CHAPTER 9 INVESTMENTS

CHAPTER TOPICS CROSS-REFERENCED WITH THE CICA HANDBOOK, Part II and IFRS Statement of Comprehensive Income Business Combinations Non-controlling interest Consolidated Financial Statements Investments in Associates Financial Instruments Recognition and Measurement Financial InstrumentsPresentation Financial Instruments Disclosure LEARNING OBJECTIVES
1. Explain and apply the cost/amortized cost model of accounting for investments in debt and equity instruments, and identify how the investments are reported. 2. Explain and apply the fair value through net income model of accounting for investments in debt and equity instruments, and identify how the investments are reported. 3. Explain and apply the fair value through other comprehensive income model of accounting for investments in equity instruments, and identify how the investments are reported. 4. Identify private entity GAAP and IFRS for investments in financial assets where there is no significant influence or control. 5. Explain and apply the incurred loss, expected loss, and fair value loss impairment models, and identify private entity GAAP and IFRS requirements. 6. Explain the concept of significant influence and why the equity method is appropriate, apply the equity method, and identify private entity GAAP and IFRS requirements. 7. Explain the concept of control, the basics of consolidated financial statements, and why consolidation is appropriate, and identify private entity GAAP and IFRS requirements. 8. Explain the objectives of disclosure, and identify the major types of information that are required to be reported for investments in other companies debt and equity instruments. 9. Identify differences in accounting between private entity GAAP and IFRS, and what

PE GAAP N/A and IAS1/IFRS 7 Section 1582 and IFRS 3 Section 1602 and IFRS 3 Section 1601 and IAS 27 Section 3051 and IAS 28 Section 3856 and IFRS 9/IAS 39 Section 3856 and IAS 32 Section 3856 and IFRS 7

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changes are expected in the near future. 10. Recognize the classifications of financial instruments under Canadian GAAP prior to 2011 (Appendix 9A).

This chapter focuses on the basic accounting models used to account for investments in debt and equity securities in general and which underlie current initiatives. Financial Assets and Investments
A financial asset is defined as being any asset that is: a. cash; b. an equity instrument of another entity; or c. a contractual right: i. to receive cash or another financial asset from another party; or ii. to exchange financial assets or liabilities with another party under conditions that are potentially favourable to the entity. Debt instruments represent a creditor relationship with an enterprise and include debt instruments such as investments in government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Equity instruments represent ownership interest, such as common, preferred, or other capital stock and is any contract that is evidence of a residual interest in the assets of an entity after deducting all its liabilities. A company will invest in debt and equity instruments issued by other companies to make a return, such as interest, dividends, or capital appreciation, on excess cash not needed for other purposes. The investment may be intended to generate shortterm or long-term returns, depending on the companys goals and need for the excess cash. A company may also invest for strategic reasons. Strategic investments are entered into to give the investing company (the investor) significant influence or control over the operating, investing, or financing decisions of the company in which it has invested (the investee).

Accounting for the investments depends on the type of instrument (debt or equity), managements intent, the ability to reliably measure fair value, or the extent to which a company can influence the activities of the investee company. Accounting for initial investments requires them to be measured on acquisition at fair value, which is generally the price paid. Transaction costs are added to the acquisition cost if the cost method is used and are expensed if the fair value method is used.

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Subsequent to acquisition, the change in the fair value carrying amount of financial instruments measure at fair value are called unrealized holding gains or losses. These gains and losses are usually identified separately on the financial statements. There are three accounting models used for the various non-strategic debt and equity investments. They include: a. Cost/amortized cost model. Measured at cost on acquisition (equal to fair value + transaction costs) At each reporting date, measure at cost or amortized cost Unrealized holding gains or losses are not applicable Realized holding gains and losses are reported in net income Fair value through net income model (FV-NI). c. Measured at fair value on acquisition At each reporting date, measure at fair value Unrealized holding gains or losses reported in net income Realized holding gains and losses are reported in net income

b.

Fair value through other comprehensive income model (FV-OCI). Measured at fair value on acquisition At each reporting date, measure at fair value Unrealized holding gains or losses reported in other comprehensive income (OCI) Realized holding gains and losses are transferred to net income or directly to net income

Cost/Amortized Cost Model A cost-based model is applicable to both debt and equity investments. However as shares are not amortized, the term cost is applicable for investments in equity investments. The amortized cost model applies only to investments in debt instruments and long-term notes and loans receivable.
Application of the cost model for an equity investment is as follows: Cost of the investment = fair value of the shares acquired (or fair value of what was given up to acquire them if more reliable) plus any transaction costs on acquisition o Unless impaired, investment reported at its cost each balance sheet date o Recognize dividend income when the entity has a claim to the dividend o When the shares are disposed of, derecognize them and report a gain or loss on disposal in net income. Gain or loss is the difference between the investments carrying amount and the proceeds on disposal. o
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Application of the Cost model to debt investments is as follows: o Cost of the investment = fair value of the debt instrument acquired (or fair value of what was given up to acquire them if more reliable) plus any transaction costs on acquisition o Unless impaired, investment reported at its amortized cost plus any outstanding interest each balance sheet date o Recognize interest income as it is earned, amortizing any premium or discount at the same time by adjusting the carrying amount of the investment. o When the investment is disposed of, first bring the accrued interest and discount or premium amortization up to date. Derecognize the investment, reporting any gain or loss on disposal in net income. Gain or loss is the difference between the investments amortized costs at the date of disposal and the proceeds received for the security.

IFRS requires that the bond premium or discount use the effective interest method. Private entity GAAP allows the straight line method. In practice, the discount or premium on a bond investment is not usually recognized and reported separately, though it could be.

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Fair Value through Net Income (FV-NI) Model

The Fair Value through Net Income (FV-NI) model is also applicable to both debt and equity investments. This model is also referred to as fair value through profit or loss (FVTPL) in International Standards. Application of the FV-NI model is as follows: o Measurement at acquisition = fair value of the investment acquired (or fair value of what was given up to acquire them if more reliable). Transaction costs are expensed. o Carrying amount of each FV-NI investment is adjusted to its fair value at each reporting date with all resulting unrealized holding gains and losses reported in net income along with any dividends or interest income earned. o For FV-NI investments held for trading purposes (i.e. held to sell in the near term or to generate a profit from short-term fluctuations in price) both interest and dividend income need not be reported separately from the holding gains or losses, but rather accounted for and reported together to mirror how such investments are managed. o When the entity holding the investment needs to or wants to track the holding gains and losses separately, the dividend is recognized in an account such as Dividend income, and the adjustment to fair value at each reporting date is recognized in a separate account such as Gain (or Loss) on FV-NI Investment in Shares. o For debt investments, separate reporting is more complex because the recognition of the interest income separately requires that the discount

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or premium be amortized before the change in fair value is recognized. The amortization of the discount/premium changes the investments carrying amount so the fair value adjustment entry has to take this into account. There are several ways the bookkeeping for this can be handled, but the text takes the approach that maintains the investment account at fair value and the necessary amortized cost information is kept in supplementary records. The steps are as follows: Recognize the interest as Interest Income on FV-NI Debt Investments: as it is earned, adjusting the book value of the investment by the amount of any discount or premium amortization The change arising from the adjustment of the investment to its current fair value at each reporting date is recognized as Gain (or Loss) on FVNI Debt Investments. When the investment is disposed of, the realized gain or loss on disposal is equal to the fair value at the last measurement date and the proceeds of disposal.

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Fair Value through Other Comprehensive Income (FV-OCI) Model

Chapter 4 introduced the concept of other comprehensive income (OCI). To recap the terms associated with OCI: o o o Comprehensive income change in equity (or net assets) of an entity during a period from non-owner source transactions and events. It is the total of net income and other comprehensive income. Other comprehensive income (OCI) made up of revenues, gains, expenses, and losses that accounting standards say are included in comprehensive income, but excluded from net income. Accumulated other comprehensive income (AOCI) the balance of all past charges and credits to other comprehensive income to the balance sheet date.

Example of a combined income and comprehensive income statement: Sales Cost of goods sold Gross profit Operating expenses Net income Other comprehensive income Unrealized holding gain, net of tax Comprehensive income $800,000 (600,000) 200,000 90,000 110,000 30,000 $140,000

The Fair Value through Other Comprehensive Income (FV-OCI ) model

under IASB proposals for financial instruments normally will be limited to equity investments in other companies, though this is not finalized and so may extend to debt securities. Application of the model is as follows: o Measurement at acquisition = fair value of the investment acquired (or fair value of what was given up to acquire them if more reliable). Unlike FV-NI investments, transaction costs tend to be added to the carrying amount of the investment. When the investment is adjusted at the first reporting date, the transaction costs will automatically become part of the holding gain or loss recognized in OCI. o Carrying amount of each FV-OCI investment is adjusted to its fair value at each reporting date with all resulting unrealized holding gains and losses reported in other comprehensive income. o Any dividend or interest income earned is reported in net income. o When the investment is disposed of, there are two versions of how the FVOCI model can be applied the when holding gains and losses are realized: FV-OCI with recycling previously unrealized gains and losses to the date of disposal are transferred (recycled) into net income FV-OCI without recycling - previously unrealized gains and losses to the date of disposal are transferred directly into retained earnings

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Impairments
Review for impairment is generally only applicable to investments valued at cost/amortized cost because fair value investments would automatically reflect any impairment. Both IFRS and private entity GAAP require entities adjust for impairment at each reporting date, preferably on an individual investment basis unless doing so would not be timely, in which case investment portfolios with similar characteristics could be grouped and assessed. Impairments on investments are recognized when there is no longer reasonable assurance that the future cash flows associated with them will be either collected in their entirety or when due. Three models could be used to calculate and record the losses. A loss assessed under all models would be recognized in net income and reversals are generally permitted up to amortized cost, though there are some limitations on reversals. These models are: Incurred loss model Expected loss model Fair value loss model

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Below is a summary that can be used to compare the differences and similarities between the impairment loss models.

Strategic Investments
There are two ways that strategic investments are classified as: Significant influence investments bought to give the holder significant influence over the operating, financing, and investing decisions of the investee. Control investments bought to give the holder control over the operating, financing, and investing decisions of the investee. The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. Investments by one corporation in the common share of another and the accounting method to be used can be classified according to the percentage of the voting share of the investee held by the investor (however this is only a guideline and other factors need to be considered): a b c Holding Less than 20%-investor has passive interest Fair Value Method Between 20% and 50%- investor has significant interest More than 50%-investor has controlling interest Method Fair Value Equity Method Consolidation

Other factors in addition to percentage ownership would include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or provision of technical information.

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Equity Method When an investor can exercise significant influence over operating and financial policies of the investee company they are considered to have "significant influence," and is required to account for the investment using the equity method. Under the equity method the investment's carrying amount is periodically increased (decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. The adjustments made to the carrying amount will also result in increases or decreases to investment income. When the investment is originally purchased, the difference between the book value of the company being purchased and the actual amount paid is allocated to the appropriate assets and liabilities purchased. These may be tangible assets (such as inventories), intangible assets (such as patents), or unrecorded assets (such as a customer base). Any excess amount that cannot be allocated to an identifiable tangible or intangible asset/liability as a fair value adjustment is allocated to goodwill. The subsequent accounting for the excess fair value or goodwill follows accounting procedures that would normally be followed for these assets and recognized as either decreases or increases in the investment income.

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Under both IFRS and private entity GAAP, impairments in value are assessed at each balance sheet date and a loss is recorded if the carrying amount is more than the investments recoverable amount. The loss may be reversed if future events indicate that the recoverable amount has improved. On disposal of investment in an associate, the investment account and investment account are brought up to date as at the date of sale and the investment carrying amount is removed from the books through the recording of a gain or loss on the sale.

Consolidation
When one corporation (the parent) acquires a voting interest of more than 50% in another corporation (the subsidiary), the investor corporation is deemed to have a controlling interest. When the parent treats the subsidiary as an investment, consolidated financial statements are generally prepared instead of separate financial statements for the parent and the subsidiary. If the parent and the subsidiary prepare separate financial statements, the investment in the common stock of the subsidiary is presented as a long-term investment on the financial statements of the parent under the equity method. The equity method is sometimes called one line consolidation because the results for net income and retained earnings will be the same whether financial statements are prepared using the equity method or prepared using consolidation.

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Presentation, Disclosure, and Analysis

Investments presentation and disclosure are similar under IFRS and private entity GAAP with some differences, but generally will be: Current Assets o Classification: under IFRS, if it is expected to be sold or otherwise realized with the entitys normal operating cycle or within 12 months from the balance sheet date, held primarily for trading, or is a cash equivalent. Under private entity GAAP, if it is usually realizable within 12 months from the balance sheet date (or operating cycle if longer) and it can be readily converted into cash). o Could include debt and equity instruments measured at cost or amortized cost and those at FV-NI. o Disclosure: under both IFRS and private entity GAAP, the carrying amount of investments and the method used; net gains or losses recognized by method of accounting; interest income, impairment losses and reversals o Under IFRS, need to provide quantitative measures of their risk exposures and concentrations, and information on how management manages these risks. Noncurrent assets o Could include investments held at cost or amortized cost or FV-NI if they dont meet the requirement to be classified as current, and FVOCI investments as they are usually held for long-term strategic purposes o Investments in Associates (unless held for sale). Income is reported as income before discontinued operations, discontinued operations, or other comprehensive income, according to its nature in the associates financial statements. Disclosure for associates accounted for under the equity method include disclosure of the investment category, method of accounting used, fair value of any of these investments if they have an active market, separate disclosure of the income from investments under the equity method, and information about the associates year ends that are different than the investors.

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IFRS and Private Entity GAAP Comparison

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