1. Intercorporate Investmets

Question 1

Define ‘investment in financial assets’.

Answer 1

When the investing firm has no significant control over the operations of the investee firm.

Question 2

Define ‘investments in associates’.

Answer 2

When the investing firm has significant influence over the operations of the investee firm, but not control.

Question 3

Define ‘business combinations’.

Answer 3

When the investing firm has control over the operations of the investee firm.

Question 4

How is determined the category of intercorporate investments? Percentage of ownership?

Answer 4

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. Ultimately, the category is based on the investor’s ability to influence or control the investee.

Question 5

Which is a mean value of percentage of ownership for ‘financial assets’?

Answer 5

An ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee.
However, it may possible to have significant influence with less than 20% ownership. In this case, the investment is considered an ‘investment in associates’.

Question 6

Which is a usually range of percentage of ownership for ‘investments in associates’?

Answer 6

An ownership interest between 20% and 50% is typically a non-controlling investment. However, the investor can usually significantly influence the investee’s business operations.

Conversely, without significant influence, an ownership interest between 20% and 50% is considered an investment in financial assets.

Question 7

An ownership interest of more tha 50% is always a ‘controlling investment’?

Answer 7

No. 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. In these cases, the investment is not considered controlling.

Question 8

Which method of accounting is used for ‘investments in associates’ and for business combinations’?

Answer 8

Investments in associates: equity method

Business combinations: acquisition method

Question 9

For joint ventures, equity method or acquisition method or proportionate consolidation?

Answer 9

A JV is an entity whereby control is shared by two or more investors. Both IFRS and US GAAP require the equity method for joint ventures. In rare cases, IFRS and US GAAP allow proportionate consolidation as opposed to the equity method.

Question 10

Which are three classifications of ‘financial assets’?

Answer 10

1. Held-to-maturitu
2. Fair value through profit or loss (held-for-trading or designated at fair value)
3. Available-for-dale

Question 11

How ‘held-to-maturity’s securities’ are reported on the balance sheet?

Answer 11

Held-to-maturity securities are reported on the balance sheet at amortized cost. Amortized cost is the original cost of the debt security plus any discount, or minus any premium, that has been amortized to date.

Amortized cost is simply the present value of the remaining cash flows (coupons payments and face amount) discounted at the market rate of interest at issuance.

Question 12

How ‘held-for-trading securities’ are reported on the balance sheet?

Answer 12

At fair value.

Question 13

Explain ‘securities designated at fair value’. It reduces or increases volatility?

Answer 13

Firms can choose to report debt and equity securities that would otherwise be treated as held-to-maturity or available-for-sale at fair value. Designating financial assets and liabilities at fair value can reduce volatility and inconsistencies that result from measuring using different valuation bases.

Question 14

How ‘available-for-sale securities makers are reported on balance sheet?

Answer 14

At fair value.

Question 15

For ‘held-to-maturity securities’, which is recognized in the income statement?

Answer 15

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.

Question 16

For ‘held-for-trading securities’, which is recognized in the income statement?

Answer 16

The changes in fair value, both realized and unrealized, are recognized in the income statement along with any dividend or interest income.

Question 17

For ‘designated at fair value securities’, which is recognized in the income statement?

Answer 17

Unrealized gain and losses in designated financial assets and liabilities are recognized in the income statement, similar to the treatment of held-for-trading securities.

Question 18

For ‘available-for-sale securities’, which is recognized in the income statement?

Answer 18

Only the realized gains or losses, and 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 OCI, as they are now realized, and recognized in the income statement.

Question 19

Which is the only one difference in the treatment for reporting intercorporate investments under IFRS and US GAAP?

Answer 19

The treatment under IFRS is similar to US GAAP, except for unrealized gains or losses that result from foreign exchange movements.

Foreign exchange gains and losses on available-for-sale DEBT securities are recognized in the income statement under IFRS.

The entire unrealized gain or loss is recognized in equity under US GAAP.

For available-for-dale EQUITY securities, the treatment under IFRS is similar to the treatment under US GAAP.

Question 20

Comment about the restrictions of reclassification if investments in financial assets.

Answer 20

IFRS typically 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.

Question 21

How to reclassify debt securities classified as available-for-dale into held-to-maturity?

Answer 21

Recall, held-to-maturity is reported on the BS at amortized cost and available-for-sale is reposted on the BS at fair value.

So, 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 OCI, is amortized over the security’s remaining life.

Question 22

How to reclassify held-to-maturity securities into available-for-sale?

Answer 22

Recall, held-to-maturity is reported on the BS at amortized cost and available-for-sale is reposted on the BS at fair value.

So, the carrying value is remeasured to the security’s fair value, with any difference recognized in OCI.

• reclassifying 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.

Question 23

How to reclassify held-for-trading or designated at fair value securities into or out? Is it allowed under IFRS and under US GAAP? Explain the cases of investiments transferring out of available-for-sale.

Answer 23

IFRS typically does not allow reclassification of investments into or out of the designated at fair value category.

US 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 OCI is recognized in income statement.

Question 24

In which frequency IFRS and US GAAP require that held-to-maturity and available-for-sale securities brokerages evaluates for impairment?

Answer 24

At each reporting period.

Question 25

Explain impairment under IFRS and under US GAAP. Reversals are allowed?

Answer 25

Under US GAAP, a security is considered impaired if its decline in value is determined to be other than temporary. For both held-to-maturity and available-for-sale securities, the write-down to fair value is treated as a realized loss (I.e., recognized in the income statement).
A subsequent reversal of impairment losses is NOT allowed.

Under IFRS, impairments are recognized in the income statement as under US GAAP.
If the held-to-maturity 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 available-for-sale debt securities may be reversed under the same conditions. Reversals are not permitted for equity securities.

Question 26

Explain IFRS 9 (new classification of financial assets).

Answer 26

Held-to-maturity —> amortized cost

Fair value through profit or loss: same

Available-for-sale —> Fair value through OCI

Question 27

Explain reclassification under IFRS 9.

Answer 27

Reclassification of equity securities under the new standards is not permitted as the initial designation (fair value through profit or loss or fair value through OCI) is irrevocable. Reclassification is debt securities is permitted only if the business model has changed. For example, unrecognized gains/losses on debt securities carried at amortized cost and reclassified as fair value through profit or loss are recognized in the income statement. Debt securities that are reclassified out of fair value through profit or loss as measured at amortized cost are transferred at fair value on the transfer date, and that fair value will become the carrying amount.

Question 28

How investments in associates are recorded on the balance sheet? And how investee’s earnings are accounted?

Answer 28

Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a non current 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. Dividend received from the investee are treated as a return of capital and thus, reduce the investment account. Unlinke investments in financial assets, dividends received from the investee are not recognized in the investor’s income statement.

Question 29

Do US GAAP and IFRS allow equity method investments to be recorded at fair value?

Answer 29

UsS 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.

Question 30

Under the equity method, the investor does not actually report the separate assets and liabilities of the investee. Rather, the investor reports the investment in one line in its balance sheet. This one-line investment account includes the proportionate share of the investee’s net assets at fair value and the goodwill. True or false?

Answer 30

True.

Question 31

Explain impairments and reversals of investments in associates under IFRS and US GAAP.

Answer 31

Equity method investments must be tested for impairment. Under US 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 evidências by one or more loss events. Under both IFRS and US GAAP, if there is a recovery in value in the future, the asset cannot be written-up.

Question 32

Under IFRS, business combinations are not differentiated based on the structure of surviving entity. Which are three categories of business combinations under US GAAP?

Answer 32

• Merger: the acquiring firm absorbs all the assets and liabilities of the acquired firm m, which ceases to exist. The acquiring firm is the surviving entity.
• Acquisition: both entities continue to exist in a parent-subsidiary relationship. Recall that when less than 100% of the subsidiary is owned by the parent, the parent prepares consolidated financial statements but reports the unowned (minority or non-controlling) interest on its financial statements.
• Consolidation: a new entity is formed that absorbs both of the combining companies.

Question 33

Under which method is it necessary to create a minority interest account for the portion of acquired company’s equity that is not owned by acquirer company?

Answer 33

Acquisition method.

Question 34

Under which method the assets and liabilities of target and acquirer companies are combined?

Answer 34

Acquisition method.

Question 35

Under which method acquirer company will report its interest in target company in one-line investment account on the balance sheet?

Answer 35

Equity method.

Question 36

Under acquisition method, minority interest is reported in assets, liabilities or in stockholder’s equity?

Answer 36

Equity.

Question 37

Explain how to conciliate income statement under acquisition method and under equity method.

Answer 37

Under the acquisition method, the revenue and expenses are combined. It is also necessary to create a minority interest (expense) in the income statement for the portion of target company’s net income that is not owned by the acquirer.

Under the equity method, acquirer company will report its share is target company’s net income in a one-line account in the income statement (Equity in income of Target).

Question 38

Explain ‘full goodwill’ and ‘partial goodwill’.

Answer 38

Full goodwill = (fair value of equity of whole subsidiary) - (fair value of net identifiable net assets of the subsidiary)

Partial goodwill = %owned x full goodwill

Full goodwill is required under US GAAP and allowed under IFRS.

Partial goodwill is allowed only under IFRS.

Question 39

How full vs. partial goodwill are reflected on the minority interest on the balance sheet?

Answer 39

If the full goodwill method is used, noncontrolling interest is based on the acquired company’s fair value.

If the partial goodwill method is used, noncontrolling interest is based on the fair value of the acquired company’s identifiable net assets.

Question 40

Is Goodwill amortized if tested for impairment? When?

Answer 40

Goodwill is not amortized. Instead, it is tested for impairment at least annually.

Question 41

How it work when acquisition purchase price is less than fair value of net assets acquired (bargain purchase)?

Answer 41

Both IFRS and US GAAP require that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.

Question 42

Both US GAAP and IFRS require the which method of accounting for joint ventures?

Answer 42

Equity method.

In rare circumstances, the proportionate consolidation method may be allowed under IFRS and US GAAP. Proportionate consolidation is similar to acquisition, except the investor (venturer) only reports the proportionate share of the assets, liabilities, revenues, and expenses of the JV. Since only the proportionate share is reported, no minority owner’s interest is necessary.

Question 43

Define SPE. What is the typical motivation to crate a SPE? What is a VIE?

Answer 43

A special purpose entity (SPE) is a legal structure created to isolate certain assets and liabilities of the sponsor. An SPE can take a form of a corporation, partnership, joint venture, or trust.

The typical motivation is to reduce risk and thereby lower the cost of financing.

The FASB (US GAAP) uses the term variable interest entity (VIE) to describe a special purpose entity that meets certain conditions. According to FASB, 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 of the following:

a) decision making rights
b) the obligation to absorb expected losses
c) the right to receive expected residual returns

If a 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 / receives the majority of the rewards.

• the IASB (IFRS) continues to use the term SPE and the sponsoring entity must consolidated if it controls the SPE.

Question 44

Explain what is a variable interest entity (VIE)

Answer 44

The FASB (US GAAP) uses the term variable interest entity (VIE) to describe a special purpose entity that meets certain conditions. According to FASB, 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 of the following:

a) decision making rights
b) the obligation to absorb expected losses
c) the right to receive expected residual returns

If a 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 it receives the majority of the rewards.

• the IASB (IFRS) continues to use the term SPE and the sponsoring entity must consolidated if it controls the SPE.

Question 45

How to treat ‘restructuring costs’ related to an acquisition?

Answer 45

Restructuring costs are expensed when incurred - and not capitalized as part of the acquisition cost - under both IFRS and US GAAP.

Question 46

How to treat ‘ contingent assets and liabilities’ related to an acquisition under IFRS and under US GAAP?

Answer 46

Under IFRS, only contingent liabilities whose fair value can be measured reliably are recognized at the time of acquisition. Contingent assets are never recognized. In subsequent periods, contingent liabilities are measured at the higher of the value initially recognized, or the best estimate of the amount needed to settle the liabilities.

US GAAP divides contingent assets and liabilities into contractual and non contractual. Contractual contingent assets and liabilities are recorded at their fair values on the acquisition date. Non-contractual contingent assets are also recorded of ‘’more likely than not’ they meet the definition of an asset or liability. Subsequently, measurement of contingent liabilities is similar under IFRS, while contingent assets are recognized at the lower of the initial value and the best estimate of the future settlement amount.

Question 47

How to treat ‘in-procsss R&D’ related to a business combination?

Answer 47

In process R&D is capitalized as an intangible asset and included as an asset under both US GAAP and IFRS. In-process R&D is subsequently amortized (if successful) or impaired (if unsuccessful).

Question 48

You need know the four important effects on the balance sheet and income statement items that result from the choice of accounting method - the equity method, the proportionate consolidation method, and the acquisition method (in most situations).

Answer 48

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.