Financial Reporting and Analysis (SS 5) LOS 16-18
Historically, two accounting methods have been used for business combinations:
1) the purchase method 2) the pooling-of-interest method (has been eliminated from US GAAP and IFRS
Joint Venture
A joint venture is an entity whereby control is shared by two or more investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In rare cases, IFRS and U.S. GAAP allow proportionate consolidation as opposed to the equity method.
Answer: Investment in financial assets - HFT Now let's imagine that the bonds are called on the first day of the next year for $101,000. Calculate the gain or loss recognition for each classification:
A net gain of $2,500 ($101,000 - $98,500 carrying value) is recognized in the income statement.
Consolidation
A new entity is formed that absorbs both of the combining companies
Answer: Investment in financial assets - HTM Now let's imagine that the bonds are called on the first day of the next year for $101,000. Calculate the gain or loss recognition for each classification:
A realized gain of $4,170 ($101,000 - $96,830 carrying value) is recognized in the income statement.
Business Combinations
An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used. It is possible to own more than 50% of an investee and not have control. For example, control can be temporary or barriers may exist such as bankruptcy or governmental intervention. In these cases, the investment is not considered controlling. Conversely, it is possible to control with less than a 50% ownership interest. In this case, the investment is still considered a business combination.
Example: Impaired goodwill Last year, Parent Company acquired Sub Company for $1,000,000. On the date of acquisition, the fair value of Sub's net assets was $800,000. Thus, Parent reported acquisition goodwill of $200,000 ($1,000,000 purchase price - $800,000 fair value of Sub's net assets). At the end of this year, the fair value of Sub is $950,000, and the fair value of Sub's net assets is $775,000. Assuming the carrying value of Sub is $980,000, determine if an impairment exists and calculate the loss (if applicable) under U.S. GAAP and under IFRS.
Answer: U.S. GAAP (two-step approach): 1.Since the carrying value of Sub exceeds the fair value of Sub ($980,000 carrying value > $950,000 fair value), an impairment exists. 2.In order to measure the impairment loss, the implied goodwill must be compared to the carrying value of the goodwill. At the impairment measurement date, the implied value of the goodwill is $175,000 ($950,000 fair value of Sub - $775,000 fair value of Sub's net assets). Since the carrying value of the goodwill exceeds the implied value of the goodwill, an impairment loss of $25,000 is recognized ($200,000 goodwill carrying value - $175,000 implied goodwill) thereby reducing goodwill to $175,000. IFRS (one-step approach): Goodwill impairment and loss under IFRS is 980,000 (carrying value) - 950,000 (fair value) = 30,000.
LOS 17 - Employee Compensation: Post-Employment and Share-Based
Accounting for pension plans may be complex, but the economic reasoning is not too difficult to grasp. Despite convergence between U.S. GAAP and IFRS, significant differences remain, particularly with respect to recognition of periodic pension cost in income statement versus in OCI. You should be able to explain how reported results are affected by management's assumptions. You should also be able to adjust the reported financial results for economic reality by calculating total periodic pension cost. Share-based compensation is also introduced. Compensation expense is based on fair value on the grant date, and it is often necessary to use an option pricing model to estimate fair value. Make sure you understand the effects of changing the model inputs on fair value.
Issues with Equity Method (Investments in Associates) Leverage
Also, the investee's individual assets and liabilities are not reported on the investor's balance sheet. The investor simply reports its proportionate share of the investee's equity in one-line on the balance sheet. By ignoring the investee's debt, leverage is lower. In addition, the margin ratios are higher since the investee's revenues are ignored.
Debt securities classified as AFS - Reclassification
Debt securities classified as AFS can be reclassified as HTM if the holder intends to (and is able to) hold the debt to its maturity date. The security's balance sheet value is remeasured to reflect its fair value at the time it is reclassified. Any difference between this amount and the maturity value, and any gain or loss that had been recorded in other comprehensive income, is amortized over the security's remaining life.
Fair Value Through Profit or Loss (for Debt and Equity Securities)
Debt securities may be classified as fair value through profit or loss if held for trading, or if accounting for those securities at amortized cost results in an accounting mismatch. Equity securities that are held for trading must be classified as fair value through profit or loss. Other equity securities may be classified as either fair value through profit or loss, or fair value through OCI. Once classified, the choice is irrevocable.
Financial Assets - FV through P/L (Designated at FV)
Firms can choose to report debt and equity securities that would otherwise be treated as held-to-maturity or available-for-sale securities at fair value. Designating financial assets and liabilities at fair value can reduce volatility and inconsistencies that result from measuring assets and liabilities using different valuation bases. Unrealized gains and losses on designated financial assets and liabilities are recognized on the income statement, similar to the treatment of held-for-trading securities.
Funding of other post employment benefits
Pension plans are typically funded at some level, while other post-employment benefit plans are usually unfunded. In the case of an unfunded plan, the employer recognizes expense in the income statement as the benefits are earned; however, the employer's cash flow is not affected until the benefits are actually paid to the employee.
LOS 16.a: Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities.;
Percentage of ownership (or voting control) is typically used to determine the appropriate category for financial reporting purposes. However, the ownership percentage is only a guideline
Acquisition Method
all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded. In the case where the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling (minority) interest account for the proportionate share of the subsidiary's net assets that are not owned by the parent
Impairments of Investments in Associates
Equity method investments must be tested for impairment Under U.S. GAAP, if the fair value of the investment falls below the carrying value (investment account on the balance sheet) and the decline is considered permanent, the investment is written-down to fair value and a loss is recognized on the income statement. Under IFRS, impairment needs to be evidenced by one or more loss events. Under both IFRS and U.S. GAAP, if there is a recovery in value in the future, the asset cannot be written-up.
Financial Assets - AFS The treatment of Financial Assets under IFRS is similar to U.S. GAAP, except for unrealized gains or losses that result from FX movements.
FX gains and losses on AFS DEBT securities are recognized in the income statement under IFRS. The entire unrealized gain or loss is recognized in equity under U.S. GAAP. For AFS equity securities, the treatment under IFRS is similar to the treatment under U.S. GAAP.
IFRS - Impairment and Recovery for Debt and Equities
For debt securities, loss events can include default on payments of interest or principal, likely bankruptcy or reorganization of the issuer, concessions from the bondholders, or other indications of financial difficulty on the part of the issuer. However, a credit rating downgrade or the lack of a liquid market for the debt are not considered to be indications of impairment in the absence of other evidence. For equities, a loss event has occurred if the fair value of the security has experienced a substantial or extended decline below its carrying value or if changes in the business environment facing the equity issuer (such as economic, legal, or technological developments) have made it unlikely that the value of the equity will recover to its initial cost.
Defined-benefits example
For example, an employee might earn a retirement benefit of 2% of her final salary for each year of service. Consequently, an employee with 20 years of service and a final salary of $100,000 would receive $40,000 ($100,000 final salary × 2% × 20 years of service) each year upon retirement until death. Since the employee's future benefit is defined, the employer assumes the investment risk.
Example: Full goodwill vs. partial goodwill Continuing the previous example, suppose that Wood paid $450 million for 75% of the stock of Pine. Calculate the amount of goodwill Wood should report using the full goodwill method and the partial goodwill method.
Full goodwill method: Wood's balance sheet goodwill is the excess of the fair value of the subsidiary ($450 million / 0.75 = $600 million) over the fair value of identifiable net assets acquired, just as in the example above. Acquisition goodwill = $40 million. Partial goodwill method: Wood's balance sheet goodwill is the excess of the acquisition price over Wood's proportionate share of the fair value of Pine's identifiable net assets: Purchase price $450 million Less: 75% of fair value of net assets 0.75 × $560 = $420 million Acquisition goodwill $30 million
Financial Asset
Percentage of ownership (or voting control) is typically used to determine the appropriate category for financial reporting purposes. However, the ownership percentage is only a guideline IFRS currently (current standards) classifies investments in financial assets as held-to-maturity, available-for-sale, or fair value through profit or loss (which includes held-for-trading and securities designated at fair value). Under U.S. GAAP, the accounting treatment for investment in financial assets is similar to current IFRS. IFRS 9 (the new standards) is applicable for annual periods beginning January 1, 2018, (early adoption is allowed).
Goodwill under the acquisition method
Under U.S. GAAP, goodwill is the amount by which the fair value of the subsidiary is greater than the fair value of the acquired company's identifiable net assets (full goodwill ). Under IFRS, goodwill is the excess of the purchase price over the fair value of the acquiring company's proportion of the acquired company's identifiable net assets (partial goodwill ). However, IFRS permits the use of the full goodwill approach also.
U.S. GAAP does permit securities to be reclassified into or out of held-for-trading or designated at fair value.
Unrealized gains are recognized on the income statement at the time the security is reclassified. For investments transferring out of available-for-sale category into held-for-trading category, the cumulative amount of gains and losses previously recorded under other comprehensive income is recognized in income. For a debt security transferring out of available-for-sale category into held-to-maturity category, the cumulative amount of gains and losses previously recorded under other comprehensive income is amortized over the remaining life of the security. For transferring investments into available-for-sale category from held-to-maturity category, the unrealized gain/loss is transferred to comprehensive income.
Example: Implementing the Equity Method Suppose that we are given the following: •December 31, 20X5, Company P (the investor) invests $1,000 in return for 30% of the common shares of Company S (the investee). •During 20X6, Company S earns $400 and pays dividends of $100. •During 20X7, Company S earns $600 and pays dividends of $150. Calculate the effects of the investment on Company P's balance sheet, reported income, and cash flow for 20X6 and 20X7.
Using the equity method for 20X6, Company P will: •Recognize $120 ($400 × 30%) in the income statement from its proportionate share of the net income of Company S. •Increase its investment account on the balance sheet by $120 to $1,120, reflecting its proportionate share of the net assets of Company S. •Receive $30 ($100 × 30%) in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payment. At the end of 20X6, the carrying value of Company S on Company P's balance sheet will be $1,090 ($1,000 original investment + $120 proportionate share of Company S net income - $30 dividend received). For 20X7, Company P will recognize income of $180 ($600 × 30%) and increase the investment account by $180. Also, Company P will receive dividends of $45 ($150 × 30%) and lower the investment account by $45. Hence, at the end of 20X7, the carrying value of Company S on Company P's balance sheet will be $1,225 ($1,090 beginning balance + $180 proportionate share of Company S net income - $45 dividend received).
Analytical Issues for Investments in Associates
When an investee is profitable, and its dividend payout ratio is less than 100%, the equity method usually results in higher earnings as compared to the accounting methods used for minority passive investments. Thus, the analyst should consider if the equity method is appropriate for the investor. For example, an investor could use the equity method in order to report the proportionate share of the investee's earnings, when it cannot actually influence the investee.
Analysis of Investments in Financial Assets
When analyzing a firm with investments in financial assets, it is important to separate the firm's operating results from its investment results (e.g., interest, dividends, and gains and losses). For comparison purposes, using market values for financial assets is generally preferred. Also, it is necessary to remove nonoperating assets when calculating the return on operating assets ratio. Finally, the analyst must assess the effects of investment classification on reported performance. Investment results may be misleading because of inconsistent treatment of unrealized gains and losses. For example, if security prices are increasing, an investor that classifies an investment as held-for-trading will report higher earnings than if the investment is classified as available-for-sale. This is because the unrealized gains are recognized in the income statement for a held-for-trading security. The unrealized gains are reported in stockholders' equity for an available-for-sale security.
A special purpose entity (SPE)
is a legal structure created to isolate certain assets and liabilities of the sponsor. An SPE can take the form of a corporation, partnership, joint venture, or trust. The typical motivation is to reduce risk and thereby lower the cost of financing. SPEs are often structured such that the sponsor company has control over the SPE's finances or operating activities while third parties have controlling interest in the SPE's equity. In the past, SPEs were often maintained off-balance-sheet, thereby enhancing the sponsor's financial statements and ratios
Other post-employment benefits
like primarily healthcare benefits for retired employees, are similar to a defined-benefit pension plan: the future benefit is defined today but is based on a number of unknown variables. For example, in a post-employment healthcare plan, the employer must forecast healthcare costs that are expected once the employee retires.
Partial Goodwill (Only under IFRS)
partial goodwill = purchase price - (% owned × FV of net identifiable assets of the subsidiary)
Defined-contribution plan
retirement plan whereby the firm contributes a certain sum each period to the employee's retirement account. The firm's contribution is based on any number of factors including years of service, the employee's age, compensation, profitability, or even a percentage of the employee's contribution. Investment decisions are left to the employee. Financial reporting requirements: Pension expense is simply equal to the employer's contribution. There is no future obligation to report on the BS.
funded status of the plan
the difference in the benefit obligation and the plan assets Overfunded - assets exceed pension obligation Underfunded - pension obl exceeds the plan assets
Financial Reporting for Defined-benefit plan
the employer must estimate the value of the future obligation to its employees. This involves forecasting a number of variables such as future compensation levels, employee turnover, retirement age, mortality rates, and an appropriate discount rate. A company that offers defined pension benefits typically funds the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.
Defined-benefits plan
the firm promises to make periodic payments to the employee after retirement. The benefit is usually based on years of service, and compensation near or at retirement.
Issues with Equity Method (Investments in Associates) Earnings recognition
the proportionate share of the investee's earnings is recognized in the investor's income statement, but the earnings may not be available to the investor in the form of cash flow (dividends). That is, the investee's earnings may be permanently reinvested.
Transactions with the Investee
Because of its ownership interest, the investor may be able to influence transactions with the investee. Thus, profit from these transactions must be deferred until the profit is confirmed through use or sale to a third party. 1. Upstream 2. Downstream
Acquisition
Both entities continue to exist in a parent-subsidiary relationship. Recall that when less than 100% of the sub is owned by the parent, the parent prepares consolidate Fin Statements but reports the unowned (minority) interest on its financial statements
Upstream Transactions with the Investee
In an upstream sale, the investee has recognized all of the profit in its income statement. However, for profit that is unconfirmed (goods have not been used or sold by the investor), the investor must eliminate its proportionate share of the profit from the equity income of the investee. For example, suppose that Investor owns 30% of Investee. During the year, Investee sold goods to Investor and recognized $15,000 of profit from the sale. At year-end, half of the goods purchased from Investee remained in Investor's inventory. All of the profit is included in Investee's net income. Investor must reduce its equity income of Investee by Investor's proportionate share of the unconfirmed profit. Since half of the goods remain, half of the profit is unconfirmed. Thus, Investor must reduce its equity income by $2,250 [($15,000 total profit × 50% unconfirmed) × 30% ownership interest]. Once the inventory is sold by Investor, $2,250 of equity income will be recognized.
Fair Value Through OCI (for Equity Securities Only)
The accounting treatment under fair value through OCI is the same as under the previously used available-for-sale classification.
Merger
The acquiring firm absorbs all the assets and liabilities of the acquired firm, which ceases to exist. The acquiring firm is the surviving entity
Example: Investment in financial assets - HTM At the beginning of the year, Midland Corporation purchased a 9% bond with a face value of $100,000 for $96,209 to yield 10%. The coupon payments are made annually at year-end. Let's suppose the fair value of the bond at the end of the year is $98,500. Determine the impact on Midland's balance sheet and income statement if the bond investment is classified as held-to-maturity, held-for-trading (or fair value through profit or loss), and available-for-sale.
The balance sheet value is based on amortized cost. At year-end, Midland recognizes interest revenue of $9,621 ($96,209 beginning bond investment × 10% market rate at issuance). The interest revenue includes the coupon payment of $9,000 ($100,000 face value × 9% coupon rate) and the amortized discount of $621 ($9,621 interest revenue - $9,000 coupon payment). At year-end, the bond is reported on the balance sheet at $96,830 ($96,209 beginning bond investment + $621 amortized discount).
Answer: Investment in financial assets - HFT
The balance sheet value is based on fair value of $98,500. Interest revenue of $9,621 ($96,209 beginning bond investment × 10% yield-to-maturity at issuance) and an unrealized gain of $1,670 ($98,500 - $96,209 - $621) are recognized in the income statement.
Answer: Investment in financial assets - AFS
The balance sheet value is based on fair value of $98,500. Interest revenue of $9,621 ($96,209 beginning bond investment × 10% yield-to-maturity at issuance) is recognized in the income statement. The unrealized gain of $1,670 ($98,500 - $96,209 - $621) is reported in stockholders' equity as a component of other comprehensive income.
Implied Value of Goodwill
The implied fair value of the goodwill is calculated in the same manner as goodwill at the acquisition date. That is, the fair value of the reporting unit is allocated to the identifiable assets and liabilities as if they were acquired on the impairment measurement date. Any excess is considered the implied fair value of the goodwill.
Pooling- of-interest method (uniting-of-interest method under IFRS)
combined the ownership interests of two firms and viewed the participants as equals - neither firm acquired the other. The A and L of the two firms were simply combined Note that fair values played no role in accounting for a business combination using this method —the actual price paid was suppressed from the balance sheet and income statement. Analysts should be aware that transactions reported under the pooling method prior to 2001 (2004) may still be reported under that method. Key Attributes 1) The two firms are combined using histroical BV 2) Operating results for the prior periods are restated as though the two firms are always combined 3) Ownership interests continue, and former accounting bases are maintained
Financial Assets - AFS
debt and equity securities that are neither held-to-maturity nor held-for-trading. Like held-for-trading securities, available-for-sale securities are reported on the balance sheet at fair value. However, only the realized gains or losses, and the dividend or interest income, are recognized in the income statement. The unrealized gains and losses (net of taxes) are excluded from the income statement and are reported as a separate component of stockholders' equity (in other comprehensive income). When the securities are sold, the unrealized gains and losses are removed from other comprehensive income, as they are now realized, and recognized in the income statement.
Now , the accounting method used is
the acquisition method (which replaces the purchase method) and is required
Investments in associates
An ownership interest between 20% and 50% is typically a noncontrolling investment; however, the investor can usually significantly influence the investee's business operations. Significant influence can be evidenced by the following: •Board of directors representation. •Involvement in policy making. •Material intercompany transactions. •Interchange of managerial personnel. •Dependence on technology. It may be possible to have significant influence with less than 20% ownership. In this case, the investment is considered an investment in associates. Conversely, without significant influence, an ownership interest between 20% and 50% is considered an investment in financial assets. The equity method is used to account for investments in associates.
IFRS - Impairment and Recovery
As under U.S. GAAP, impairments under IFRS are recognized in the income statement. Impairment of a debt or equity security is indicated if at least one loss event has occurred, and its effect on the security's future cash flows can be estimated reliably. Losses due to occurrences of future events (regardless of the probability of occurrence) are not recognized.
Excess of Purchase Price Over Book Value Acquired
At the acquisition date, the excess of the purchase price over the proportionate share of the investee's book value is allocated to the investee's identifiable assets and liabilities based on their fair values. Any remainder is considered goodwill. In subsequent periods, the investor recognizes expense based on the excess amounts assigned to the investee's assets and liabilities. The expense is recognized consistent with the investee's recognition of expense. For example, the investor might recognize additional depreciation expense as a result of the fair value allocation of the purchase price to the investee's fixed assets.
Joint Ventures
Both U.S. GAAP and IFRS require the equity method of accounting for joint ventures In rare circumstances, the proportionate consolidation method may be allowed under U.S. GAAP and IFRS. Proportionate consolidation is similar to a business acquisition, except the investor (venturer) only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Since only the proportionate share is reported, no minority owners' interest is necessary.
Business Combinations (classification, measurement, and disclosure under International Financial Reporting Standards (IFRS))
Business combinations: In an acquisition, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded. When the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling interest account for the proportionate share of the subsidiary's net assets and net income that is not owned by the parent.
Amortized Cost (for Debt Securities Only)
Debt securities that meet two criteria are accounted for using the amortized cost method (which is the same as the held-to-maturity method discussed before). Criteria for amortized cost accounting: 1.Business model test: Debt securities are being held to collect contractual cash flows. 2.Cash flow characteristic test: The contractual cash flows are either principal, or interest on principal, only.
Goodwill Impairment Testing
Goodwill is not amortized. Instead, it is tested for impairment at least annually. Impairment occurs when the carrying value exceeds the fair value. However, measuring the fair value of goodwill is complicated by the fact that goodwill cannot be separated from the business. Because of its inseparability, goodwill is valued at the reporting unit level. Under IFRS, testing for impairment involves a single step approach. If the carrying amount of the cash generating unit (where the goodwill is assigned) exceeds the recoverable amount, an impairment loss is recognized. Under U.S. GAAP, goodwill impairment potentially involves two steps. Step 1: if the carrying value of the reporting unit (including the goodwill) exceeds the fair value of the reporting unit, an impairment exists. Step 2:Once it is determined the goodwill is impaired, the loss is measured as the difference between the carrying value of the goodwill and the implied fair value of the goodwill. The impairment loss is recognized in the income statement as a part of continuing operations.
Financial Assets - FV through P/L (Held for Trading)
Held-for-trading securities are debt and equity securities acquired for the purposes of profiting in the near term, usually less than three months. Held-for-trading securities are reported on the balance sheet at fair value. The changes in fair value, both realized and unrealized, are recognized in the income statement along with any dividend or interest income.
Held-to-maturity securities - Reclassification
Held-to-maturity securities can be reclassified as available-for-sale if the holder no longer intends or is no longer able to hold the debt to maturity. The carrying value is remeasured to the security's fair value, with any difference recognized in other comprehensive income. Note that reclassifying a held-to-maturity security may prevent the holder from classifying other debt securities as held-to-maturity, or even require other held-to-maturity debt to be reclassified as available-for-sale.
IFRS 9 (New standards) - Analysis of Investments
IFRS 9 does away with the terms held-for-trading, available-for-sale, and held-to-maturity. Instead, the three classifications are 1) amortized cost, (HTM) 2) fair value through profit or loss (FVPL) (HFT) 3) fair value through other comprehensive income (FVOCI) (AFS)
Reclassification of Investments in Financial Assets - IFRS (FV or HFT)
IFRS typically does not allow reclassification of investments into or out of the designated at fair value category. Reclassification of investments out of the held-for-trading category is severely restricted under IFRS.
IFRS - Reversals
If the HTM security's value recovers in a later period, and its recovery can be attributed to an event (such as a credit upgrade), the impairment loss can be reversed. Impairments of AFS debt securities may be reversed under the same conditions as impairments of held-to-maturity securities. Reversals of impairments are not permitted for equity securities.
Impairment of Financial Assets
If the value that can be recovered for a financial asset is less than its carrying value and is expected to remain so, the financial asset is impaired. IFRS and U.S. GAAP require that held-to-maturity (HTM) and available-for-sale (AFS) securities be evaluated for impairment at each reporting period. This is not necessary for held-for-trading and designated at fair value securities because declines in their values are recognized on the income statement as they occur.
Downstream (investor to the investee) Transactions with the Investee
In a downstream sale, the investor has recognized all of the profit in its income statement. Like the upstream sale, the investor must eliminate the proportionate share of the profit that is unconfirmed. For example, imagine again that Investor owns 30% of Investee. During the year, Investor sold $40,000 of goods to Investee for $50,000. Investee sold 90% of the goods by year-end. Investor's profit is $10,000 ($50,000 sales - $40,000 COGS). Investee has sold 90% of the goods; thus, 10% of the profit remains in Investee's inventory. Investor must reduce its equity income by the proportionate share of the unconfirmed profit: $10,000 profit × 10% unconfirmed amount × 30% ownership interest = $300. Once Investee sells the remaining inventory, Investor can recognize $300 of profit.
Bargain Purchase!!
In rare cases, acquisition purchase price is less than the fair value of net assets acquired. Both IFRS and U.S. GAAP require that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.
U.S. GAAP - Impairment and Recovery
Under U.S. GAAP, a security is considered impaired if its decline in value is determined to be other than temporary. For both HTM and AFS securities, the write-down to fair value is treated as a realized loss (i.e., recognized on the income statement). A subsequent reversal of impairment losses is not allowed
Investments in Associates
Investment ownership of between 20% and 50% is usually considered influential. Influential investments are accounted for using the equity method. Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset. In subsequent periods, the proportionate share of the investee's earnings increases the investment account on the investor's balance sheet and is recognized in the investor's income statement. Dividends received from the investee are treated as a return of capital and thus, reduce the investment account. Unlike investments in financial assets, dividends received from the investee are not recognized in the investor's income statement. If the investee reports a loss, the investor's proportionate share of the loss reduces the investment account and also lowers earnings in the investor's income statement. If the investee's losses reduce the investment account to zero, the investor usually discontinues use of the equity method. The equity method is resumed once the proportionate share of the investee's earnings exceed the share of losses that were not recognized during the suspension period.
Reporting of Intercorporate Investments (Current Standards) - Financial Assets
Investment ownership of less than 20% is usually considered passive. The acquisition of financial assets is recorded at cost (presumably the fair value at acquisition), and any dividend or interest income is recognized in the investor's income statement Recognizing the change in the fair value of financial assets depends on their classification as either 1) held-to-maturity, 2) held-for-trading, or 3) available-for-sale. Firms can also designate financial assets and financial liabilities at fair value.
Investments in Associates/ Joint Ventures (classification, measurement, and disclosure under International Financial Reporting Standards (IFRS))
Investments in associates/joint ventures: With the equity method, the proportionate share of the investee's earnings increase the investor's investment account on the balance sheet and are recognized in the investor's income statement. Dividends received reduce the investment account. Dividends received are not recognized in the investor's income statement under the equity method. In rare cases, proportionate consolidation may be allowed. Proportionate consolidation is similar to a business combination, except the investor only includes the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. No minority owners' interest is required.
Investments in financial assets (classification, measurement, and disclosure under International Financial Reporting Standards (IFRS))
Investments in financial assets: Dividends and interest income are recognized in the investor's income statement. Held-to-maturity securities are reported on the balance sheet at amortized cost. Subsequent changes in fair value are ignored. Fair value through profit or loss securities are reported at fair value, and the unrealized gains and losses are recognized in the income statement. Available-for-sale securities are also reported at fair value, but the unrealized gains and losses are reported in stockholders' equity.
Under the equity method, the investor ,not the investee, does the following
It is important to note that the purchase price allocation to the investee's assets and liabilities is included in the investor's balance sheet, not the investee's. In addition, the additional expense that results from the assigned amounts is not recognized in the investee's income statement. Under the equity method of accounting, the investor must adjust its balance sheet investment account and the proportionate share of the income reported from the investee for this additional expense.
Reclassification under IFRS 9
Reclassification of equity securities under the new standards is not permitted as the initial designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities from amortized cost to FVPL (or vice versa) is permitted only if the business model has changed. Unrecognized gains/losses on debt securities carried at amortized cost and reclassified as FVPL are recognized in the income statement. Debt securities that are reclassified out of FVPL as measured at amortized cost are transferred at fair value on the transfer date, and that fair value will become the carrying amount.
Financial Assets HTM
Recognizing the change in the fair value of financial assets depends on their classification as either held-to-maturity, held-for-trading, or available-for-sale. Firms can also designate financial assets and financial liabilities at fair value. Interest income (coupon cash flow adjusted for amortization of premium or discount) is recognized in the income statement but subsequent changes in fair value are ignored.
Answer: Investment in financial assets - AFS Now let's imagine that the bonds are called on the first day of the next year for $101,000. Calculate the gain or loss recognition for each classification:
The unrealized gain of $1,670 is removed from equity, and a realized gain of $4,170 ($101,000 - $96,830) is recognized in the income statement.
LOS 16.c: Analyze how different methods used to account for intercorporate investments affect financial statements and ratios.
There are four important effects on the balance sheet and income statement items that result from the choice of accounting method (in most situations): 1.All three methods report the same net income. 2.Equity method and proportionate consolidation report the same equity. Acquisition method equity will be higher by the amount of minority interest. 3.Assets and liabilities are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in-between. 4.Revenues and expenses are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in-between.
Under the equity method, Company P will report its 80% share of Company S's net income in a one-line account in the income statement. Under the acquisition method, the revenue and expenses of Company P and Company S are combined. It is also necessary to create a minority interest in the income statement for the portion of Company S's net income that is not owned by Company P. Company P reports 100% of Company S's revenues and expenses even though Company P only owns 80%. Thus, a minority interest is created by multiplying the subsidiary's net income by the percentage of the subsidiary not owned. In our example, the minority interest is $800 ($4,000 S net income × 20%). The minority interest is subtracted in arriving at consolidated net income. Notice the acquisition method results in higher revenues and expenses, as compared to the equity method, but net income is the same.
This example assumed that the parent company acquired its interest in the subsidiary by paying the proportionate share of the subsidiary's book value. If the parent pays more than its proportionate share of book value, the excess is allocated to tangible and intangible assets. The minority interest computation in the example also would be different.
Fair Value Option
U.S. GAAP allows equity method investments to be recorded at fair value. Under IFRS, the fair value option is only available to venture capital firms, mutual funds, and similar entities. The decision to use the fair value option is irrevocable and any changes in value (along with dividends) are recorded in the income statement.
Business Combinations
Under IFRS, business combinations are not differentiated based on the structure of the surviving entity. Under U.S. GAAP, business combinations are categorized as: 1) Merger 2) Acquisition 3) Consolidation
SPE (classification, measurement, and disclosure under International Financial Reporting Standards (IFRS))
Under IFRS, the sponsor of a special purpose entity (SPE) must consolidate the SPE if their economic relationship indicates that the sponsor controls the SPE. U.S. GAAP requires that a variable interest entity (VIE) must be consolidated by its primary beneficiary.
The FASB uses the term variable interest entity (VIE) to describe
a special purpose entity that meets certain conditions. According to FASB ASC Topic 810, Consolidation, a VIE is an entity that has one or both of the following characteristics: 1.At-risk equity that is insufficient to finance the entity's activities without additional financial support. 2.Equity investors that lack any one of the following: •Decision making rights. •The obligation to absorb expected losses. •The right to receive expected residual returns. If an SPE is considered a VIE, it must be consolidated by the primary beneficiary. The primary beneficiary is the entity that absorbs the majority of the risks or receives the majority of the rewards
Pension
deferred compensation earned over time through employee service. Most common arrangements are defined-contribution plans and defined benefit plans
Full Goodwill (required under US GAAP ; Allowed under IFRS)
full goodwill = (fair value of equity of whole subsidiary) - (fair value of net identifiable net assets of the subsidiary)
