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Investing forStrategic 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 gain/loss in income statement OR elect for gain/loss in other comprehensive income buy to earn dividend revenue or to sell when profitable
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)
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
An Exercise – The Case of Parallel Universe Shareholders of A Shareholders of B Company A Company B
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?
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?
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
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
Excess of purchase price over proportion of book value find fair value of all of J. Bassell’s Identifiable assets and liabilities Book value Fair value Difference Cash and receivables Inventory Prepaids Land Buildings Equipment Intangibles Current liabilities Long-term liabilities Difference is called a Fair value increment
Calculation of purchase price discrepancy 100%30% Purchase price 210,000 Book value 500,000 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
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.
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
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 Cost 8,000 Profit 4,000 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
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 revenue 1,200 Investment in Bassell 1,200
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 Cost 8,000 Profit 4,000 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 revenue 4,000 Investment in Bassell 4,000 after the normal entry for picking up OC’s share of Bassell’s earnings (with FVI amortization) has been made
E9-23 (a) Investment in Novotna Corp. 355,000 Cash 355,000
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
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
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
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?
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
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
$50,000 $375,000 $425,000 Subsidiary’s (Bassell) net assets = book value = $500,000 Buy 75% of Bassell for $425,000
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
this is the purchase price paid by OC Calculation of purchase price discrepancy 100%75%25% Purchase price 425,000 Book value 500,000 142,000 567,000 375,000 125,000 Purchase price discrepancy 67,00050,00017,000 Fair value increments: Inventory 10,000 7,500 2,500 Land (30,000) (22,500) (7,500) Equipment 50,00037,500 12,500 30,000 22,500 7,500 Goodwill 37,000 27,500 9,500
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
During the year Parent company can use either the cost method or equity method to account for 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.
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
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
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.
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.
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.
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”.
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.
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 …
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 …
Reference: BUS320 Lecture 06s.ppt pp. 38-40
Reference: BUS320 Lecture 05s2.pdf pp. 9-10
Reference: BUS320 Lecture 05s2.pdf pp. 11-13
Reference: BUS320 Lecture 04s2.pdf pp. 5-6
Reference: BUS320 Lecture 06s.ppt p. 31 Reference: BUS320 Lecture 06s2.pdf pp. 1-2 Reference: BUS320 Lecture 02s.ppt pp. 52-53