CHAPTER 9InvestmentsPart 1

*InvestmentsFirms can make investments in debt securities (e.g. investments in government debt, corporate bonds, convertible debt, and commercial paper) or equity securities (buying common stock or preferred shares in another company)Benefits to the firmHigher rate of return than bank savings or current accountsshort-term returns (interest or dividend paymentslong-term returns (stock price appreciation)corporate strategyInvestments are accounted for based on :Type of instrument (debt vs. equity)Managements intent (e.g. Investing for short vs long term)Ability to reliably measure instruments fair value, orExtent to which firm has control over investee

*Accounting ModelsThere are four main models of accounting for investments: Cost model (investment in other firms shares)

Amortized cost model (investment in other firms debt security)Use if being held to maturity

Fair value through net income model (FV-NI or FVTPL)Use if held to sell in near term or to generate profit through fluctuations in price

Fair value through other comprehensive income model (FV-OCI)Use if investments in equity that are not held for trading purposes

Under all models, interest earned and dividends received are recognized in net income

*Accounting Models: Summary

Cost ModelAmortized Cost ModelFV-NIFV-OCITransaction costsCapitalizedCapitalizedExpensedExpensed or CapitalizedAt acquisition, measure at:Cost (fair value + transaction costs)Cost (fair value + transaction costs)Fair valueFair valueEnd of Period measure at:CostAmortized costFair valueFair valueUnrealized holding gains/losses reported in:Not applicableNot applicableNet incomeOCIRealized holding gains/losses reported in: Net incomeNet incomeNet incomeNet income (recycling), or retained earnings

*IFRS Requirements (IAS 39)Amortized cost used only ifThe firms business model is to manage the instrument as if held to maturityANDContractual cash flow can be characterised as the payments of principal and interest on principal outstanding at specified datesOtherwise use FV-NI.IFRS proposed draft standard includes two additional options: Equity 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 to correct an accounting mismatch

*Cost Model: Equity InvestmentChanges in investments market value have no effect on balance sheet or income statement until sold At acquisition recognize the cost of investment at fair value (plus direct transaction costs)In subsequent periods report at cost (unless impaired)Receipts of dividend recognized as dividend income When investment is sold, the difference between original cost and final market value is called a realized gain/loss which is reported in net income.

*Amortized Cost ModelUsed for investments in another firms debt security At acquisition recognize the cost of investment at fair value (plus direct transaction costs)In subsequent periods report at amortized cost (unless impaired)recognize interest receivablerecognize interest income as earnedamortize any discount/premium by adjusting carrying amount of investment When investment is soldfirst bring accrued interest and discount/premium amortization up to date. Derecognize investment and report a gain/loss on disposal in net income.

*Sale of InvestmentsDiscount (or premium) is amortized from last date of amortization to the date of saleNew carrying amount calculated, which is the amortized cost balance plus the discount (or minus the premium) amortized from last date of amortizationGain (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

BE9-7 Amortized Cost

On September 1, Louisa Ltd. purchased $80,000 of five-year, 9% bonds for $74,086, resulting in an effective (yield) rate of 11%. The bonds pay interest each March 1 and September 1. Louisa Ltd. applies ASPE, accounts for the investment under the amortized cost approach using the effective interest accounting policy, and has a December 31 year end. The following March 1, after receiving the semi-annual interest on the bonds, Louisa sells the bonds for $75,100. Prepare Louisas journal entries for:

(a) the purchase of the investment, (b) any adjusting entry(ies) needed at December 31, (c) the receipt of interest on March 1, and (d) the sale of the bond investment on March 1. *

*Fair Value through Net Income (FV-NI) ModelAt acquisition record investment at fair valueExpense transactions costsAt end of period, adjust investments to the current fair valueThe resulting unrealised holding gain or loss is reported in net incomeInterest or dividend income plus holding gain or loss reported as Investment Income

BE9-8 FV-NIAbdul Corporation purchased 400 common shares of Sigma Inc. for trading purposes for $13,200 on September 8 and accounted for the investment under ASPE at FV-NI. In December, Sigma declared and paid a cash dividend of $1.75 per share. At year end, December 31, Sigma shares were selling for $35.50 per share. In late January, Abdul sold the Sigma shares for $34.95 per share. Prepare Abdul Corporations journal entries to record (a) the purchase of the investment, (b) the dividends received, (c) the fair value adjustment at December 31, and (d) the January sale of the investment.

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*Fair Value through Other Comprehensive Income (FV-OCI)At acquisition record investments at fair value Transaction costs are usually added to investments carrying amountAt end of period adjust investments to current fair valueThe resulting unrealised 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

*Fair Value through Other Comprehensive Income (FV-OCI)When investments are sold the balance of the unrealized holding gains or losses are transferred from OCI/AOCIUnder FV-OCI with recycling, unrealized holding gains or losses are transferred into net incomeUnder FV-OCI without recycling, unrealized holding gains or losses are transferred directly into retained earnings bypassing net income

E9-11 FV-NI and FV-OCIArantxa Corp made the following cash purchases of investments during 2011:Jan 15 purchased 10,000 shares of Nirmala Corp.s common shares at $33.50 per share plus commission of $1,980.April 1 purchased 5,000 shares of Oxana Corp.s common shares at $52.00 per share plus commission of $3,370September 10 purchased 7,000 shares of WTA Corp.s preferred shares at $26.50 per share plus commission of $4,910On May 20, 2010 Aranxa sold 4,000 of the Nirmala common shares at a market price of $35/share less brokerage commisions of $3,850. The year-end fair values/share were as follows: Nirmala $30, Oxana $55, and WTA $28.*

E9-11 FV-NI and FV-OCI cont.In addition the CFO told you that Arantxa Corp holds these investments with the intention of selling them in order to earn short-term profits from appreciation in their prices and accounts for them using the FV-NI model.Assume that Arantxa follows IFRS and dividend and interest income is not reported separately.Prepare the j/e to record the three investmentsPrepare the j/e for the sale of the 4,000 Nirmala shares on May 20Prepare the adjusting entries needed on Dec. 31, 2011Repeat a) b) and c) assuming the investments will be accounted for using the fair value through other comprehensive income model.

Arantxas policy is to capitalize transaction costs on the acquisition of FV-OCI investments and reduce the proceeds on disposal.*

*ReclassificationsFirms are not allowed to reclassify investment from one category to another, unless there is a change in business model in relation to investmentsIf reclassification is to a FV-based model, then revalue at FV and recognize gain/loss in income If reclassification is from FV-based model to another, then FV at time of reclassification becomes the new carrying amount

*ImpairmentIn some instances the value carried for investments may be overstated on the balance sheetFirms must periodically test for impairment of investments using one of three models:Incurred loss modelExpected loss modelFull fair value model

*Impairment: Incurred Loss ModelImpairment test is done only if there are indications that impairment has occurred e.g.Severe financial problemsThe firms has defaulted on interest/principal paymentsSignificant financial reorganization or bankruptcyImpairment loss is defined as the difference between the carrying amount and revised present value of expected cash flows using discounted cash flow method. Discount rate for present value calculations is current or historical market rateImpairment loss is recognized in net income.Any subsequent changes in value are adjustments to the impairment loss.

*Impairment: Expected Loss ModelFirm must continually do impairment testingImpairment loss is defined as difference between carrying amount and revised present value of expected cash flowsDiscount rate used is the effective interest rate from time of acquisitionImpairment loss is recognized in net income.

*Impairment: Full Fair Value Loss ModelImpairment loss is defined as the difference between carrying amount and fair value Fair value is determined using the discounted cash flow model, using the current interest rate at time of impairment test Impairment loss is recognized in net income

*ImpairmentIFRS 9 requirement: Incurred loss model for all financial investments accounted for using cost/amortized cost model using original discount rate. May be reversed for debt instrumentsFull fair value model for FV-NI instrumentsIAS 39 requirement: Incurred loss model also used for FV-OCI where trigger event has occurred.Private entity GAAP requirement: Incurred loss model for financial investments accounted for at cost/amortized cost using current market rate

*ReclassificationsFirms are not allowed to reclassify investment from one category to another, unless there is a change in business model in relation to investmentsIf reclassification is to a FV-based model, then revalue at FV and recognize gain/loss in income If reclassification is from FV-based model to another, then FV at time of reclassification becomes the new carrying amount

*Strategic Equity InvestmentsThe accounting treatment for equity investments varies with the level of influence the firm has over the firm it is investing in:Three levels of the type of investmentLittle or no influenceSignificant influence - Associate Control - Subsidiary

*1. Less than Significant InfluenceTypically 0-20% ownershipLittle or no influence on the firms financial or operating policyAccounted for using the cost/amortized cost, FV-NI or FV-OCI models learned before

*2. Determination of Significant InfluenceSignificant influence is defined as the power to participate in the financial and operating policy decisions of an entity, but not control over those policies.2 criteria for significant influence are:Quantitative test: 20% to 50% ownershipQualitative test. Examples are:Whether the firm is represented on the Board of DirectorsThe existence of material intercompany transactionsExchange of management personnelProvision of technical information

*2. Associate or Significant InfluenceIf firm has significant influence in another firm then the type of investment is that of an Associate or Significant InfluenceUnder IFRS, investments in associates/significant influence are accounted for using the equity method of accountingUnder private entity GAAP, investors can use eitherEquity method, or Cost method (However, if the associate shares are traded in an active market the FV-NI model is used)

*2. Associate or Significant Influence - Equity MethodAt acquisition, the investment is recorded at costInvestor reports in net income its share of the investee net income for the yearDr: Investment account Cr: Investment IncomeAny dividends received are credited to the Investment accountUse accrual accounting

*2. Associate or Significant Influence - Equity MethodThe difference between the amounts paid for the investment and the investees book value is part of the cost of the investmentIf this difference is due to long-lived assets with fair values greater than book value, the difference must be amortizedThe investor keeps the major income classifications that the investee used

*2. Associate or Significant Influence - Equity Method: ExampleGiven:Maxi Corp. purchases 20% of Mini Corp., and exercises significant influenceJanuary 2, 2010 Maxi purchases 48,000 shares @ $10 per shareFor the year 2010 Mini Corp. reports a net income of $200,000December 31, 2010 shares of Mini Corp. have a market price of $12 per shareJanuary 28, 2011 Mini Corp. declared and paid a total cash dividend of $100,000For the year 2011, Mini Corp. reports a net loss of $50,000

*2. Equity Method: ImpairmentThe investment is assessed at the end of each reporting period to determine if there are indicators of impairment and impairment test doneImpairment loss is recognized in income and measured as the carrying amount in excess of investments recoverable amount Investments recoverable amount is measured as the higher of value in use and fair value less cost to sellImpairment losses may be reversed

*2. Associate or Significant Influence - Equity Method: DisposalWhen investment is sold, both investment account and investment income accounts are brought up to date (i.e. adjusted for investors share of associates income and changes in book value up to date of sale)Investments carrying value is removed and any gains/losses are recognized in net income

*3. Investments in SubsidiariesA corporation (the parent) controls another corporation (the subsidiary)Control is generally acquired through purchasing 50% or more voting sharesControl is defined as continuing power to determine/direct the strategic operating, financing, and investment policies/activities, without the co-operation of others

*3. Investments in SubsidiariesUnder IFRS, investments for subsidiaries are accounted for using consolidated financial statements where the two corporations are reported as a single business entityUnder private entity GAAP, the parent can eitherConsolidate all subsidiaries, orAccount for all subsidiaries under FV-NI or cost method (cant use if active market exists)

*Consolidated Financial StatementsConsolidated Statements are reported by Parent

Combined Balance Sheet, line-by-line (100%)Combined Income Statement, line-by-line (100%)Eliminate any unrealized inter-company gains and lossesEliminate any inter-company balancesParent eliminates the investment in the subsidiary companyNon-controlling interest reported (the percent of the subsidiary not owned by the parent) on both balance sheet and income statements

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