an investment category when IFRS 9 becomes mandatory on January 1, 2015, or when a reporting entity chooses to adopt IFRS 9 early.
An investment where the investor is able to significantly influence the opera- tions of the investee is called an investment in associate and must be accounted for using the equity method, as described in IAS 28. This requires the investor to record its share of any changes in the shareholders’ equity of the investee, adjusted for the amortization of the acquisition differential and the holdback and realiza- tion of profits from the intercompany sale of assets.
Significant Changes in GAAP in the Last Three Years
1. The effective date for IFRS 9 has been changed from January 1, 2013, to Janu- ary 1, 2015, with early adoption permitted. Under IFRS 9, all nonstrategic equity investments must be measured at fair value, with changes in fair value reported in net income; however, an entity can irrevocably elect on initial recognition to report the fair value changes on an equity investment that is not held for short-term trading in other comprehensive income. 2. IFRS 10 replaced certain components of IAS 28 and SIC 12; IFRS 11 replaced
IAS 31 and SIC 13; and IRFS 12 replaced the disclosure requirements previ- ously listed in IAS 28 and 31.
3. IFRS 13 is a new standard on fair value measurement. It replaces the fair value measurement guidance that was previously contained in individual IFRSs with a single, unified definition of fair value and a framework for measuring fair value. It also states the required disclosures about fair value measurements. It includes guidance to determine fair value measurement in inactive or illiquid markets. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price). It would reflect the highest and best use for non financial assets.
Changes Expected in GAAP in the Next Three Years
No major changes are expected in the next three years for the topics discussed in this chapter.
Required:
Prepare High’s journal entries with respect to this investment for both Year 5 and Year 6.
The following are summarized income statements for the two companies for Year 7:
Lowe paid no dividends in Year 7.
Required:
(a) Prepare the journal entries that High should make at the end of Year 7 with respect to its investment in Lowe.
(b) Prepare High’s income statement for Year 7, taking into consideration the journal entries in part (a).
Part B
High Inc. Lowe Corp. Operating income before income taxes $750,000 $340,000
Income tax expense 300,000 140,000
Net income before discontinued operations 450,000 200,000 Loss from discontinued operations (net of tax) — 20,000
Net income *$450,000 $180,000
*The net income of High does not include any investment income from its investment in Lowe.
The 10% purchase should be accounted for under the fair value method. High’s journal entries during Year 5 are as follows:
Investment in Lowe 192,000
Cash 192,000
Purchase of 10% of shares of Lowe
Cash (10% 3 120,000) 12,000
Dividend income 12,000
Investment in Lowe (200,000 2 192,000) 8,000
Unrealized gain on FVTPL investment 8,000
The 25% purchase in Year 6 changes the investment to one of significant influence, which is accounted for prospectively under the equity method.
The journal entries in Year 6 are as follows:
Investment in Lowe 500,000
Cash 500,000
Purchase of additional 25% of shares of Lowe
Investment in Lowe (35% 3 270,000 profit) 94,500
Investment income 94,500
Cash (35% 3 130,000 dividends) 45,500
Investment in Lowe 45,500
(a) Applying the equity method, High makes the following journal entries in Year 7:
Investment in Lowe (35% 3 180,000) 63,000
Discontinued operations—investment loss, (35% 3 20,000) 7,000
Investment Income (35% 3 200,000) 70,000
(b)
Part B
On January 1, Year 1, Joshua Corp. purchased 20% of the outstanding ordinary shares of Deng Company at a cost of $950,000. Deng reported profit of $900,000 and paid dividends of $600,000 for the year ended December 31, Year 1. The mar- ket value of Joshua’s 20% interest in Deng was $990,000 at December 31, Year 1. On June 30, Year 2, Deng paid dividends of $350,000. On July 2, Year 2 Joshua sold its investment in Deng for $1,005,000. Deng did not prepare financial statements for Year 2 until early in Year 3.
Required:
(a) Prepare the journal entries for Joshua Corp. for Years 1 and 2 for the above- noted transactions under the following reporting methods: cost, equity, FVTPL, and FVTOCI.
(b) Prepare a schedule to show the profit, OCI, comprehensive income, and change in retained earnings for Joshua for Year 1, Year 2, and the total of the changes for Years 1 and 2 under the four methods.
(c) Prepare a schedule to compare the change in cash with change in profit, com- prehensive income, and retained earnings for Joshua for the sum of the two years under the four methods.
(d) Comment on the similarities and differences in financial reporting for the four methods.
LO2, 3, 6
S ELF -STUDY P ROBLEM 2
HIGH INC. INCOME STATEMENT Year Ended December 31, Year 7
Operating income $750,000
Investment income* 70,000
Income before income taxes 820,000
Income tax expense 300,000
Net income before discontinued operations 520,000
Discontinued operations 2 investment loss (net of tax)* 7,000
Net income $513,000
* A footnote would disclose that these items, in whole or in part, came from a 35% investment in Lowe, accounted for using the equity method.
(a) Credit entries are noted in brackets.
Cost Equity FVTPL FVTOCI
Jan. 1, Year 1
Investment in Deng 950,000 950,000 950,000 950,000
Cash (950,000) (950,000) (950,000) (950,000)
To record the acquisition of 20% of Deng’s shares Dec. 31, Year 1
Investment in Deng (20% 3 900,000) 180,000
Investment income (180,000)
Accrue share of profit
Cash (20% 3 600,000) 120,000 120,000 120,000 120,000
Dividend income (120,000) (120,000) (120,000)
Investment in Deng (120,000)
Receipt of dividend from Deng
Investment in Deng (990,000 2 950,000) 40,000 40,000
Unrealized gains (reported in profit) (40,000)
OCI (40,000)
To record investment at fair value June 30, Year 2
Cash (20% 3 350,000) 70,000 70,000 70,000 70,000
Dividend income (70,000) (70,000) (70,000)
Investment in Deng (70,000)
Receipt of dividend from Deng July 2, Year 2
Cash 1,005,000 1,005,000 1,005,000 1,005,000
Investment in Deng (950,000) (940,000) (990,000) (990,000) Gain on sale (reported in profit) (55,000) (65,000) (15,000)
OCI–unrealized gains (15,000)
Record sale of investment
Accumulated OCI–reclassification to
retained earnings 55,000
Retained earnings (55,000)
Clear accumulated OCI to retained earnings
(b)
(in $000s) Cost Equity FVTPL FVTOCI
YR1 YR2 Total YR1 YR2 Total YR1 YR2 Total YR1 YR2 Total
Profit 120 125 245 180 65 245 160 85 245 120 70 190 OCI 40 15 55 Comprehensive income 120 125 245 180 65 245 160 85 245 160 85 245 Change in retained earnings 120 125 245 180 65 245 160 85 245 120 125 245 (c)
SOLUTION
TO SELF-STUDY PROBLEM 2
(in $000s) Cost Equity FVTPL FVTOCI
Cash received
Dividends in Year 1 120 120 120 120
Dividends in Year 2 70 70 70 70
Sales proceeds in Year 2 1,005 1,005 1,005 1,005
Total cash received 1,195 1,195 1,195 1,195
(d)
Similarities
– Change in cash is the same for all methods .
– Profit for the two years in total is the same for the first three methods and comprehensive income is the same for all methods .
– Change in retained earnings for the two years in total is the same for all methods .
– Change in cash is equal to change in profit for the two years in total for the first three methods .
– Change in cash is equal to change in comprehensive income for the two years in total for all methods .
– Change in cash is equal to change in retained earnings for the two years in total for all methods .
Differences
– Timing of income recognition is different .
– Gains from appreciation go through profit for first three methods but never get reported in profit for the FVTOCI investment .
Cash paid for investment 950 950 950 950
Change in cash 245 245 245 245
5 Change in profit 245 245 245 190
5 Change in comprehensive income
245 245 245 245
5 Change in retained earnings 245 245 245 245
R EVIEW Q UESTIONS
1. How is the concept of a business combination related to the concept of a parent–subsidiary relationship?
2. Distinguish between the financial reporting for FVTPL investments and that for investments in associates.
3. What is the difference between a “control” investment and a “joint control” investment?
4. What is the purpose of IFRS 8 on Operating Segments?
5. What criteria would be used to determine whether the equity method should be used to account for a particular investment?
6. The equity method records dividends as a reduction in the investment account. Explain why.
7. The Ralston Company owns 35% of the outstanding voting shares of Purina Inc. Under what circumstances would Ralston determine that it is inappro- priate to report this investment using the equity method?
8. Because of the acquisition of additional investee shares, an investor may need to change from the fair value method for a FVTPL investment to the LO1 LO2 LO2 LO1 LO2, 4 LO3 LO4 LO3
equity method for a significant influence investment. What procedures are applied to effect this accounting change?
9. An investor uses the equity method to report its investment in an investee. During the current year, the investee reports other comprehensive income on its statement of comprehensive income. How should this item be reflected in the investor’s financial statements?
10. Ashton Inc. acquired a 40% interest in Villa Corp. at a bargain price because Villa had suffered significant losses in past years. Ashton’s cost was $200,000. In the first year after acquisition, Villa reported a loss of $700,000. Using the equity method, how should Ashton account for this loss?
11. Able Company holds a 40% interest in Baker Corp. During the year, Able sold a portion of this investment. How should this investment be reported after the sale?
12. Briefly describe the disclosure requirements related to an investment in an associated company.
13. Which of the reporting methods described in this chapter would typically report the highest current ratio? Briefly explain.
14. How should a private company that has opted to follow ASPE report an investment in an associate?
15. How will the investment in a private company be reported under IFRS 9, and how does this differ from IAS 39?
LO3 LO3 LO3 LO5 LO6 LO7 LO2
Hil Company purchased 10,000 common shares (10%) of Ton Inc. on January 1, Year 4, for $345,000, when Ton’s shareholders’ equity was $2,600,000, and it clas- sified the investment as a FVTPL security. On January 1, Year 5, Hil acquired an additional 15,000 common shares (15%) of Ton for $525,000. On both dates, any difference between the purchase price and the carrying amount of Ton’s share- holders’ equity was attributed to land. The market value of Ton’s common shares was $35 per share on December 31, Year 4, and $37 per share on December 31, Year 5. Ton reported net income of $500,000 in Year 4 and $520,000 in Year 5, and paid dividends of $480,000 in both years.
The management of Hil is very excited about the increase in ownership inter- est in Ton because Ton has been very profitable. Hil pays a bonus to management based on its net income determined in accordance with GAAP.
The management of Hil is wondering how the increase in ownership will affect the reporting of the investment in Ton. Will Hil continue to classify the investment as FVTPL in Year 5? What factors will be considered in determining whether the equity method should now be used? If the equity method is now appropriate, will the change be made retroactively? They would like to see a comparison of income for Year 5 and the balance in the investment account at the end of Year 5 under the two options for reporting this investment. Last but not least, they would like to get your opinion on which method should be used to best reflect the performance of Hil for Year 5.
Case 2-1
LO2, 3, 4
Required:
Respond to the questions raised and the requests made by management. Prepare schedules and/or financial statements to support your presentation.
Floyd’s Specialty Foods Inc. (FSFI) operates over 60 shops throughout Ontario. The company was founded by George Floyd when he opened a single shop in the city of Cornwall. This store sold prepared dinners and directed its products at cus- tomers who were too busy to prepare meals after a long day at work. The concept proved to be very successful, and more stores were opened in Cornwall. Recently, new stores were opened in five other Ontario cities. Up to the current year, the shares of FSFI have been owned entirely by Floyd. However, during this year, the company suffered severe cash flow problems, due to too-rapid expansion exacer- bated by a major decline in economic activity. Profitability suffered and creditors threatened to take legal action for long-overdue accounts. To avoid bankruptcy, Floyd sought additional financing from his old friend James Connelly, who is a majority shareholder of Cornwall Autobody Inc. (CAI), a public company. Subse- quently, CAI paid $950,000 cash to FSFI to acquire enough newly issued shares of common stock for a one-third interest.
At the end of this year, CAI’s accountants are discussing how they should properly report this investment in the company’s financial statements.
One argues for maintaining the asset at original cost, saying, “What we have done is to advance money to bail out these stores. Floyd will continue to run the organization with little or no attention to us, so in effect we have lent him money. After all, what does anyone in our company know about the specialty food busi- ness? My guess is that as soon as the stores become solvent, Floyd will want to buy back our shares.”
Another accountant disagrees, stating that the equity method is appropriate. “I realize that our company is not capable of running a specialty food company. But the requirements state that ownership of over 20% is evidence of significant influence.”
A third accountant supports equity method reporting for a different reason. “If the investment gives us the ability to exert significant influence, that is all that is required. We don’t have to actually exert it. One-third of the common shares certainly give us that ability.”
Required:
How should CAI report its investment? Your answer should include a discussion of all three accountants’ positions.
Magno Industries Ltd., a public company, is a major supplier to the automotive replacement-parts market, selling parts to nearly every segment of the industry. Magno has a September 30 year-end.
During January Year 5, Magno acquired a 13% interest in the common shares of Grille-to-Bumper Automotive Stores, and in June Year 5 it acquired an additional 15%. Grille-to-Bumper is a retail chain of company-owned automotive replace- ment parts stores operating in most Canadian provinces. Its shares are not traded in an active market. Grille-to-Bumper has a December 31 year-end and, despite being profitable each year for the last 10 years, has never paid a dividend. While
Case 2-2
LO2, 4, 7
Case 2-3
Magno occasionally makes sales to Grille-to-Bumper, it has never been one of its major suppliers.
After the second acquisition of Grille-to-Bumper’s shares, Magno Indus- tries contacted Grille-to-Bumper to obtain certain financial information and to discuss mutual timing problems with respect to financial reporting. In the ini- tial contact, Magno found Grille-to-Bumper to be uncooperative. In addition, Grille-to-Bumper accused Magno of attempting to take it over. Magno replied that it had no intention of attempting to gain control but rather was interested only in making a sound long-term investment. Grille-to-Bumper was not impressed with this explanation and refused to have any further discussions regarding future information exchanges and the problems created by a difference in year-ends.
At the year-end of September 30, Year 5, Magno’s management expressed a desire to use the equity method to account for its investment.
Required:
(a) What method of accounting would you recommend Magno Industries use for its investment in Grille-to-Bumper Automotive common shares? As part of your answer, discuss the alternatives available.
(b) Why would the management of Magno want to use the equity method to account for the investment, as compared with other alternatives that you have discussed?
(c) Are there any circumstances under which the method you have recommended might have to be changed? If so, how would Magno Industries account for such a change?
Canadian Computer Systems Limited (CCS) is a public company engaged in the development of computer software and the manufacturing of computer hardware. CCS is listed on a Canadian stock exchange and has a 40% non-controlling inter- est in Sandra Investments Limited (SIL), a U.S. public company that was de-listed by an American stock exchange due to financial difficulties. In addition, CCS has three wholly owned subsidiaries.
CCS is audited by Roth & Minch, a large public accounting firm. You, the CA, are the audit manager responsible for the engagement.
CCS has a September 30 fiscal year-end. It is now mid-November, Year 11, and the year-end audit is nearing completion. CCS’s draft financial statements are included in Exhibit I . While reviewing the audit working papers (see Exhibit II ), you identify several issues that raise doubts about CCS’s ability to realize its assets and discharge its liabilities in the normal course of business.
After you have reviewed the situation with the engagement partner, he asks you to prepare a memo for his use in discussing the going-concern problem with the president of CCS, and suggests that you look to IAS 1 for guidance. Your memo should include all factors necessary to assess CCS’s ability to continue operations. You are also to comment on the accounting and disclosure implications.
Required:
Prepare the memo requested by the partner.
(CICA adapted)
Case 2-4
CANADIAN COMPUTER SYSTEMS LIMITED EXTRACTS FROM CONSOLIDATED BALANCE SHEET
As at September 30 (in thousands of dollars)
Year 11 Year 10 Assets
Current assets
Cash $ 190 $ 170
Accounts receivable 2,540 1,600
Inventories, at the lower of cost and net realizable value 610 420 3,340 2,190 Plant assets (net of accumulated depreciation) 33,930 34,970
Property held for resale 1,850 1,840
Other assets 410 420
$39,530 $39,420 Liabilities
Current liabilities
Demand loans $ 1,150 $ 3,080
Accrued interest payable 11,510 10,480
Accounts payable 2,500 2,100
Mortgages payable due currently because of loan defaults 21,600 21,600
Long-term debt due within one year 290 1,780
Debt obligation of Sandra Investments Limited 50,000 55,420 87,050 94,460
Long-term debt 26,830 21,330
Other long-term liabilities 250 330
114,130 116,120 Contributed Capital and Deficit
Contributed capital Issued:
261 9% cumulative, convertible, preferred shares 10 10
1,000,000 Class B preferred shares 250 250
10,243,019 Common shares 100,170 100,010 100,430 100,270 Deficit (175,030 ) ( 176,970 ) (74,600) (76,700 ) $ 39,530 $39,420 EXHIBIT I
CANADIAN COMPUTER SYSTEMS LIMITED EXTRACTS FROM CONSOLIDATED STATEMENT
OF OPERATIONS AND DEFICIT For the years ended September 30
(in thousands of dollars)
Year 11 Year 10 Sales Hardware $ 12,430 $ 19,960 Software 3,070 3,890 15,500 23,850 Other income 1,120 – 16,620 23,850 (continued)
Expenses
Operating 10,240 15,050
Interest 4,590 4,690
General and administrative 2,970 4,140
Depreciation 2,400 3,630
Provision for impairment in plant assets — 2,220 20,200 29,730
Loss before the undernoted items (3,580) (5,880)
Loss from Sandra Investments Limited (2,830) (55,420)
Loss before discontinued operations (6,410) (61,300)
Gain (loss) from discontinued operations 8,350 (4,040)
Net income (loss) 1,940 (65,340)
Deficit, beginning of year (176,970) (111,630)
Deficit, end of year $(175,030) $(176,970)
EXTRACTS FROM AUDIT WORKING PAPERS
1. Cash receipts are collected by one of CCS’s banks. This bank then releases funds to CCS based on operating budgets prepared by management. Demand loans bear- ing interest at 1% over the bank’s prime rate are used to finance ongoing operations. The demand loans are secured by a general assignment of accounts receivable and a floating-charge debenture on all assets.
2. CCS accounts for its interest in SIL using the equity method. As a result of SIL’s recurring losses in prior years, the investment account was written off in Year 9. In Year 10, CCS recorded in its accounts the amount of SIL’s bank loan and accrued interest, as CCS guaranteed this amount. During Year 11, CCS made debt payments of $5.42 million and interest payments of $1.8 million on behalf of SIL. In October Year 11, SIL issued preferred shares in the amount of US$40 million, used the pro- ceeds to pay down the bank loan, and was re-listed on the stock exchange. Interest expense on the debt obligation in Year 11 totalled $2.83 million and has been included in the income statement under “Loss from Sandra Investments Limited.”
3. Current liabilities include mortgages payable of $21.6 million due currently. They have been reclassified from long-term debt because of CCS’s failure to comply with operating covenants and restrictions. The prior year’s financial statements have been restated for comparative purposes.
4. Long-term debt is repayable over varying periods of time. However, the banks reserve