Chapter 1 Accounting for Investments © 2013 Advanced Accounting, Canadian Edition by G. Fayerman.

Chapter 1Chapter 1

Accounting for Accounting for InvestmentsInvestments

© 2013 Advanced Accounting, Canadian Edition by G. Fayerman

Identifying Non-strategic Identifying Non-strategic Investments in Equity: CriteriaInvestments in Equity: Criteria

• If a company makes a non-strategic investment, it

is considered a financial asset. (IFRS specifically

exempts strategic investments from the definition

of financial assets.)

• A financial asset is defined as any of the

following:

1. Cash

2. An equity instrument of another company

3. A contractual right to receive cash or another

financial asset from another company

4. A contractual right to exchange financial instruments

under conditions that are potentially favourable. LO 1

Identifying Non-strategic Identifying Non-strategic Investments in Equity: CriteriaInvestments in Equity: Criteria

• Investments in the equity of other companies that are non-strategic meet the second criteria of the definition of a financial asset.

• There is a presumption that a company that owns less than 20% of the voting shares of another company does not have control, joint control, or significant influence. It can therefore be inferred that the company must have a non-strategic investment unless other factors prove otherwise (IAS 28).

LO 1

Identifying Non-strategic Investments Identifying Non-strategic Investments in Equity: Initial Recognitionin Equity: Initial Recognition

• Until 2015, companies will be required to classify shares in equity instruments as either “fair value through profit or loss” or “available for sale” (IAS 39).

• For year ends beginning January 1, 2015, IFRS 9 Financial Instruments replaces IAS 39. (This textbook

assumes early adoption of IFRS 9.)

• When adopting IFRS 9, companies must classify their investments in equity instruments at fair value through profit and loss (FVTPL). All equity instruments are recorded at fair value even if a market does not exist.

LO 1

Identifying Non-strategic Investments Identifying Non-strategic Investments in Equity: Initial Recognitionin Equity: Initial Recognition

Possible exceptions to FVTPL:

(1) In limited circumstances, cost may be an appropriate estimate of

fair value(e.g., if insufficient, more recent information is not available to determine fair

value, or if there is a wide range of possible fair value measurements and if cost

represents the best estimate of fair value within that range).

(2) At the day of acquisition when the investment in shares is

originally recorded, the company has the option of making an

“irrevocable election” where it decides that subsequent changes to

fair value will be put in other comprehensive income rather than

through profit and loss.This election cannot be made for investments that are held for trading.

In addition, this amount cannot be “recycled” through profit and loss.

LO 1

RecordingRecording Non-strategic Non-strategic Equity InvestmentsEquity Investments

• Transaction costs for investments that are FVTPL are expensed immediately.

• There is no requirement that dividend income be disclosed separately on the statement of comprehensive income.

• If a non-strategic investment is reported at FVTPL, there is no requirement to test for impairment. This is logical since the investment already reflects the fair value and any adjustment, whether an increase in value or an impairment, has been reflected in net income.

LO 1

Strategic Investments: Strategic Investments: Parent-Subsidiary RelationshipsParent-Subsidiary Relationships

• A subsidiary is defined as an entity that is controlled by another company, the parent.

• The criterion for identifying a parent–subsidiary relationship is control.

• IFRS 10 also requires that consolidated financial statements be prepared when there is a parent–subsidiary relationship. Determining whether one company controls another is then crucial to determining which entities should prepare consolidated financial statements.

LO 2

Strategic Investments: Strategic Investments: Parent-Subsidiary RelationshipsParent-Subsidiary Relationships

• Note that three criteria must be present in order for there to be control. The parent must have:1. the ability to direct the financial and operating policies of another company (the power criterion),2. the ability to obtain returns from the other company (the returns criterion), and3. the ability to use its power to affect those returns (the link criterion).

• Only one company can control another company; control cannot be shared.

• A reporting company must assess control continuously. A company’s ability to control another company may change as facts and circumstances change.

LO 2

Strategic Investments:Strategic Investments:Control - The Power CriterionControl - The Power Criterion

• The ability to direct financial and operating policies refers to a company’s capacity to control. One key aspect of control is the distinction between the capacity to control and that of actual control. Capacity to control does not require the holder to actually exercise control.

• Power arises from rights. Some examples of rights that provide power to the investor:

• voting rights (or potential voting rights) of an investee;• rights to appoint, reassign, or remove members of an investee’s key

management personnel (or another entity) who have the ability to direct the relevant activities; and

• rights to direct the investee to enter into, or veto any changes to, transactions for the benefit of the investor.

LO 2

Strategic Investments: Strategic Investments: Control - The Returns CriterionControl - The Returns Criterion

• Variable returns are defined as “returns that are not fixed and have the potential to vary as a result of the performance of the investee” (IFRS 10.B56).

• Returns could be both positive and negative. If a company owns common shares of another company it can expect variable returns since the dividend (positive) and changes in value of the shares are variable (positive and negative).

• Some examples of returns:• dividends, other distributions of economic benefits from an investee, and

changes in the value of the investor’s investment in that investee;• remuneration for servicing an investee’s assets or liabilities, fees and

exposure to loss from providing credit or liquidity support; and• returns that are not available to other interest holders.

LO 2

Strategic Investments: Strategic Investments: Control - The Link CriterionControl - The Link Criterion

• Link criterion: the ability to use power over the investee to affect the amount of the investor’s returns, which links the first two criteria (the power criterion and the returns criterion).

• For example, when a company has more than 50% of the voting shares, and it is the votes that determine a company’s power, it is obvious that this same company will have the ability to affect the returns since it is through their votes that relevant decisions are made.

LO 2

Presentation of Consolidated Financial Presentation of Consolidated Financial Statements for Controlled EntitiesStatements for Controlled Entities

• “An entity that is a parent shall present consolidated financial statements.” (IFRS 10 , para. 4).

• The process of consolidation requires the parent company to combine its financial statements with the financial statements of its subsidiary.

• By consolidating the two statements, the economic entity is presented as one single company. Consolidated financial statements recognize that the separate legal entities are components of one economic unit and are distinguishable from the separate parent and subsidiary company statements.

LO 2

Assume that ABC Co. acquires its 100%-owned investment in XYZ Co. on December31, 2013. A simplifying assumption here is that the amount paid for the investment is equal to the book value of XYZ at that date.

Assume that ABC Co. acquires its 100%-owned investment in XYZ Co. on December31, 2013. A simplifying assumption here is that the amount paid for the investment is equal to the book value of XYZ at that date.

Example 1.6

LO 2

Presentation of Consolidated Presentation of Consolidated Financial StatementsFinancial Statements

ABC XYZ Adjustments ConsolidatedCompany Company

Statement of Financial PositionAs at December 31, 2013

AssetsCash 1,000 1,200 2,200Accounts receivable 2,000 1,000 3,000Inventory 4,000 2,000 6,000Investment in XYZ Co. 3,000 (3,000) 0

10,000 4,200 (3,000) 11,200

Liabilities and EquityAccounts payable 2,000 1,200 3,200Common shares 4,500 1,500 (1,500) 4,500Retained earnings 3,000 1,200 (1,200) 3,000Cumulative OCI 500 300 (300) 500

10,000 4,200 (3,000) 11,200

Strategic Investments: AssociatesStrategic Investments: Associates

• IAS 28, para. 2, defines an associate as:“an entity…over which the investor has

significant influence and that is neither a subsidiary nor an interest in a joint venture.”

• Significant influence is defined as:“the power to participate in the financial and

operating policy decisions of the investee but is not control or joint control over those policies.”

• Note: There is no requirement for the investor to hold any shares, or have a beneficial interest, in the associate.

LO 3

Strategic Investments: AssociatesStrategic Investments: Associates

For significant influence:

•There is no requirement for the investor to hold any shares, or have a beneficial interest, in the associate.

•Key is participation as opposed to domination (control).

•It is the capacity to participate that is required, not actual participation.

•The holding of 20% or more of the voting power leads to the presumption of significant influence.

LO 3

Strategic Investments: AssociatesStrategic Investments: Associates

Indicators of significant influence include:

•Board representation

•Participation in decisions about dividends/profit retentions

•Material transactions between the investor and investee

•Exchange of managerial staff

•Provision of/dependence on technical information

LO 3

The Equity MethodThe Equity Method• Associates are accounted for using the “equity”

method

• Commonly referred to as the “single-line” method or “one-line consolidation” method

• All entries are recorded against the single line investment account

• Involves revaluing the investment and crediting the P&L with the investor’s share of post acquisition profits (after certain adjustments)

LO 3

“Investment in Associate”“Investment in Associate”

“Share of profit/(loss) of Associate”“Share of profit/(loss) of Associate”

Applying the Equity MethodApplying the Equity Method

Initial investment in the associate (cost)

+/- share of post-acquisition retained earnings*

+/- share of current year profits/(losses)*

– share of post acquisition dividends

+/- share of increases/(decreases) in post-acquisition

OCI

= Equity carrying amount

* Subject to some adjustmentsLO 3

Strategic Investments: Strategic Investments: Identifying Joint ArrangementsIdentifying Joint Arrangements

• A company may engage in arrangements that provide for joint control. The definition of control is the same as that used for the assessment of parent–subsidiary relationships.

• IFRS 11 Joint Arrangements identifies joint control as:

“The contractually agreed sharing of control over an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control”.

• The investors are bound by a contractual arrangement and it is the contractual arrangement that establishes control. LO 4

Strategic Investments: Strategic Investments: Joint OperationsJoint Operations

Identifying joint operations:

•In a joint operation, the investor has a contractual right or obligation to the assets and liabilities of the operation.

•A joint arrangement that is not structured as a separate entity is a joint operation. However, a separate entity could still be a joint operation.

•A joint operation is usually a joint arrangement that involves the use of the assets and other resources of the parties, often to manufacture and sell joint products.

LO 4

Strategic Investments: Strategic Investments: Joint OperationsJoint Operations

Accounting and reporting joint operations:

•The party to the joint operation is required to report its share of each asset and liability, revenue, or expense that it owns.

LO 4

Strategic Investments: Joint VenturesStrategic Investments: Joint Ventures

Identifying joint ventures:

•A joint venture must be set up as a separate vehicle. This could mean that a corporation is created but it could also take other legal forms that separate the venture from the investors.

•A company is a party to a joint venture when it does not have the right to the assets or the obligations for the liabilities, only to the net assets.

•A company is a party to a joint venture if it has rights only to a share of the outcome generated by a group of assets and liabilities carrying on an economic activity (i.e., to share in the net income).

LO 4

Strategic Investments: Joint VenturesStrategic Investments: Joint Ventures

Accounting and reporting joint ventures:

•The investor in the joint venture will record in its own books an investment in the joint venture equal to the fair value of the contribution made to obtain their percentage ownership.

•Since the investor has joint control, then all parties must have significant influence.

•The investor is required to report the investment using the equity method.

LO 4

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