Table of Contents

1. Introduction

2. Investment in Debt Securities

3. Investment in Equity Securities

4. Accounting for Business Combination

5. Summary

1. Introduction

A company may invest in debt (such as bonds) and/or equity (such as shares) securities. In general, the accounting treatment for
these investments depends on the managerial intent of the investment and on the length of the holding period of these
investments.

Objectives: Investments and Acquisitions

Upon completion of this topic, you should be able to

• describe the accounting treatment for investment in debt securities

• distinguish between the cost method and equity method of accounting for investment in equity securities

• describe the two methods of accounting for business combinations

2. Investment in Debt Securities

Debt securities are instruments that provide the holder a promise to pay the face value (or par value) of the instrument at the
maturity date as well as an interest payment at specific intervals. Debts instruments may be issued by companies and government
bodies.

Trading securities

Investments in debt instruments may be held for short-term periods for making short-term profits. These investments are referred
to as trading securities and are classified under current assets as marketable securities. At the acquisition date, these investments
are recorded at the acquisition cost by debiting Debt Investments and crediting Cash. At the end of each period, these
investments are revalued to their fair market value and the change in value (although unrealised) is recorded in the income
statement as an unrealised gain or loss. When a company sells these investments, the difference between the sale price and the
beginning fair market value of the investment is recorded in the income statement as a realised gain or loss.

Held-to-maturity securities

Investment in debt instruments may also be held until maturity. These investments are referred to as held-to-maturity securities
and are classified as current or noncurrent assets depending on their maturity date. At the acquisition date, these investments are
recorded at the acquisition cost by debiting debt investments and crediting cash.

Held-to-maturity debt instruments (eg, bonds) offer the holder a promise to repay the face value of the instrument at its maturity
date and to also make coupon interest payments at specific intervals during the life of the instrument:

• If the coupon interest rate equals the market interest rate, the acquisition cost of any debt instrument will equal its face
value. In this case, the instrument is said to be issued at par value.
• If the coupon interest rate is lower than the market interest rate, the acquisition cost of the debt instrument will be below
its face value. In this case, the debt instrument is said to be issued at a discount.
• If the coupon interest rate is higher than the market interest rate, the acquisition cost of the debt instrument will be above
its face value. In this case, the debt instrument is said to be issued at a premium.
At the end of each period, these investments are not revalued to their fair market value. Instead, they are kept at their amortised
cost value. This means that the difference between the acquisition cost and the face value of the security (that is, discount or
premium) is amortised over the life of the security. At maturity date, the entire difference between the acquisition cost and the
face value is amortised. Since these investments are not revalued to fair market value, there is no gain or loss to account for.
The investing company, however, must account for the amortisation of the discount or the premium and it also must account for
the interest payments it receives at specific intervals.

Available for sale securities

Finally, investment in debt instruments may also be held with a view to sell, should market conditions favour the sale or should
the holding company need cash. These investments are referred to as "available for sale" securities and are classified as current
assets or non-current assets, as appropriate.
Treatment of transactions

• Acquisition

o At the acquisition date, these investments are recorded at the acquisition cost by debiting Debt Investments and
crediting Cash. At the end of each period, these investments are revalued to their fair market value and the change
in value (while unrealised) is recorded in the owners' equity section of the balance sheet as "unrealised gains and
losses of securities available for sale".

• Sale

o When a company sells these investments, the difference between the sale price and the beginning fair market
value of the investment is recorded in the income statement as a realised gain or loss. However, any unrealised
gains or losses associated with these investments, that were already recorded in the equity section of the balance
sheet will be transferred to the income statement as realised gains or losses.

Keep in mind that the above treatment is not uniform across countries. Some countries do not allow the use of mark-to-market
for investments held for trading or for those available for sale. They may either require companies to apply the lower of cost or
market method or they may not permit companies to revalue these investments altogether.

3. Investment in Equity Securities

Investment in equity instruments involves investing in the capital of companies. The accounting treatment for these investments
depends on the influence of the investing company on the operating and financial decision of the investee company. If the
influence is insignificant, accounting for these investments follows the "cost method". If the influence is significant, accounting
for these investments follows the "equity method" and the investee is referred to as an associated company. Finally, if the
influence is considered controlling, the investing company must combine the accounts of the investee with its own accounts and
prepare consolidated financial statements. In this case, the investee is referred to as a subsidiary or an affiliate.

How does one decide whether the influences are insignificant, significant or controlling?

• In certain countries, this decision is generally based on the ownership percentage. That is, if the investor owns less than
20%, the influence is considered insignificant. If the ownership percentage is between 20% and 50%, the influence is
considered significant. If the ownership percentage is above 50%, the influence is considered controlling.

• In other countries (including that of the IASB), the focus is not on the percentage of ownership but on the influence level.
In these countries, the use of the equity method is required where the investor has significant influence, and does not plan
to sell the investment in the near future. Significant influence is presumed to exist when the investor has the power to
participate in financial and operating policy decisions. The preparation of consolidated financial statements is required
whenever the investor has a controlling influence, even if the ownership percentage is below 50%. Where an investor has
insignificant influence, the investment is accounted for using the cost method.
Cost Method
Under the cost method, the investment is recorded at the acquisition cost by debiting Equity or Stock Investments and crediting
Cash. Whenever the investee announces its income for the period, the investor does not recognise its share of the income.
However, whenever the investee declares dividends, the investor recognises its share of dividends declared as dividend revenues
as follows:
 Dividends Receivable XXX
Dividends Revenues XXX
When dividends are paid, Cash is debited and Dividends Receivable is credited. Investments in equity instruments, which are
accounted for under the cost method, may be held for a short-term period for making short-term profits or held with a view to
sell.
• If the investments are held for a short-term period, they are referred to as trading securities, and are classified under
current assets as marketable securities. At the end of each period, these investments are revalued to their fair market
value and the change in value is recorded in the income statement as an unrealised gain or loss. When a company sells
these investments, the difference between the sale price and the beginning fair market value of the investment is recorded
in the income statement as a realised gain or loss.
• These investments may also be held with a view to selling them should market conditions favour the sale, or should the
holding company need cash. In this case, these investments are referred to as "available for sale" securities, and are
classified as current assets or non-current assets, as appropriate. At the end of each period, these investments are revalued
to their fair market value and the change in value is recorded in the owners' equity section of the balance sheet as
"unrealised gains and losses of securities available for sale". When a company sells these investments, the difference
between the sale price and the beginning fair market value of the investment is recorded in the income statement as a
realised gain or loss. However, any unrealised gains or losses associated with these investments that were already
recorded in the equity section of the balance sheet will be transferred to the income statement as realised gains or losses.
• Keep in mind that the above treatment is not uniform across countries. Some countries do not allow the use of mark-to-
market for equity investments held for trading or for those available for sale. They may either require companies to apply
the lower of cost or market method or they may not permit companies to revalue these investments altogether.
Equity Method

Under the equity method, the investment is recorded at the acquisition cost by debiting Equity or Stock Investments and
crediting Cash. Whenever the investee announces its income for the period, the investor recognises its share of the income as
follows:

Stock Investments XXX

Investment Income XXX
Whenever the investee declares dividends, the investor recognises its share of dividends declared as follows:

Dividends Receivable XXX

Stock Investments XXX
When dividends are paid, Cash is debited and Dividends Receivable is credited. Note that investments accounted for using the
equity method are recognised on the balance sheet under non-current assets as "investment in associated companies". According
to the IASB, the carrying amount of an equity-method investment should be reduced to recognise non-temporary impairment.

Consolidated Financial Statements

The preparation of consolidated financial statements is required when the investor has a controlling influence on the investee.
The controlling company (parent company) and the controlled company (subsidiary) will still have their own financial
statements. However, at period-end, the financial statements of both companies will be combined to form a single set of financial
statements. This process involves aggregating on line-by-line basis information about the assets, liabilities, revenues and
expenses of both entities into consolidated income, balance sheet and cash flow statements. This aggregation, however, requires
eliminating all inter-company transactions (eg, intercompany sales and purchases, intercompany investments and intercompany
payables and receivables, etc).
Often, the parent company does not own 100% of the shares of its subsidiary. The remaining shares are referred to as minority
interest. Minority interest shareholders will also have a share of the subsidiary's income for the period. The equity portion of
minority shareholders will be recognised below liabilities but above the owners' equity section in the consolidated balance sheet.
The minority interest shareholders' share of the subsidiary's net income will be recognised in the consolidated income statement
as a deduction of consolidated net income.
Exercise - Investing in Equity
To complete this exercise, read each scenario carefully and select the most appropriate answer in each case.
Question 1:
You are ABC's financial controller. In the last year, ABC has made a substantial investment in equity. It now owns 25 percent of
the manufacturing company, Azteco. Given that ABC operates in a country that classifies level of influence based on percentage
ownership, how would you typically describe its influence on Azteco?
Question 2:
As ABC has a significant influence on Azteco, what accounting method should you use?
Question 3:
ABC uses the equity method of accounting. This month, Azteco announced its income for the current period. ABC's share of the
income is $45,000. How should you deal with this information?
Question 4:
Assuming that ABC's share of Azteco's income for the current period is $45,000, based on international accounting standards,
which accounting method should you use if you plan to sell ABC's investment in Azteco in the short-term?
Question 5:
ABC now uses the cost method of accounting. This month, Azteco announced its income for the current period. ABC's share of
the income is $45,000. How should you deal with this information?

The correct responses with explanation are summarised in the video below.

Investing in Equity
from GlobalNxt University

00:25

4. Accounting for Business Combination

When a company combines with another company, the combination can result in one company gaining control of (or acquiring)
another company, or in the two companies uniting their interests.
Uniting interests takes place when it is not clear which of the two companies is the acquirer. Under IAS 22, acquisitions must be
accounted for using the "purchase method" while uniting of interests must be accounted for using the "pooling of interests
method". This treatment, however, is not uniform across the world. For example, recently the US Financial Accounting
Standards Board (FASB) has disallowed the use of the pooling of interests method. Australia has always disallowed the use of
the pooling of interests method to account for business combination. Some countries still allow the use of both methods while
others allow the use of the pooling of interest methods when certain criteria are met.
Methods of Accounting for Business Combination
Purchase Method
According to IAS 22, assets and liabilities of the acquired company are included in the consolidated financial statements at their
fair market value. The difference between the cost of the purchase and the fair value of the net assets is recognised as "goodwill".
Note that in some countries, goodwill is considered as the difference
between the cost of the purchase and the book value of the net assets acquired. Under IAS 22, goodwill should be amortised
over its useful life and subject to an annual impairment test. In the US, based on new accounting rules, companies will no longer
amortise goodwill. However, it will be subject to an impairment test at the end of each period.
Pooling of Interests Method
IAS 22 defines pooling of interests as a business combination in which the shareholders of the combining enterprises combine
control over the whole of their net assets and operations. The combination aims to achieve a continuing mutual sharing in the
risks and benefits attaching to the combined entity such that neither party can be identified as the acquirer. IAS 22 specifies the
following criteria for the use of this method:
• The substantial majority of voting common shares of the combining enterprises are exchanged or pooled.

• The fair value of one enterprise is not significantly different from that of the other enterprise.
• The shareholders of each enterprise maintain substantially the same voting rights and interests in the combined entity,
relative to each other, after the combination as before.
IAS 22 notes that, under the pooling of interests method, the book values of the assets and liabilities of the combining companies
are carried forward without having to restate them to their fair market value. The retained earnings of the acquired company are
also carried forward. More importantly, under this method, there will not be any goodwill recognised on the books because the
combination does not involve an exchange of cash but an exchange of common shares.
Many companies prefer to structure their acquisitions so that they meet the specified criteria for the use of the pooling of interest
method. The pooling of interest method has a couple of financial advantages. For example, there is no goodwill to amortise
under this method and hence future profits will be higher, relative to that under the purchase method. Also, because the acquired
assets are kept at their book value, companies can generate future profits from the sale of these assets at their fair market value.

5. Summary
The following are the main points covered in this topic:

• The accounting treatment for equity and debt investments depends on the managerial intent of the investment and on the
length of the holding period of these investments.

• The accounting treatment for equity investments also depends on the influence of the investing company on the operating
and financial decision of the investee company o If the influence is insignificant, accounting for these investments
follows the "cost method".

o If the influence is significant, accounting for these investments follows the "equity method".

o If the influence is considered controlling, the investing company must prepare consolidated financial statements.

• Business combinations are generally accounted for using the purchase method. In certain situations, business
combinations may be accounted for using the pooling of interests method.

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