Question

In your own words discuss in detail the various non influential as well as influential investments that company may have on their financial statements. Also compare and contrast how they are treated/recorded on the companies financial statements.

Answer 1

Accounting for equity investments depends on the extent of ownership:

• Controlling interest: where Company A owns more than 50% equity of Company B, it has control over Company B and is required to prepare consolidated financial statements.
• Significant influence: where Company A owns anywhere between 20% and 50% of equity of Company B, it has significant influence over Company B and is required to account for investment in Company B using the equity method.
• No controlling interest and no significant influence: if Company A owns less than 20% of Company B’s equity, neither consolidation nor equity method is required.

Where the ownership is anywhere below 20%, the equity investment can be classified into any of the following categories:

• Available for sale: includes all equity investments other than those in held for trading and fair value through profit and loss categories. Unrealized gains or losses is recognized in other comprehensive income. Realized gains and losses and dividends are recognized in profit and loss.
• Held for trading: accounts for equity investments held for sale in short-term, say 3 months, carried at fair value. Dividend income is recognized in profit and loss.
• Designated at fair value through profit and loss: is a classification allowed by accounting standards for equity investments that otherwise meet criteria for available for sale or held for trading categories; accounting treatment is similar to that for held for trading equity investments.

New accounting standards have introduced a new classification framework for equity investments representing less than 20% ownership in companies. They require such equity investments to be accounted for either as (a) fair value through profit and loss or (b) fair value through other comprehensive income.

Investments are assets which represent a company’s right to receive cash from its stake in another company, government, etc. Investments are made through purchase of bonds or shares or other financial instruments of the investee. The intent behind making such investments is to generate investment income (interest and dividend) and to benefit from expected capital gain.

Investments are reported by the investing company on its balance sheet, classified into current and non-current portion. Investments which are expected to be sold within next 12 months are called short-term investments while investments other than short-term investments are called long-term investments. Some investments, which are can be easily converted to cash with negligible fluctuation in its value, are classified as cash equivalents.

Investments can be made in debt securities, equity securities, commodities, derivative securities, etc. Debt securities are financial instruments that represent right to a determined stream of cash flows for a definite period of time. For example, government bonds, corporate bonds, municipal bonds, notes receivable, etc. all have a pre-determined payout for a specific period. Equity instruments are securities that represent residual (ownership) interest in a company, for example, shares of common stock, etc. Derivative securities are financial instruments which ‘derive’ their value from other financial instruments. They are contracts whose value depend on another variable, for example, price of a common share of a company or its bond price or on price of a commodity, etc.