27-1 copyright 2006 mcgraw-hill australia pty ltd ppts t/a new zealand financial accounting 3e by...

27-1 Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant SamkinSlides prepared by Grant Samkin and Annika Schneider

Accounting for equity investments

Chapter 27


Learning objectives

• Be aware of how to account for equity investments

• Be aware that investments in associates (defined as investees over which the investor has significant influence) must be accounted for by using the equity method of accounting, and know how to apply this method of accounting

• Be aware of tests that can be applied to determine the existence of significant influence

• Be aware of the disclosure requirements of NZ IAS 28 ‘Investments in Associates’

(Continues)


Status of newly converged accounting standards

• Prior to 2005, equity investments could be measured at:

– cost; or – revalued amount

• From 2005, equity investments are to be measured in accordance with NZ IAS 139 ‘Financial Instruments: Recognition and Measurement’ and NZ IAS 32 ‘Financial Instruments: Presentation and Disclosure’

(Continues)


Status of newly converged accounting standards (cont.)

• NZ IAS 28 ‘Investments in Associates’ replaces FRS-38 ‘ Accounting for Investments in Associates’

– These standards are fundamentally the same, with few material differences


Introduction to accounting for equity investments

• The chapter considers how to account for equity investments where the investor does not have control over the investee

• To determine the correct accounting treatment of equity investments a number of factors should be considered:

– What is the nature of the investor’s operations?– Is the investment held for trading purposes?

(Continues)


Introduction to accounting for equity investments (cont.)

• If the investor has significant influence over the investee, the equity method of accounting must be applied

– investment in an associate is increased by any post-acquisition movements in the associate’s earnings and reserves

• An equity investment is deemed to exist where (NZ IAS 32):

– the investor has acquired an equity instrument, which can be defined as:

any contract that evidences a residual interest in an entity’s assets after deducting all its liabilities


Why do firms make equity investments?

• Instead of leaving cash in low interest bank deposits

• To have ready access to funds for dividend payments, taxes and periodic capital works

• When sources of cash are needed in the short term, firms invest in marketable securities readily convertible to cash

– disclosed as current assets

• Marketable securities:– are debentures, shares, options or bonds readily

sold at reasonably short notice

(Continues)


Why do firms make equity investments? (cont.)

• Long-term investments:

– shares in listed companies to yield income from dividends and increases in market value

– diversified portfolio of shares to reduce overall risk exposure

– larger stake in a specific company in anticipation of a takeover bid or to gain representation on the board


Types of investments

• Equity investments– Usually shares in an organisation– Give investor an ownership interest and therefore

share in profits

• Bonds– Instrument that binds one party to repay funds

to another party at a specified time and rate– For example, debentures and unsecured notes– Can be issued at face value, discount or premium– Some can have both debt and equity characteristics

(Continues)


Types of investments (cont.)

• Cash investments– Can be converted to cash at short notice– For example, interest-bearing deposits

• Property investments– Various investments in physical property– For example, land and buildings– Held to earn rentals and/or capital appreciation– Can be purchased directly or through a property trust

• Also derivative instruments (Ch. 15)– Derive their value from other underlying assets– For example, futures and options


Accounting standards for equity investments

• Financial instrument (NZ IAS 32)– any contract that gives rise to a financial asset of one

entity and a financial liability or equity instrument of another entity

• Categories of financial instruments in which equity investments can be included (NZ IAS 39):

– financial asset or financial liability at fair value through profit and loss

– available-for-sale financial assets

(Continues)


Accounting standards for equity investments (cont.)

• Financial asset at fair value through profit or loss

– Equity investments (current or non-current assets) can be recorded at fair value

– Any periodic adjustments for movements in fair value are included in the profit or loss for the period

– Classified as held for trading or, upon initial recognition, designated at fair value through profit or loss

(Continues)



• Available-for-sale financial assets

– Includes all financial assets that don’t fall within other categories in NZ IAS 39

– Are to be measured at fair value with changes in fair value to be recognised directly in equity

– When financial asset is derecognised (e.g. through sale, changes in fair value are to be transferred out of equity and recognised in profit or loss)

(Continues)



• Investments in associates

– Associate: investees over which the investor has significant influence

– Investee: entity in which another entity has an ownership interest

– Investor: entity/person that has an ownership interest in another entity

– Significant influence: power to participate in investee’s financial and operating policy decisions (but not control or joint control)

(Continues)



• NZ IAS 28 requires that:– where an investor does significantly influence an

investee, the investor must adopt the equity method of accounting


Equity method of accounting

• NZ IAS 28 requires:– use of equity accounting within the financial statements;

and – application of equity accounting to include corporate

investments and non-corporate investments

• Significant influence:– used in determining whether the equity method

is to be applied– normally stems from investor’s voting power in

the investee– assumed to exist where investor holds 20 per cent

or more of investee’s voting power(Continues)


Equity method of accounting (cont.)

• Significant influence (cont.)

– Other indicators: representation on board participation in policy-making processes material transactions between investor and investee interchange of managerial personnel provision of essential technical information

– If the investor subsequently ceases to have significant influence, they must cease using equity accounting


Application of the equity method of accounting

• If not material, investor not required to comply with NZ IAS 28

• Investment in associate is initially recognised at cost

• Carrying amount of investment is increased or decreased to recognise investor’s share of investee’s post-acquisition profits

• Investor’s share of investee’s profit or loss to be included in investor’s profit or loss

• Distributions (e.g. dividends) from investee reduce the investment’s carrying amount

(Continues)


Application of the equity method of accounting (cont.)

• Adjustments to carrying amount also for:– changes in investor’s proportionate interest in

investee from changes in investee’s equity not included in investee’s profit or loss

• For example, revaluations of property, plant and equipment and foreign exchange translation differences

• Investor’s share of changes recognised directly in investor’s equity

(Continues)



• If investor is required to prepare consolidated accounts they should:

– recognise investment in associate by applying equity method in consolidated financial statements; and

– apply cost or fair value methods in own individual financial statements

• If investor does not prepare consolidated financial reports they should:

– apply the equity method to their own ‘separate’ financial report

(Continues)



• At acquisition, the difference between investor’s share of adjusted values of investee’s net assets and cost of investment is regarded as:

– goodwill; or – discount on acquisition

• When recognising investor’s share of associate’s post-acquisition profits:

– adjustments are to be made to profit share to take into account depreciation based on fair values of associate’s asset

(Continues)



• Rationale for adopting the equity method– Stream of dividend receipts (revenue under

the cost method) might provide inaccurate guide to investee’s performance and value

– Provides a better indication of investment’s underlying worth

• Criticisms by opponents of equity method– Breaches realisation principle tied to notion

of conservatism– Investor reports its share of investee’s profits,

even without any dividends– Account balance of investment is neither cost

nor fair value(Continues)



• Refer to Worked Example 27.1, 'Comparison of cost method and the equity method of accounting', pp. 1116–21

Cost method• To recognise initial acquisition of shares:

Debit Investment in associate

Credit Cash at bank

• To recognise receipt of pre-acquisition dividend:

Debit Cash at bank

Credit Investment in associate

(Continues)



Cost method (cont.)• To recognise dividends provided by associate

from post-acquisition profits:Debit Dividend receivable

Credit Dividend revenue

• To recognise receipt of previous dividend provided:Debit Cash at bank

Credit Dividend receivable

(Continues)



Equity method (where investor is a parent)

• In consolidation worksheet (Year 1):Debit Investment in associate

Credit Share of associate’s profit

Debit Dividend revenueCredit Investment in associate

(Continues)




Credit Retained profits (opening)

Debit Share of associate’s profit/loss


Debit Dividend revenue



Credit Revaluation reserve

(Continues)



Equity method (where investor is not a parent)• In investor’s accounts (Year 1):


Credit Share of associate’s profit


(Continues)



• In investor’s accounts (Year 2):Debit Share of associate’s profit/loss


Debit Dividend revenue



Credit Revaluation reserve

(Continues)



• Investor’s share of associate’s profit/loss to be adjusted for (NZ IAS 28):

– any depreciation differences caused by reassessing values of associate’s assets to fair value at date of acquisition

• Carrying amount of investment to be adjusted by (NZ IAS 28):

– post-acquisition increments or decrements in associate’s total reserves except to the extent that movements have already been reflected in associate’s or in carrying amount of investment

(Continues)



• Refer to Worked Example 27.2, 'Adoption of equity accounting in the presence of a difference between fair values of depreciable assets and their book values; and a post-acquisition asset revaluation', pp. 1122–24


Credit Retained earnings• In consolidation worksheet (Year 2):

Debit Investment in associateCredit Share of associate’s profits


Debit Investment in associateCredit Revaluation reserve


Inter-entity transactions• Carrying amount of investment in associate must

be increased or decreased by:– amount of investor’s share of associate’s post-acquisition

profit or loss after adjustments for certain inter-entity transactions

• Investor required to adjust share of associate’s profit or loss for its share of any unrealised profits or losses from transactions between:

– associate and investor (or any controlled entities); and– associate and any other associate of the investor

(Continues)


Inter-entity transactions (cont.)

• Transactions between associate and member of economic entity– The proportion of unrealised profits or losses

to be eliminated is investor’s ownership interest in associate

• Transactions between two associates of the investor– The proportion of unrealised profits or losses

to be eliminated is product of investor’s ownership interest in each associate

(Continues)



• Refer to Figure 27.2, 'Investor Company and it subsidiaries and associates', p. 1125

• Investor company:– Subsidiary A: 100% owned– Subsidiary B: 80% owned– Associate A: 40% owned– Associate B: 30% owned

(Continues)



• Transaction 1

– Associate A sells goods to Subsidiary A for a profit of $10 000

– At balance date, Subsidiary A still has 50% of the goods on hand

– Amount of unrealised gain = 50% of $10 000 = $5000

– Amount to be eliminated = 40% of $5000 = $2000

(Continues)



• Transaction 2– Same circumstances as Transaction 1, except

goods sold by Associate A to Subsidiary B– Same amount to be eliminated, even though

Subsidiary B is only 80% held• Transaction 3

– Associate A sells goods to Associate B for a $20 000 profit

– At balance date, 75 per cent of goods on hand– Amount of unrealised gain = 75% of $20 000

= $15 000– Amount to be eliminated = 12% (0.40 × 0.30)

of $15 000 = $1800

(Continues)



• Investor might not be able to access necessary information owing to lack of control over associate

• Refer to Worked Example 27.3, 'Sale of inventory and a depreciable asset from an associate to an investor', pp. 1127–9

– Journal entries as per previous examples


Losses incurred by an associate

• Equity method to be discontinued when:– effect of equity-accounting losses or revaluation

decrements causes investment carrying amount to fall below zero

• When it is possible that associate will generate accounting profits or recognise revaluation increments in a subsequent period

– Investment in associate to be increased only by investor’s share of profits or revaluation increments when such increases offset losses and revaluation decrements not recognised following suspension of the equity method


Carrying amount of the investment in an associate

• If investment carrying amount exceeds recoverable amount:

– carrying amount to be written down to recoverable amount; and

– write-down to be recognised in the income statement

• If recoverable amount then increases above carrying amount:

– reversal required up to maximum of previous write-down(s)

– reversal amount to be recognised in income statement

• Maximum amount to be shown for investment in associate is carrying amount from equity method


Disclosure requirements

• As per NZ IAS 28:– fair value of investments in associates with published

price quotations– summarised financial information of associates– reasons why investor concludes it has significant

influence when it has less than 20% voting power– reasons why investor concludes it does not have

significant influence when it has more than 20% voting power

– reporting date of associate’s financial reports if different from that of investor

(Continues)


Disclosure requirements (cont.)• As per NZ IAS 28 (cont.):

– nature and extent of significant restrictions on associates’ ability to transfer funds to the investor

– unrecognised share of associate’s losses– the fact that an associate is not accounted for under

the equity method– summarised financial information of associates not

accounted for using the equity method– various details of significant associates– amount of investor’s share of associates’ profit or

loss before income tax and income tax expense– amount of impairment losses and reversals– amount of investor’s share of associates’ capital

and other expenditure commitments(Continues)


Disclosure requirements (cont.)

• As per NZ IAS 28 (cont.):

– investments in associates accounted for using the equity method to be classified as non-current assets

– investor’s share of associates’ profit or loss to be separately disclosed

– investor’s share of changes recognised directly in associates’ equity to be recognised directly in equity by the investor

(Continues)


Disclosure requirements (cont.)

• In accordance with NZ IAS 37 an investor shall disclose:

– its share of associate’s contingent liabilities incurred jointly with other investors

– those contingent liabilities arising because investor is severally liable for associate’s liabilities

(Continues)


Summary

• The chapter considers issues relating to the valuation and disclosure of equity investments

• If an active market, equity investments to be valued at fair value (NZ IAS 39)

• If investor has significant influence over investee (i.e. an associate), equity accounting must be used to account for investor’s interest in associate

• If an entity is deemed to be an associate, various disclosures are required in notes to investor’s financial statement (regardless of whether equity accounting is applied)


Summary of main changes to accounting standards

• From 2007 (or 2005 for early adopters), if equity investments have a quoted market price in an active market and fair value can be reliably measured:

– investments to be measured at fair value (NZ IAS 39)

• Under NZ IAS 28, investments in partnerships to be treated as investments in associates and equity accounting to be applied

• Goodwill amortisation now specifically prohibited

(Continues)


Summary of main changes to accounting standards (cont.)

• NZ IAS 28 does not address issue of investor’s share of movements in associate’s reserves subsequent to acquisition of each ownership interest being recognised as part of reserves

27-1 copyright 2006 mcgraw-hill australia pty ltd ppts t/a new zealand financial accounting 3e by...

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