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Investing for Strategic Reasons. Part II. BUS320 Fall 2010. Invest for strategic reasons Buy into other companies to influence or control their activities Capture more market share Solidify a customer or supplier. Up to 20% little or no influence carry at FV on the balance sheet

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Investing for strategic reasons

Investing forStrategic Reasons

Part II

BUS320 Fall 2010


Investing for strategic reasons

Invest for strategic reasons

Buy into other companies to influence or control their activities

Capture more market share

Solidify a customer or supplier


Investing for strategic reasons

Up to 20%

little or no influence

carry at FV on the balance sheet

gain/loss in income statement OR

elect for gain/loss in other comprehensive income

buy to earn dividend revenue or to sell when profitable


Investing for strategic reasons

20% to 50%

“power to participate in the financial and operating policy

decisions of an entity, but not control over those policies”

IAS 28

significant influence but no control

representation on board of directors

participation in decision-making process

material intercompany transactions

interchange of management personnel

provision of technical information

influence assumed – disclose if no influence

use equity method

investment referred to as an associate (IAS 28)


Investing for strategic reasons

Greater than 50%

control

prepare consolidated financial statements

Cons. F/S for reporting to shareholders of the parent company

Parent Company

statement of earnings

balance sheet

statement of changes

in equity

statement of cash flows

Subsidiary Company

+ statement of earnings

+ balance sheet

+ statement of changes

in equity

+ statement of cash flows

However, the preparation of cons. F/S affects neither the individual company financial statements of the parent company nor the individual company financial statements of the subsidiary company

Use cost method or equity method for day to day transactions


Investing for strategic reasons

An Exercise – The Case of Parallel Universe

Shareholders of A

Shareholders of B

Company A

Company B


Investing for strategic reasons

An Exercise (contd.) – The Case of Parallel Universe

  • In Universe One

  • What journal entry should Company A make on January 1, 20X2 to record the transaction?

  • What journal entry should Company B make on January 1, 20X2 to record the transaction?

  • In Universe Two

  • What journal entry should Company A make on January 1, 20X2 to record the transaction?

  • What journal entry should Company B make on January 1, 20X2 to record the transaction?


Investing for strategic reasons

An Exercise (contd.) – The Case of Parallel Universe

  • In Universe One

  • What would Company A’s financial statements look like?

  • What would Company B’s financial statements look like?

  • What kind of financial statements would be useful to the shareholders?

  • In Universe Two

  • What would Company A’s financial statements look like?

  • What would Company B’s financial statements look like?

  • What kind of financial statements would be useful to the shareholders?


Investing for strategic reasons

The Equity Method

At acquisition, record at cost plus acquisition expenses

Subsequent to acquisition:

treat investment as part of company by:

increasing investment account by share of earnings

decreasing investment account by share of dividends declared

Investment in Grey Company

Acquisition price

Share of earnings

Share of dividends

Balance, end of year


Investing for strategic reasons

Two complicating factors

1. Price paid for the investment

$60,000

$150,000

$210,000

Book value of J. Bassell Company = shareholders’ equity = $500,000

Buy 30% of the company and pay $210,000


Investing for strategic reasons

Excess of purchase price over proportion of book value

find fair value of all of J. Bassell’s Identifiable assets and liabilities

Book valueFair valueDifference

Cash and receivables

Inventory

Prepaids

Land

Buildings

Equipment

Intangibles

Current liabilities

Long-term liabilities

Difference is called a Fair value increment


Investing for strategic reasons

Calculation of purchase price discrepancy

100%30%

Purchase price210,000

Book value500,000

Do you know why FVI on Inventory is amortized over one year?

150,000

Purchase price discrepancy 60,000

FVI will be amortized as follows:

Fair value increments (FVI):

Inventory 10,000

Land (30,000)

Equipment 50,000

3,000

(9,000)

15,000

9,000

÷ 1 = 3,000

÷ 3 = 5,000

There is no amortization on goodwill

Goodwill 51,000


Investing for strategic reasons

Each year:

calculate pro-rata share of J. Bassell’s net earnings

adjust it for the amortization of FVI

Assume J. Bassell earned $40,000 and paid dividends of $10,000.

share of earnings (30%) 12,000

less: depreciation of equip (5,000)

inventory (3,000)

4,000

Investment in Bassell 4,000

Investment revenue (income) 4,000

Receipt of a dividend from Bassell

Cash 3,000

Investment in Bassell 3,000

Amortization of FVI

Note: the receipt of dividends is NOT revenue.


Investing for strategic reasons

Investment in Bassell

210,000

4,000

3,000

211,000

If there are discontinued operations:

calculate share of normal operations

calculate share of discontinued operations

report as separate items on the income statement

Check each year for impairment of goodwill


Investing for strategic reasons

2. Intercompany transactions

Because of influence, portion of intercompany transactions

treated as unrealized if they have not been sold to a third party

Assume Bassell (B) sells inventory to Our Company (OC) for $12,000. The inventory originally cost Bassell $8,000. Bassell,

therefore, recorded a profit of $4,000. OC has not sold it yet.

OC

Inventory sale $12,000

Cost8,000

Profit4,000

X .3 = 1,200

OC’s share

B

From OC’s share of Bassell’s

earnings remove 1,200 because

the inventory has not been sold

by OC.

Upstream transaction


Investing for strategic reasons

Assume Bassell’s net income is $50,000

OC’s share of that net income is $15,000 ($50,000 x .3)

30% = $15,000 (includes $1,200 which is

30% of the $4,000)

Removing $1,200 removes the

part of OC’s share that is the

unrealized

$50,000

Includes the profit

of $4,000

after the normal entry for picking up OC’s share of Bassell’s earnings (with FVI amortization) has been made

Journal entry to remove unrealized profit:

Investment revenue1,200

Investment in Bassell1,200


Investing for strategic reasons

Assume, instead, that OC sells inventory to Bassell for

$12,000. The inventory cost OC $8,000. Therefore, the

profit on the sale is $4,000. Bassell has not sold it yet.

OC

Inventory sale $12,000

Cost8,000

Profit4,000

Profit is in OC’s records.

therefore, all of it is

removed. Reduce the

Investment revenue by

$4,000.

B

Downstream transaction

Journal entry to remove unrealized profit:

Investment revenue4,000

Investment in Bassell4,000

after the normal entry for picking up OC’s share of Bassell’s earnings (with FVI amortization) has been made


Investing for strategic reasons

E9-23

(a)Investment in Novotna Corp. 355,000

Cash355,000


Investing for strategic reasons

E9-23(b)

Cost of investment$355,000

Carrying amount

Assets$1,300,000

Liabilities   100,000

1,200,000

x 25% 300,000

Cost in excess of

share of carrying amount$ 55,000

Allocated

Assets subject to depreciation

[($860,000 – $800,000) X 25%] $15,000

Goodwill   40,000

$55,000

don’t forget to take the proportion

this is the purchased price discrepancy

which is then allocated to the FVI on the assets and GW


Investing for strategic reasons

for dividends Jenna received from Novotna

E9-23(b)

Cash ($120,000 X .25)30,000

Investment in Novotna Corp. 30,000

Investment in Novotna Corp.67,500

Investment Income (ordinary)50,000*

Investment Income (disc. operations)17,500**

*$200,000 X .25

**$70,000 X .25

Investment Income (ordinary) 1,500

Investment in Novotna Corp. 1,500

Undervalued depreciable assets ($15,000 ÷ 10) = $1,500

Goodwill is not amortized, but rather is tested on an annual basis for impairment.

for picking up Jenna’s share of Novotna’s income, separately for the two different types of income

as shown here, Jenna can use a separate entry to record FVI amortization


Investing for strategic reasons

Impairment under Equity Method

Record share of associate’s net income, deduct dividends received,

amortized fair value increments

Therefore, usually impairment is not an issue

If investment’s recoverable amount is less than its carrying value,

recognize an impairment loss and write down the investment account

If value of investment value improves can reverse loss in the future

Carrying value has FVI and possibly GW

these amounts are written down first before reducing the book value

portion of the investment account

  • “recoverable amount” of an asset is the higher of

  • its value in use, and

  • fair value less costs to sell


Investing for strategic reasons

Investment in Associate

FVI + GW

- amortization of FVI

When we write down an associate, the GW goes first and then the FVI

+ share of NI

BV

Why does it matter which item goes first?

- share of dividends

What difference(s) could this make?


Investing for strategic reasons

Sale of Associate Investment

At time of sale, bring investment account up to date

add share of NI to date

amortize any FVI

Then compare the updated carrying amount to selling price and recognize gain/loss


Investing for strategic reasons

Consolidation

Control

Parent has the ability to elect members to the body that sets the

operating and financing policies of the subsidiary

usually means owning more than 50% of the shares

“New definition: power to direct the activities of the other entity to

generate returns”

Process on acquisition same as for equity method

Record the investment at the amount you paid for it

if buy for cash, measurement is easy

if exchange shares, value at the market value of the shares


Investing for strategic reasons

$50,000

$375,000

$425,000

Subsidiary’s (Bassell) net assets = book value = $500,000

Buy 75% of Bassell for $425,000


Investing for strategic reasons

Go through the same process of identifying the fair value of

all of the identifiable assets and liabilities – determine the difference

from the book value

Difference = fair value increments (FVI)

Calculate FVI and GW

Because OC controls Bassell, we take the fair value of the net assets

and divide it between OC and the shareholders who own the other 25%

who are called the noncontrolling interest (NCI) shareholders

Treat as two kinds of shareholders

Know what OC paid for 75% of the company; therefore, calculate what

would have been paid for 100% by dividing purchase price by 75%

some question about whether this is reasonable


Investing for strategic reasons

this is the purchase price paid by OC

Calculation of purchase price discrepancy

100%75%25%

Purchase price425,000

Book value500,000

142,000

567,000

375,000

125,000

Purchase price discrepancy 67,00050,00017,000

Fair value increments:

Inventory 10,000 7,500 2,500

Land (30,000) (22,500) (7,500)

Equipment50,00037,50012,500

30,00022,500 7,500

Goodwill 37,000 27,500 9,500


Investing for strategic reasons

Each financial reporting period:

Add +100% of the FVI to the sub’s assets and liabilities

Amortize any FVI adjusting the asset/liability and its associated

revenue or expense (100%)

Adjust OC and the sub for any intercompany realized and

unrealized profits

Adjust balance sheet accounts for the cumulative effect of

past amortizations of FVI

THEN add them together.

Check every year for the impairment of goodwill; if impaired write it down


Investing for strategic reasons

During the year

Parent company can use either the cost method or equity method to accountfor interactions with the sub.

Cost

record dividends as revenue

no changes to the investment account

Equity

record % of adjusted net income of sub to investment account

reduce investment account when dividend received

When consolidating, the investment account is removed along with the

common shares of the sub and its retained earnings and

comprehensive income at acquisition.


Investing for strategic reasons

Joint Ventures

Text says either proportionate consolidation or the equity method can be used

IFRS wants the equity method to be used

account for the investment similar to buying a significant influence

investment


Investing for strategic reasons

Other items

Basket purchase of securities

allocate purchase to individual securities

proportionately if values known

if one value not known – allocate to others based on value

and assign remainder to one that is unknown

Investment denominated in a foreign currency

at acquisition – convert to Canadian $ at exchange on that day

each reporting period, restate in Canadian $ at exchange rate on

balance sheet date

take gain/loss to income statement

or

other comprehensive income


Investing for strategic reasons

CA9-2


Investing for strategic reasons

CA9-2

Issue: Investment in Irish TV

Since shared control, this is a joint venture and would use proportionate consolidation or the equity method. (Normally discussed in advanced accounting courses and covered by IAS 31. This is also an area of change and currently the IASB is proposing to remove the proportionate consolidation option and require the equity method.)

Issue: Investment in Ulster TV

Fair value

- No representation on Board and unable to influence decisions in practice.

- At fair value under IFRS (assuming this is an equity interest versus a debt instrument).

- Other.

Significant influence

- Owns 29.9% of the shares which exceeds the 20% threshold and would appear to represent significant influence.

- Use equity method – accrue share of post acquisition profits.

- Other.

Conclusion: measure at fair value since it does not appear that the entity has significant influence.


Investing for strategic reasons

RA9-5


Investing for strategic reasons

RA9-5

(b) Cash used for investments represents 27% (4% in 2007) of total cash used for all investing activities. However, the amount of investments reported on the balance sheet actually declined significantly from 2007 to 2008. The reason for this is that the assets held in the available-for-sale category declined 39% due to a loss of market value (see note 8). The long term investments are also significant to Potash as they represent 34% (45% in 2007) of the company’s long term assets.


Investing for strategic reasons

RA9-5 (contd.)

(c) As per note 8, Potash has three investments that it accounts for using the equity method as follows:

Sociedad Quimica y Minera de Chile S.A (SQM) in which the company owns 32% and the quoted market value is $1,677 million.

Arab Potash Company (APC) in which Potash owns 28% and the quoted market value is $1,156.3 million.

An “Other” category where no information is provided.

For SQM, note 8 indicates that there is a difference between the carrying value and Potash’s net book value of $196.3 million which is the company’s portion of the fair value of the reserves and the concessions of SQM. This difference will be amortized to net earnings on a units-of-production basis. The difference between the carrying value and Potash’s proportionate net book value for APC relates to fair value increments of fixed assets and mining concessions, of which there is $58.7 million remaining to be amortized on a units-of-production of basis.

Potash’s share of these investees’ earnings was $255.8 million and has been included in other income. Dividends received from these investees totaled $89.1 million which would be reported as a decline in the investment.


Investing for strategic reasons

RA9-5 (contd.)

(d) As per note 8, the company also has three investments that are recorded as available-for-sale, meaning these are reported at fair value at each reporting period. These investments are as follows:

Sinofert in which Potash owns 22% and is valued at $746.8 million;

Israel Chemicals Limited in which Potash owns 11% and is valued at $998.1 million.

Auction rate securities which were valued at $17.2 million.

Dividends received from these investments (and any other equity investments not reported under the equity method) totaled $107 million, as indicated in note 23 under “Other Income”.


Investing for strategic reasons

RA9-5 (contd.)

(e) An impairment loss of $88.8 million was reported related to the Auction rate securities. In note 8, Potash explains that due to negative conditions in the global credit markets, the auctions for the Auction rate securities failed to settle when they came due and the market become illiquid. As a result, the company will not be able to gain any cash from these investments until either a buyer can be found or the securities are settled on maturity which range from 2017 to 2046. Consequently, the company has determined that there is an “other-than-temporary” decline in value.


Investing for strategic reasons

Mid-Term Exam


Investing for strategic reasons

Reference:

Additional Exercise 01s

(i) Discontinued Operations section of SAL’s income statement for the year ended December 31, 20X1 should show a net-of-tax operating loss of …

(ii) Discontinued Operations section of SAL’s income statement for the year ended December 31, 20X1 should show a net-of-tax gain on the aircraft division’s equipment of …

(iii) Income from Continuing Operations on SAL’s income statement for the year ended December 31, 20X1 should show an after tax operating income of …

(iv) Discontinued Operations section of SAL’s income statement for the year ended December 31, 20X2 should show a net-of-tax operating income/loss of …

(v) Discontinued Operations section of SAL’s income statement for the year ended December 31, 20X2 should show a net-of-tax gain/loss on the aircraft division’s equipment of …


Investing for strategic reasons

Reference:

Additional Exercise 02s

(i) For the year 20X2, QCL should recognize gross profit or loss from the above contract in the amount of …

(ii) At the end of the year 20X2, QCL should report on its balance sheet the following Inventory(Liability) account with a net balance of …

(iii) For the year 20X3, QCL should report on its income statement construction expense from the above contract in the amount of …

(iv) For the year 20X4, QCL should report on its income statement construction expense from the above contract in the amount of …

(v) For the year 20X4, QCL should recognize gross profit or loss from the above contract in the amount of …


Investing for strategic reasons

Reference:

BUS320 Lecture 06s.ppt pp. 38-40


Investing for strategic reasons

Reference:

BUS320 Lecture 05s2.pdf pp. 9-10


Investing for strategic reasons

Reference:

BUS320 Lecture 05s2.pdf pp. 11-13


Investing for strategic reasons

Reference:

BUS320 Lecture 04s2.pdf pp. 5-6


Investing for strategic reasons

Reference:

BUS320 Lecture 06s.ppt p. 31

Reference:

BUS320 Lecture 06s2.pdf pp. 1-2

Reference:

BUS320 Lecture 02s.ppt pp. 52-53


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