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CM2 purchased some shares of one of its suppliers, Infrared Co., as an investment. CM2 paid $140,186 for the shares. Although management plans to hold this investment for the long-term, the company may need to sell it in the future for liquidity purposes. Conner and Martin also think that making investments in some of their other suppliers can be a good way to ensure quality and consistency in the components they buy from these suppliers. Because many of its suppliers are public companies, it should be fairly easy for CM2 to buy shares on the open market.
Conner and Martin mention that they might go so far as to buy 10–15% of the common stock of one of their main suppliers and up to 30% of the common stock of another supplier of routers, which are critical pieces in the CM2 system. They want you to help them understand whether it makes a difference if they buy just 10–15% or if they buy 30% of these suppliers’ shares. Both these suppliers have been around for some time and, with very few exceptions, the parts ordered from them have been of high quality and delivered on time; Conner and Martin tell you that if they do buy these stocks, they anticipate holding them for a long time.
Action
1. Use the investment in Infrared Co. to illustrate the accounting and financial reporting implications of an equity investment in a supplier. While the growth prospects for Infrared are quite good, in the current year it reported a net loss of $120,000 and paid cash dividends of $24,000. The fair value of the Infrared shares is $150,000 at year-end. Prepare journal entries for the Infrared investment, assuming:
(a) CM2’s investment represents 10% of Infrared shares.
(b) CM2’s investment represents 30% of Infrared shares.
Indicate the differential effect on income between the accounting for the conditions under assumptions 1 and 2.
2. Conner and Martin have heard that as long as they do not hold more than 20% of the shares of one of these suppliers, they are able to recognize the unrealized gains on these equity investments in income. Prepare a memorandum to Conner and Martin with references to the authoritative literature on the accounting for equity investments of less than 20% ownership. Discuss other factors beyond the percentage of shares owned that should be considered in determining the accounting for investments if they hold at least 20% but less than or equal to 50% of the stock of another company.
Expert Answer
1-
Journal entry of Investment in Supplier Infrared Co:
Particulars
Investment in Infrared Co……Dr$140,186
To Cash/Bank$140,186
(being investment made in shares)
Cash…………………………………………….Dr 24000
To Dividend 24000
(being dividend received in cash)
(a) CM2’s investment represents 10% of Infrared shares
In this case CM2 will earn dividend according to investment holding of 10%. And it has not any significant influence over the supplier.Under the income statement CM2 will show dividend income. Like
Income Statement
Other Income
(a) Interest Income (in case of a company other than a finance company);
(b) Dividend Income;
In Balance Sheet, Investment will be shown as long term investment (in shares) valued at cost.
(b) CM2’s investment represents 30% of Infrared shares
A holding of 20% or more of the voting power (directly or through subsidiaries) will indicate significant influence unless it can be clearly demonstrated otherwise. If the holding is less than 20%, the investor will be presumed not to have significant influence unless such influence can be clearly demonstrated. [IAS 28.6]
Accounting for associates
In its consolidated financial statements, an investor should use the equity method of accounting for investments in associates
Applying the equity method of accounting: Under the equity method of accounting, an equity investment is initially recorded at cost and is subsequently adjusted to reflect the investor’s share of the net profit or loss of the associate. [IAS 28.11]
Distributions and other adjustments to carrying amount. Distributions (i.e Dividend) received from the investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be required arising from changes in the investee’s other comprehensive income that have not been included in profit or loss (for example, revaluations). [IAS 28.11]
2-
If Conner and Martin holds 20% or more share of other company (but not more than 50%) which carry a right to vote, (directly or through subsidiaries) will indicate significant influence. While significant influence gives power to participate in the financial and operating policy decisions but not control them. Hence in case where Conner & Marting will hold more than 20% of share of another company then they can manage financial & operating policy which can help them to get best quality product. Although CM2 is receiving material of high quality & delivery in time but significant influence will cope with any anticipated risk of not receiving the material in time or good quality.
