dividends received are credited to the Investment account The accrual basis of accounting is applied Consider the following example of Maxi Limited:

42 Equity Method: Example Given: Maxi Corp. purchases 20% of Mini Corp., and exercises significant influence January 2, 2010 Maxi purchases 48,000 $10 per share For the year 2010 Mini Corp. reports a net income of $200,000 December 31, 2010 shares of Mini Corp. have a market price of $12 per share January 28, 2011 Mini Corp. declared and paid a total cash dividend of $100,000 For the year 2011, Mini Corp. reports a net loss of $50,000 Prepare all necessary journal entries, using the Equity Method

43 Equity Method: Example January 2, 2010 Investment in Mini Corp. 480,000 Cash 480,000 (48,000 shares x $10) December 31, 2010 Investment in Mini Corp. 40,000 Investment Income 40,000 ($200,000 net income x 20%) December 31, 2010 No entry required to reflect market price (or fair value). Investment is not impaired. January 28, 2011 Cash 20,000 Investment in Mini Corp. 20,000 ($100,000 Dividend x 20%) December 31, 2011 Investment Loss 10,000 Investment in Mini Corp. 10,000 ($50,000 net loss x 20%)

44 Equity Method Amounts paid in excess of (or less than) investee’s book value becomes part of the cost of the investment –These amounts must be accounted for appropriately after the acquisition –For example, if the difference is due to long-lived assets with fair values greater than book value, the difference must be amortized Share of discontinued operations and other comprehensive income of investee are reported in the same way by the investor (major classifications of income are retained)

45 Equity Method: Impairment Investments with significant influence are assessed at the end of each reporting period to determine if there are indicators of impairment If there are indicators of impairment, the impairment test is carried out Impairment loss is recognized in income and is measured as carrying amount in excess of investment’s recoverable amount Investment’s recoverable amount is measured as the higher of value in use and fair value less cost to sell Impairment losses may be reversed

46 Equity Method: Disposal On disposal of the investment, both investment account and investment income accounts are brought up to date (i.e. adjusted for investor’s share of associate’s income and changes in book value up to date of sale) Investment’s carrying value is removed and any gains/losses are recognized in net income

47 Investments in Subsidiaries A corporation (the parent) can acquire control of another corporation (the subsidiary) Control is generally acquired through purchasing 50% or more voting shares Control is defined as continuing power to determine/direct the strategic operating, financing, and investment policies/activities, without the co-operation of others

48 Investments in Subsidiaries Under IFRS, investments for subsidiaries are accounted for preparation of consolidated financial statements –The two corporations are reported as a single business entity Under private entity GAAP, parent company has the following options when accounting for subsidiaries: –Consolidate all subsidiaries –Account for all subsidiaries under either equity or cost method (cost method cannot be used if shares are traded in an active market, and FV-NI is used instead)

49 Consolidated Financial Statements Parent Corporation -Income Statement -Balance Sheet Subsidiary Corporation -Income Statement -Balance Sheet Consolidated Entity (Reported by Parent Corporation) Combined Balance Sheet, line-by-line (100%) Combined Income Statement, line-by-line (100%) Eliminate any unrealized inter-company gains and losses Eliminate any inter-company balances Parent eliminates the investment in the subsidiary company Non-controlling interest reported (the percent of the subsidiary not owned by the parent) on both balance sheet and income statements

50 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

51 Presentation and Disclosure For investments without significant influence or control, key presentation issue is classification of investment as current vs. long-term Key disclosures include following types of information: –Carrying amount of investments –Income statement effects –Financial risk IFRS generally has more onerous disclosure requirements than private entity GAAP

52 Investments Accounting Models Introduction Cost / amortized cost model Fair value through net income model Fair value through OCI model GAAP classificationsImpairment Incurred loss model Expected loss model Fair value loss model Accounting standards for impairment IFRS / Private Entity GAAP Comparison Looking ahead Comparison Strategic Investments Investments in associates Investments in subsidiaries Presentation, Disclosure, and Analysis Financial statement presentation and disclosure Analysis

53 Looking Ahead Area of accounting for financial assets in general is undergoing significant change IASB and FASB are currently working on simplifying accounting for financial instrument (especially ones without significant influence or control) Additional changes expected from IASB include: –New impairment standard –New financial instrument derecognition standard –Revisions to conceptual frameworks (IASB and FASB)

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