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INVESTMENTS
After studying this chapter you should be able to:
Understand the nature of investments including which types of companies have significant investments.
Explain and apply the cost/amortized cost model of accounting for investments.
Explain and apply the fair value through net income model of accounting for investments.
Explain and apply the fair value through other comprehensive income model of accounting for investments.
Explain and apply the incurred loss, expected loss, and fair value loss impairment models.
Explain the concept of significant influence and apply the equity method.
Explain the concept of control and when consolidation is appropriate.
Explain how investments are presented and disclosed in the financial statements noting how this facilitates analysis.
Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future.
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Investments
Presentation, Disclosure, and Analysis
Presentation and disclosure
Analysis
Understanding Investments
Types of investments
Types of companies that have investments
Information for decision-making
Measurement
Cost / amortized cost model
Fair value through net income model
Fair value through OCI model
Impairment models
Strategic Investments
Investments in associates
Investments in subsidiaries
IFRS / ASPE Comparison
Comparison
Looking ahead
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Type of 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
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Measurement
Method of accounting for a particular investment can depend on:
Type of instrument (debt vs. equity)
Management’s intent
Company strategy
Ability to reliably measure instrument’s fair value, or
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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)
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7. Accounting Models: Summary
Cost/Amortized Cost Model
FV-NI
FV-OCI
At acquisition, measure at:
Cost (fair value + transaction costs)
Fair value
At each reporting date, measure at:
Cost or amortized cost
Unrealized holding gains/losses reported in:
Not applicable
Net income
OCI
Realized holding gains/losses reported in:
Transfer total realized to net income (recycling), or to retained earnings
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8. Cost/Amortized Cost Model: Investments in Shares
Cost model for investments in shares of another entity:
Recognize cost of investment at fair value (plus direct transaction costs)
Report at cost (unless impaired)
Recognize dividend income when have claim to dividend
When dispose of investment, derecognize and report a gain/loss on disposal in net income.
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9. Cost/Amortized Cost Model: Investments in Debt Securities
Amortized cost model for investments in debt securities of another entity:
Recognize cost of investment at fair value (plus direct transaction costs)
Report at amortized cost as well as interest receivable (unless impaired)
Recognize interest income as earned, and also amortize any discount/premium by adjusting carrying amount of investment
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.
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10. Amortized Cost Model: Example
Given:
Face amount: $100,000
Purchase date: January 1, 2014
Maturity date: January 1, 2019
Interest paid: July 1st and January 1st
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%) + PVA of ($100,000 X 4%) where n=10, i = 5%
PV is approximately equal to $92,278
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11. Amortized Cost Model: Example
The entry to record this purchase is:
Investment in Bonds 92,278
Cash ,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)
ASPE also allows straight-line method of amortizing premium or discount
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12. Bond Discount Amortization
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13. 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
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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
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15. 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”
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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-Bill 19,231
Cash ,231
Entry on Sept 15:
Cash ,000
Temporary Investment in T-Bill 19,231
Investment Income/Loss
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FV-NI: An example
A company reported on December 31, 2015:
Investments Carrying Amount Fair Value
In various shares $192, $191,200
Adjustment to fair value (192, ,200= $1,790)
Entry to record adjustment at year end:
Investment Income/Loss ,790
FV-NI Investments ,790
2015
Current assets:
FV-NI Investments $191,200
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18. 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
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19. 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)
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FV-OCI: An Example
Given share investment accounted for at FV-OCI:
Fair value at Dec. 31, $275,000
Carrying amt. at Dec. 31, ,700
Unrealized Holding Gain $ 15,300
Entry to Record:
FV-OCI Investments ,300
Unrealized Gain or loss – OCI ,300
Long-term investments (assumed)
FV-OCI Investments $ 275,000
Shareholders’ Equity
Accumulated other comprehensive income (loss) $ 15,300
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FV-OCI: An example
On January 23, 2014 sell investment for $287,220
Entry to record adjustment to fair value:
FV-OCI Investments ($287, ,000) 12,220
Unrealized Gain or loss – OCI ,220
Entry to record sale and proceeds:
Cash ,220
FV-OCI Investments ,220
Entry to transfer holding gains:
Unrealized Gain or loss – OCI (15,300+12,220) 27,520
Gain on Sale of Investment 27,520
OR (if FV-OCI without recycling)
Retained Earnings 27,520
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ASPE Classifications
ASPE 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
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IFRS Classifications
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.
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IFRS Classifications
IFRS standard effective 2015 (with early adoption possible) 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”
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IFRS Classifications
Reclassification from one category to another is not allowed, except under very limited situations
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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:
Incurred loss model
Expected loss model
Full fair value model
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27. 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)
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28. 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)
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29. 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
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30. 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-NI instruments: full fair value model
IFRS proposals include:
For instruments at amortized cost: expected loss model
For instruments at fair value: always adjust to FV
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31. Impairment: Accounting Standards
ASPE has following requirement:
For financial asset investments accounted for at cost or amortized cost: incurred loss model (using current market rate)
For equity instruments (with market values) and derivative instruments, use fair value model
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32. 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:
Little or no influence
Significant influence
Control
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33. Equity Investments: Common Shares%
Ownership 0%
20%
50%
100%
Level of Little or Significant Control
Influence none
Type of Less than Associate, or Subsidiary
Investment significant significant
influence influence
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34. Investment in Associates: Significant Influence
Applies to equity investments of significant influence (not control)
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
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35. Investment in Associates
Under IFRS, investments in associates (i.e. “significant influence”) are accounted for using the equity method of accounting
ASPE, 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)
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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:
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37. Equity Method: Example
Given:
Maxi Corp. purchases 20% of Mini Corp., and exercises significant influence
January 2, 2013 Maxi purchases 48,000 $10 per share
For the year 2013 Mini Corp. reports a net income of $200,000
December 31, 2013 shares of Mini Corp. have a market price of $12 per share
January 28, 2014 Mini Corp. declared and paid a total cash dividend of $100,000
For the year 2014, Mini Corp. reports a net loss of $50,000
Prepare all necessary journal entries, using the Equity Method
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38. Equity Method: Example
January 2, 2013
Investment in Mini Corp ,000
Cash ,000
(48,000 shares x $10)
December 31, 2013
Investment in Mini Corp. 40,000
Investment Income 40,000
($200,000 net income x 20%)
No entry required to reflect market price (or fair value). Investment is not impaired.
January 28, 2014
Cash ,000
Investment in Mini Corp. 20,000
($100,000 Dividend x 20%)
December 31, 2014
Investment Loss ,000
Investment in Mini Corp. 10,000
($50,000 net loss x 20%)
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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)
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40. 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
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41. 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
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42. 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
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43. 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 ASPE, 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)
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44. 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
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45. 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 ASPE
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46. Investments – Recent Changes
Due to the complexity of accounting for investments, a number of proposals from IASB and FASB relating to:
Simplification of existing accounting standards
New model for impairments and use of expected loss approach
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47. COPYRIGHT
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