Chapter 2 Investments In Equity Securities
Chapter Objectives • Classification of equity investments • Accounting for equity investments • Matching classifications with methods
Conceptual Basis For Classification Control Held for trading Available for sale Significantly Influenced companies Joint ventures Subsidiaries 100% 0% 50%
Classification • Non-strategic investments • held-for-trading • available-for-sale • Strategic investments • Subsidiaries • Significantly influenced companies • Interests in joint ventures
Accounting Methods • Cost method • Equity method • Fair value method (changes in Net Income) • Fair value method (changes in Comprehensive Income) • Full consolidation • Proportionate consolidation
Held-For-Trading • Defined (Section 3855) • Acquired principally for the purpose of selling or repurchasing in the short term; • A derivative; or • Any financial asset or liability that is so designated
Held-For-Trading • Application To Investments • Equity securities held for short term trading • Other non-strategic holdings that are designated as held for trading
Held-For-Trading • Accounting Procedures • Initial and subsequent measurement at fair value • Changes in fair value are allocated to Net Income • Transaction costs charged to Net Income at acquisition
Held-For-Trading Example EXAMPLE: On January 1, 2008, Holly Inc. acquires 1,000 shares of Helm Ltd. for $10 per share. The shares are classified as held for trading. On December 31, 2008, the Helm Ltd. shares are trading at $12 per share. During 2008, Helm Ltd. declares and pays dividends of $0.75 per share. On January 1, 2009, the securities are sold for $13 per share.
Held-For-Trading Example • Acquisition Of Investment
Held-For-Trading Example • Receipt Of Dividends
Held-For-Trading Example • Year End Adjustment
Held-For-Trading Example • Sale Of Investment
Available-For-Sale • Defined (Section 3855) • Non-derivative financial assets that are designated as available for sale, or that are not classified as loans and receivables, held-to-maturity, or held-for trading
Available-For-Sale • Would include all equity investments other than: • Investments in subsidiaries • Investments in significantly influenced companies • Investments in joint ventures • Investments that are classified as held for trading.
Available-For-Sale • Accounting Procedures • Initial and subsequent measurement at fair value • Changes in fair value are allocated to Comprehensive Income • Transaction costs: • charged to Net Income at acquisition, or added to the initial cost
Available-For-Sale Example EXAMPLE: On January 1, 2008, Holly Inc. acquires 1,000 shares of Helm Ltd. for $10 per share. The shares are classified as available for sale. On December 31, 2008, the Helm Ltd. shares are trading at $12 per share. During 2008, Helm Ltd. declares and pays dividends of $0.75 per share. On January 1, 2009, the securities are sold for $13 per share.
Available For Sale Example • Acquisition Of Investment
Available For Sale Example • Receipt Of Dividends
Available For Sale Example • Year End Adjustment
Available For Sale Example • Sale Of Investment
Cost Method • Applicability • Can be used when available-for-sale securities do not have quoted market prices • Procedures • Investment at cost • Earnings only when received or receivable
Cost Method • Return of capital: Occurs when dividends received exceed the investor’s share of earnings since acquisition
Return Of Capital Example EXAMPLE: On January 1, 2008, Norton Inc. acquires 10 percent of the voting shares of Montage Ltd. for $500,000. During 2008, Montage has Net Income of $350,000 and pays dividends of $250,000. During 2009, Montage has Net Income of $100,000 and pays dividends of $250,000.
Return Of Capital Example • Acquisition Of Investment
Return Of Capital Example • Receipt of 2008 dividends
Return Of Capital Example • Receipt of 2009 dividends
Subsidiaries • Paragraph 1590.03(b) – A subsidiary is an enterprise controlled by another enterprise (the parent) that has the right and ability to obtain future economic benefits from the resources of the enterprise and is exposed to the related risks.
The Concept Of Control 1590.03(b) Control of an enterprise is the continuing power to determine its strategic operating, investing, and financing policies without the co-operation of others.
The Concept Of Control • In general, based on ownership of more than 50 percent of the outstanding voting shares • Exceptions • Control may exist without majority ownership • Control may not exist even with majority ownership
The Concept Of Control Indirect Control P A B 60% 55% P Controls B
The Concept Of Control Indirect Control P 70% X 60% 30% Y 40% Z P Controls Z
Subsidiaries • Accounting Procedures • Paragraph 1590.16 An enterprise should consolidate all of its subsidiaries. (January, 1992) • Consolidation procedures will be covered in Chapters 4, 5, and 6
Significantly Influenced Companies • Defined • IAS 28 Significant influence is the power to participate in the financial and operating policy decisions of the investee, but is not control over those policies • CICA has a 20 percent guideline • Judgment would have been better • Key is the ability to elect directors
Significantly Influenced Companies • Required Accounting Procedures: Section 3051 requires the use of the equity method
Equity Method Procedures • Accounting for the investment asset • Investment is recorded at cost • Adjusted each year for the investor’s shares of the investee’s change in Retained Earnings
Equity Method Procedures • Accounting for investment income Investment income is equal to the Investor’s share of the reported Net Income of the Investee.
Equity Method Example EXAMPLE: On January 1, 2008, Fortin Inc. pays $800,000 for a 25 percent interest in the voting shares of Beauchamp Ltd. This investment gives Fortin Inc. significant influence over Beauchamp Ltd. During the year ending December 31, 2008, Beauchamp Ltd. has net income of $300,000 and pays dividends of $180,000. During the year ending December 31, 2009, Beauchamp Ltd. has a net loss of $100,000 and pays dividends of $150,000. On January 1, 2010, Fortin’s holding of Beauchamp securities is sold for $1,200,000.
Equity Method Example • Acquisition Of Investment
Equity Method Example • 2008 Income And Dividends
Equity Method Example • 2009 Income And Dividends
Equity Method Example • Sale Of Investment
Results of discontinued operations and extraordinary items of the investee must be shown in the investor’s Statement Of Net Income as separate line items after Income Or Loss Before Discontinued Operations And Extraordinary Items. Equity Method Intra Statement Disclosure
EIC No.8: negative balance can be shown if: Investor has guaranteed obligations of the investee The investor is committed to provide further financial support The investee seems assured of returning to profitability Equity Method Losses Exceed Investment Balance
Significant Influence To Control Consolidation is required Equity Method Loss Of Significant Influence
Significant Influence To No Influence Will become held-for-trading or available-for-sale The “new cost” will be the equity value at the time of the change Equity Method Loss Of Significant Influence
Equity Method • Consolidation Adjustments • All of the adjustments that would be required in preparing consolidated statements are required here. • See Chapters 5 and 6 for illustrations of these procedures.
Significantly Influenced Companies • Disclosure • Basis of valuation • Separate disclosure of the class in both the Balance Sheet and the Income Statement • Treatment of the difference between the cost of the investment and the underlying book value of the investee’s assets at the date of acquisition.
Joint Venture Arrangements • Paragraph 3055.03(c) A joint venture is an economic activity resulting from a contractual arrangement whereby two or more venturers jointly control the economic activity
Joint Venture Arrangements • Current accounting rules require the use of proportionate consolidation • Proportionate consolidation will be covered in Chapter 8 • IASB will eliminate proportionate consolidation and require the equity method