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CHAPTER 11 Investments in Debt and Equity Securities INTRODUCTION The cash flow associated with an investment in the securities of another company can be straightforward. Such an investment is usually purchased for cash, produces an annual cash flow of interest or dividends that can be recorded as revenue, and is sold for cash. What can be so complicated? First, the cost and market value of an investment will be different over the period for which it is held. If the investments can or will be sold, market value information is likely far more relevant to the financial statement user, and it is objectively determinable in securities markets. It stands to reason that market value should be recorded. The related issue is what to do with any gain or loss on the value of the investment while it is held. It hasn’t been realized though a sale transaction. Is it income or not? Accounting for investments is further complicated by the fact that investments in voting securities can represent more than just a passive investment undertaken to generate investment income. Long-term investments in voting shares may be used to establish an intercompany relationship through which the investor corporation can control or significantly influence the operating, investing, and financing strategies of the investee corporation. If the investor can control or influence the dividend policy of the investee, dividends received from the investee are not the result of an arm’s-length transaction. If investment revenue was measured as dividends declared, the amount could easily be manipulated. Furthermore, if a control relationship exists, it may not be possible to grasp the activities of the economic entity—both the investor and investee corporations—unless their records are consolidated, or added together. In accounting for investments in the shares of other corporations, the accounting problem is twofold: 1. What is the nature of the investment? 2. How can the investment, and the investment revenue, be reported to reveal the economic impact of the investment rather than just its legal form? We’ll explore these questions in this chapter, and provide an overview of this complex area. Keep in mind, though, that many accounting programs devote an entire course to this issue, so what we’re doing here is only the tip of the proverbial iceberg! CHAPTER 11 Investments in Debt and Equity Securities CLASSIFICATION OF INTERCORPORATE INVESTMENTS passive investment an intercorporate investment in which the investor cannot significantly influence or control the operations of the investee company strategic investment an investment in another company for strategic purposes; usually conveys control or significant influence or is a joint venture Investment Objectives Companies invest in the securities of other enterprises for a variety of reasons. The investment can be a passive investment, meant primarily to increase investment income, or a strategic investment, meant to enhance operations in some way: ● Investment of Idle Cash. Companies often have cash on hand that is not needed at present but will be needed in the future. Rather than allow the idle cash to remain in a low-interest bank account, companies find temporary investments with short terms that provide a higher return. These investments typically have low risk and are easily converted to cash. Cash on hand can be invested in investments that may generate return through interest or dividends and also may be sold when market price has increased. These investments will likely be of higher risk and/or a longer term, but the intent is to sell the investment when money is needed for other activities and/or when the price is attractive. ● Active Trading Investment Portfolio. Some companies, primarily financial institutions, invest in trading portfolios. Securities in the portfolio are actively traded as part of the normal course of business, generally yielding a return because of price fluctuations or a dealer’s margin. ● Long-Term Investments to Generate Earnings. Cash on hand can be invested in less liquid securities in order to increase investment income. These investments are usually money market instruments (for example, bonds), and the intent is to keep the investment until maturity. ● Strategic Alliances. An investment, especially in voting shares, may establish or cement a beneficial intercompany relationship that will increase the profitability of the investing company, both directly and indirectly. Strategic decisions may be made to invest in suppliers, customers, and even competitors. ● Legal Frameworks. Companies may choose to establish operations in one large company with numerous branches, or organize activities in a set of smaller companies, all or partially controlled by a central holding company. This may be done for tax reasons, to allow outside shareholders a small stake in particular operations, to satisfy legal requirements in particular jurisdictions, and/or to limit potential liability claims to particular portions of the enterprise. CLASSIFICATION OF INVESTMENTS Many securities are financial instruments under the definitions established in Section 3860 of the CICA Handbook. A financial instrument is any contract that gives rise to both a financial asset of one party and a financial liability or equity instrument of another party. In the context of intercorporate investments, financial assets are defined as any contractual right to receive cash or another financial asset from another company. Bonds and share investment meet this definition. Investments that are financial instruments are classified according to the rules in propsosed Section 3855, “Financial Instruments—Recognition and Measurement.” These classifications and rules are brand new, effective in any fiscal year beginning after 1 October 2006—that is, in the 2007 fiscal year. This chapter is based on the 2003 exposure draft in this area; strategic investments in shares are specifically excluded from the financial instruments sections of the CICA Handbook, but are accorded specific attention in other sections. For those interested in the rules in place up to 2006, refer to the superceded investments chapter available on the Online Learning Centre. This section explores the classification rules in depth. The classifications that follow are summarized in Exhibit 11-1. DEBT VERSUS EQUITY INVESTMENTS An investment in a debt instrument of another entity can be classified as available for sale, held to maturity, or a trading investment. An investment in common shares may be available for sale, held to maturity, or a trading investment, or, if strategic, a control investment, a significant influence investment, or a joint venture. It depends on intent and circumstances. We’ll define these terms in the sections that follow. 609 610 CHAPTER 11 Investments in Debt and Equity Securities EXHIBIT 11-1 CLASSIFICATION OF INVESTMENTS Passive Held-toMaturity Strategic Availablefor-Sale Trading held-to-maturity investments those investments that have a defined maturity date, fixed or determinable payments, and for which there is positive intent to hold to maturity Significant Influence Control Joint Venture Held-to-Maturity Investments Held-to-maturity investments must meet three tests: ● ● ● First, rather obviously, the securities must have a maturity date. This includes bonds and other money market instruments, but excludes common shares and any other investment with an indeterminate length. The securities must have fixed or determinable payments: set amounts at set points in time. Management must have the positive intent to hold the investments to their maturity dates. For example, if a company buys a bond with a 10-year maturity date, and management plans to hold it until maturity, it is classified as a held-to-maturity security. On the other hand, if management stands ready to sell the investment if the price is appealing or if the company needs cash, then the bond is an available-for-sale investment. If management plans for the investment are undecided, the investment is available for sale. This is the meaning of positive intent—there must be an active will to hold to maturity. MANAGEMENT INTENT Management intent can be a slippery classification tool. Management can change its intentions, or even misrepresent its intentions. This reduces the credibility of the financial statements, and future management representations. RECLASSIFICATION OR SALE Reclassification, or sale, of a held-to-maturity investment calls the integrity of the original classification into question. Therefore, [If the company] ... has sold or reclassified more than an insignificant amount of held-to-maturity investments in the past two years, then no securities can be classified as held-to-maturity. (CICA ED 3855) Of course, there are a few exceptions to this sweeping prohibition—for example, if there was ● an isolated event (e.g., a change in tax law or a major business combination) that caused the reclassification or sale; CHAPTER 11 Investments in Debt and Equity Securities ● ● a significant decline in the credit rating of the issuer of the investment and sale is the only appropriate response; or a sale of securities on a date very close to the original maturity date, then the sale is not “held against” the integrity of the initial classification. In any of these circumstances, the held-to-maturity classification is still open for future use. available-for-sale investment any investment that is not classified as a control, joint venture, significant influence, held-to-maturity, or trading investment; the catch-all category of investment trading investment an investment designated by management as held for trading; part of a portfolio managed for short-term profit or acquired principally for resale. Financial institutions are the major holders of trading investments. controlled investment the investment in a controlled subsidiary; normally consolidated for financial reporting control the continuing power to determine the strategic policies of an investee without the cooperation of other shareholders Available-for-Sale Investments Any investment that is available for sale if the company needs cash, or if the market value is appealing, is considered an available-for-sale investment. This category includes shortterm money-market investments, such as Treasury bills, but also bonds and shares of other companies that could be sold. While the investments are held, they will generate investment and dividend income. When they are sold, they will yield a realized gain or loss on sale. Market value will fluctuate during the time that the investments are held. The CICA Handbook definition of this category is negatively put: investments that are not in the other categories are classified here. The available-for-sale category is the catchall. To understand what this involves, we must proceed on to the other categories. Trading Investments The trading investment category is determined primarily by management intent. That is, when the investment is bought, the investment must be designated as a trading investment. This means that it is 1. held principally for the purpose of selling, or 2. is part of a portfolio of investments managed together for short-term profit. For the most part, trading investments are held by financial institutions, which engage in trading activities as part of the normal course of business. Any marketable financial instrument can be designated as a trading investment when purchased. Even if there is no plan to sell the investment in the near future, the investment can still be a trading investment, as long as intent to trade is present. Controlled Investments What are controlled investments? The CICA Handbook defines control as the continuing power to determine … strategic operating, investing and financing policies [of the other enterprise] without the cooperation of others. (CICA 1590.03) Since strategic policies of the enterprise are typically established by the Board of Directors, the right to elect a majority of the Board of Directors would normally constitute control. Of course, percentage share ownership is still the primary input to this decision. If a company owns more than 50% of the voting shares of a company, it must establish why it does not have control; if it owns 50% or less, it must establish why it does have control. An important phrase in the AcSB’s definition of control is “without the cooperation of others.” This means that, for control to be deemed to exist, the investor has to be able to withstand hostile takeover attempts. If an opponent can gather enough shares (or the support of enough voting shareholders) to take over control, then control does not exist in fact. Many corporations are “controlled” by a major shareholder who owns the largest single block of shares, but if this is less than 50%, then control does not really exist in an accounting sense. 611 612 CHAPTER 11 Investments in Debt and Equity Securities An investor can control a corporation while holding less than a majority of the corporation’s voting shares through any of several methods: ● ● ● ● parent company a corporation that controls one or more other corporations through ownership of a majority of the shares, carrying the right to elect at least a majority of the Board of Directors subsidiary company an investee company in which the investor company (the parent) controls the investee, usually by having the right to appoint a majority of the Board of Directors and/or holding in excess of 50% of the voting shares significant influence investment an investment representing ownership interest to the extent that the investor can affect strategic operating, investing, and/or financing policies of the investee The investee corporation may have two or more classes of shares that have different voting rights, in which case control can be maintained by holding a majority of the votes but not necessarily a majority of voting shares. Examples are given in Chapter 13. The investor may hold convertible securities or stock options and, if control is challenged, securities could be converted or exercised. Afterward, the investor has an absolute majority of the votes. A shareholders’ agreement may exist that gives control to a shareholder who owns less than 50% of the shares (or, to look at the reverse side, restricts the voting power of other investors). This device is common in private corporations, but can exist in public corporations as well. An investor with a minority of the shares may also be a major source of debt financing, and the debt agreement gives the investor the right to select a majority of the investee’s Board of Directors. If the investee is controlled by the investor corporation, the investor corporation is called a parent company and the investee corporation is known as a subsidiary. Significant Influence Investments Significant influence investments exist when an investor has the ability to exert influence over the strategic operating, investing, and financing policies of the investee corporation even though the investor does not control the investee. Significant influence can be exerted through several means, and not just by equity investment. The CICA Handbook cites the following possible evidence of significant influence: The ability to exercise significant influence may be indicated by, for example, representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel or provision of technical information. (CICA 3050.04) Normally, ownership of 20% or more of an investee corporation’s shares is deemed to indicate that significant influence exists. But this is a guideline, not a rule. If the investor holds less than 20% of the voting interest in the investee, it is presumed that the investor does not have the ability to exercise significant influence, unless such influence is clearly demonstrated. On the other hand, the holding of 20% or more of the voting interest in the investee does not in itself confirm the ability to exercise significant influence. (CICA 3050.04) It’s important to not put too much weight on the percentage of share ownership, though; a great deal depends on who owns the other shares, as well as on the other (non-ownership) financial and operating relationships between the investor and the investee corporations. For example, ownership of 30% of an investee corporation may not give the investee significant influence (or any influence) if the other 70% is held by a single shareholder who will not tolerate any influence. Conversely, an ownership interest of 15% may give the investor virtually unchallenged influence if ownership of the other 85% is widely dispersed. It is worth noting that, in the United States, the 20% ownership guideline is a firm rule; if 20% or more but less than a majority of the shares is owned by an investor, then significant influence is automatically deemed to exist. Therefore, an investor corporation may avoid the presumption of significant influence (and the accounting requirements that significant influence entails) by holding only 19.9%. In Canadian GAAP, however, it is the substance that matters, not a fraction of a percentage. CHAPTER 11 Investments in Debt and Equity Securities joint venture an investment resulting in a contractual arrangement whereby two or more venturers jointly control an economic activity; the joint venture is subject to joint control by the joint venturers Joint Ventures Another type of strategic equity investment is a joint venture. A joint venture is an economic activity resulting from a contractual arrangement whereby two or more venturers jointly control the economic activity. (CICA 3055.03(c)) Joint ventures are distinct in that they are subject to joint control, regardless of share ownership percentage. That is, the investors must unanimously agree on key operating, investing, and financing decisions before they are implemented. This feature of joint control means that majority ownership does not confer control, nor does the right to appoint the majority of the Board of Directors. Joint ventures are quite common in mining operations and in oil and gas ventures. The joint venturers all contribute something to exploration activities, and all share in any wealth generated. For example, a small mining company may have exploration rights over a property, and agree to explore the property with a larger joint venture partner, who provides management, working capital, and capital assets in exchange for a certain percentage of the profits. However, key decisions over when and where to explore, or when to put the property into commercial production, etc. are subject to common control of both venturers. Change in Classification Intent and ability to hold must be assessed at every balance sheet date. If intent changes, and the investment is still unsold, then its balance sheet classification and accounting treatment will change. CONCEPT REVIEW 1. Under what circumstances is an investment in bonds classified as a held-to-maturity investment? As an available-for-sale investment? 2. Can an investment in common shares be classified as a held-to-maturity investment? Explain. 3. In the current year, a company sells all its held-to-maturity investments because the market values had appreciated significantly. Can other investments now be classified as held to maturity? 4. An investor owns 40% of the shares of another company. Is this evidence enough to conclude that significant influence exists? 5. An investor owns 60% of the voting shares of another corporation, but has never become heavily involved in the management or governance of the company, although they could if they wished. Does control exist? ACCOUNTING FOR INVESTMENTS There are six ways to account for investments, depending on how the investment is classified. For a summary of the application of accounting methods, refer to Exhibit 11-2. The highlights of the accounting methods themselves are summarized in Exhibit 11-3. This section is an overview; we’ll look at some more detail, and examples, in later sections of this chapter. 613 614 CHAPTER 11 Investments in Debt and Equity Securities EXHIBIT 11-2 ACCOUNTING FOR INVESTMENTS—EXTERNAL REPORTING cost method of accounting for investments investments are recorded at cost and revenue is recorded as time passes (interest) or as declared (dividends); interest income includes premium or discount amortization Investment Type Method Held-toMaturity Investment Cost Availablefor-Sale Investment Fair Value; Gains & Losses in OCI until Sold Trading Investment Fair Value; Gains & Losses in NI Qualifier Fair Value not available: Cost Control Investment Consolidation Differential Reporting: Cost or Equity Significant Influence Investment Equity Differential Reporting: Cost Joint Venture Proportionate Consolidation Differential Reporting: Cost or Equity Cost Method The cost method is used to account for held-to-maturity investments. In the cost method ● ● ● ● ● ● The original investment is recorded at its investment cost. This is book value or carrying value, but it also represents fair value on the purchase date. It excludes any accrued interest. Transaction costs, such as brokerage fees, may be included in acquisition cost and capitalized, or immediately expensed. (CICA ED 3855.56.) Interest or dividends declared are recorded as investment income. If the investment is a long-term investment in debt securities, any premium or discount is amortized to income over the life of the investment. This will change book value. Book value will be move toward maturity value, and be equal to maturity value on the maturity date. When an investment is sold before maturity (which should be a rare event), the difference between proceeds and book value is recorded as a gain or loss on sale. When an investment matures, cash increases and the investment decreases. There is no gain or loss on the maturation of debt securities, because cash received is equal to the recorded maturity amount. CHAPTER 11 Investments in Debt and Equity Securities fair value method of accounting for investments investments are initially recorded at cost, but adjusted to fair value at each reporting date. Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments) unrealized holding gains Fair Value Method; Unrealized Gains and Losses Recognized in Other Comprehensive Income (OCI) The fair value method, with unrealized gains and losses included in other comprehensive income, is used to account for available-for-sale investments. In this method ● ● ● ● ● ● increase in fair value of an asset while held; unrealized because asset is not yet sold The original investment is recorded at its investment cost. This is fair value on the purchase date. Transaction costs, such as brokerage fees, may be included in acquisition cost and capitalized, or immediately expensed. Interest or dividends declared are recorded as investment income. Interest income includes amortization of any premium or discount inherent in the initial purchase price At the end of each reporting period, the investments are revalued to fair value (market value), whether this is higher or lower than the existing balance in the investment account. Unrealized holding gains, defined as the difference between the existing balance in the investment account (the new fair value) and the old fair value, are recorded in other comprehensive income. Such gains and losses are not included in net income, but are segregated in a special shareholders’ equity account, called other comprehensive income (OCI). When an investment is sold, the total cumulative realized holding gain or loss is reported in net income; related cumulative unrealized holding gains are eliminated from other comprehensive income in shareholders’ equity when the sale is recorded. The investment is reported at fair value on the balance sheet. realized holding gain increase in fair value of an asset while held, realized through sale Fair Value Method; Unrealized Gains and Losses Recognized in Net Income The fair value method, with unrealized gains and losses included in net income, is used to account for trading investments. In this method ● ● ● ● ● The original investment is recorded at its investment cost. This is fair value on the purchase date. Transaction costs, such as brokerage fees, may be included in acquisition cost and capitalized, or immediately expensed. Interest or dividends declared are recorded as investment income. At the end of each reporting period, the investments are revalued to fair value, whether this is higher or lower than the existing balance in the investment account. Holding gains, defined as the difference between the existing balance in the investment account (the new fair value) and the old fair value, are recorded in net income. That is, net income includes the change in value of the investment each year, whether realized through sale or unrealized because the investment is still held. The investment is reported at fair value on the balance sheet. VOLATILITY The difference between the two applications of the fair value method obviously relates to holding gain and loss recognition. For trading investments, unrealized holding gains and losses are included on the income statement. For available-for-sale investments, unrealized gains are collected in other comprehensive income until realized. Realization is a primary test for revenue recognition. For trading investments, realization is not considered necessary because of their rapid turnover. Remember, though, that if investment prices are volatile, inclusion of holding gains introduces volatility to net income. Companies with trading portfolios have registered concern about this volatility, because they are often using their trading portfolios to hedge, or offset, fluctuations caused by similar portfolios of financial liabilities, which are carried at cost, and not adjusted to fair value. Standard-setters continue to grapple with these issues. 615 616 CHAPTER 11 Investments in Debt and Equity Securities ESTIMATING FAIR VALUE Since financial statements will reflect fair value for some investments, it stands to reason that fair value must be carefully estimated. After all, fair value is not substantiated by the objective evidence of a transaction of the reporting entity. Fair value is defined as The amount of the consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act. (CICA ED 3855.17(j)) Many equity investments have a quoted market price in an active market, which is used as fair value. These market prices reflect normal market transactions and are readily available from brokers or in the financial press. When trading is light, recent bid prices are acceptable, although light trading may indicate that estimating fair value is problematic. For example, a recent price might not be relevant if significant events had taken place after the bid date (CICA ED 3855.A26). What if there are no recent transactions? The AcSB suggests that fair value can be estimated, through judicious use of valuation techniques. These valuation techniques must incorporate all factors that market participants consider when establishing prices. Fair value can be estimated through well-recognized valuation alternatives such as discounted cash flow models and option pricing models. In other cases, fair value can be inferred by referring to the current value of similar financial instruments, adjusting the market price for differences in terms and risk. Estimates are needed, and the reasonableness of any result must be carefully considered before the value can be used in the financial statements. It makes sense to disclose the method used to assess fair value, and any assumptions made. FAIR VALUE NOT AVAILABLE In some cases, it may not be possible to obtain fair value. In these cases, the investments must be carried at cost (CICA ED 3855.59c). However, if investments are classified as available for sale, and there is no apparent market value, the classification is somewhat suspect. Fair values should be ascertainable in most situations. equity method of accounting for investments investments are initially recorded at cost, and revenue is recorded as the investor’s appropriate share of earnings, increasing the investment account; dividends received reduce the investment account unremitted earnings when accounting for a significant influence investment, the difference between the investor’s cumulative share of an investee’s net income and the cumulative dividends actually received Equity Method The equity method is used for significant influence investments. Under the equity method: ● ● ● ● The original investment is recorded at its acquisition cost; this is initial book value. The investor’s proportionate share of the investee’s net income (subject to certain adjustments) is recognized on the investor’s income statement as revenue and on the balance sheet as an increase in book value. Dividends are recorded as a decrease in the investment account rather than as investment revenue. This reduces book value. When the investment is sold, the difference between proceeds and book value is recorded as a gain or loss on sale. At any point in time, the equity method investment account consists of 1. the investment’s cumulative historical cost, plus 2. the investor’s cumulative share of the investee’s adjusted earnings since the investment was made, minus 3. the investor’s share of dividends paid by the investee since the shares were purchased. The difference between the investor’s share of the investee’s net income and the dividends actually received is called unremitted earnings and increases book value above cost. CHAPTER 11 Investments in Debt and Equity Securities consolidation combining the financial statements of a parent company and its subsidiary(ies); fair value on acquisition is established, and intercompany transactions are eliminated proportionate consolidation combining the financial statements of an investor company and a joint venture enterprise; only the investor’s proportionate share of the financial elements of the joint venture are included The Consolidation Method When an investor controls an investee, consolidation is required. The parent investor must prepare consolidated statements, to enable investors (and others) to see the assets, liabilities, revenues, and expenses of the entire economic entity, consisting of the parent and all of its subsidiaries. When consolidated statements are prepared, the investment account relating to a controlled subsidiary disappears entirely from the balance sheet. Instead, the subsidiary’s assets and liabilities are added to those of the parent and reported together as a single economic entity. If the parent owns less than 100% of the subsidiary’s shares, the interest of the noncontrolling (i.e., minority) shareholders is shown as a separate account on the parent’s consolidated balance sheet and income statement. Proportionate Consolidation Method Joint ventures are reported by means of proportionate consolidation. Such a consolidated statement again involves adding the investor and investee financial statements together. This time, though, a pro-rata share of the investee’s assets, liabilities, revenues, and expenses is calculated and added to the investor’s own financial results. (This differs from a regular consolidation, where all the subsidiary’s assets, etc., are included regardless of the ownership interest, partially offset by the non-controlling interest accounts.) Proportionate consolidation is considered in depth in advanced accounting courses, and will not be further explored in this chapter. Differential Reporting We discussed differential reporting in Chapter 1. Essentially, if an organization has no public accountability and all owners consent, including those not otherwise entitled to vote, simpler accounting rules may be adopted in certain areas. Remember that the entities that are eligible for this GAAP treatment are private companies—those with no shares or debt traded on public markets. Usually, this is the smaller business sector, but not always. There are some large private companies in Canada. For these companies, if the equity holders all agree, the cost of more complex accounting standards can be avoided. The benefit of information provided is not worth the effort. Accounting for long-term investments is one of those areas. For investments, the following policies would be GAAP under differential reporting. Significant influence investments Controlled ivestments Joint ventures GAAP is responsive to user needs in this area. — — — Cost Cost or Equity Cost or Equity 617