4.2 Investing activities

Cash flows from investing activities

Investing activities capture how a company spends and receives cash related to its long-term assets and investments. This section of the statement of cash flows reveals whether a company is building for the future (buying assets) or liquidating its resource base (selling assets), making it essential for evaluating long-term strategy.

Cash flows from investing activities form one of the three main categories on the statement of cash flows, alongside operating and financing activities. They cover transactions involving property, plant, and equipment (PP&E), intangible assets, and investments in securities or other companies. A company with large cash outflows in this section is typically expanding, while large inflows may signal downsizing or asset restructuring.

Accounting for investments in securities

Investments in securities are financial assets a company holds to generate income, realize capital gains, or maintain liquidity. Accounting for these investments requires you to classify them by nature and intended use, measure them at fair value or amortized cost, and recognize gains and losses in the financial statements.

Debt vs equity securities

• Debt securities are investments in bonds, notes, or other debt instruments issued by governments or corporations. They give the holder a contractual right to receive interest payments and principal repayments on specified dates.
• Equity securities are investments in shares of stock issued by other companies. They represent an ownership interest and a right to participate in the company's profits and assets (through dividends and appreciation).

The classification matters because it drives the accounting treatment. Debt securities generate interest income, while equity securities generate dividend income. Fair value measurement rules also differ depending on this classification.

Trading vs available-for-sale securities

These two categories reflect why the company holds the investment:

• Trading securities are held primarily for short-term resale to profit from price fluctuations. They're measured at fair value, and unrealized gains and losses go directly to net income.
• Available-for-sale (AFS) securities are investments the company doesn't plan to actively trade or hold to maturity, but may sell if conditions change. They're also measured at fair value, but unrealized gains and losses are reported in other comprehensive income (OCI), not net income.

This distinction has a real impact on reported earnings. A company holding volatile securities as "trading" will see its net income swing with market prices, while the same securities classified as AFS would only affect OCI until sold.

Valuation of securities

Fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. The fair value hierarchy has three levels:

• Level 1: Quoted prices in active markets for identical assets (most reliable)
• Level 2: Observable inputs other than Level 1 prices, such as quoted prices for similar assets or valuation models using market data
• Level 3: Unobservable inputs based on the entity's own assumptions, such as discounted cash flow models (least reliable)

For actively traded securities, you'll almost always use Level 1 inputs. For thinly traded or private securities, you move down the hierarchy to Level 2 or Level 3 techniques.

Gains and losses on securities

• Realized gains and losses occur when securities are actually sold. The gain or loss equals the difference between the sale proceeds and the carrying amount.
• Unrealized gains and losses occur when fair value changes but the securities haven't been sold yet.

Where unrealized gains and losses get reported depends on classification:

Accounting for investments in associates

An associate is a company over which the investor has significant influence but not control or joint control. Significant influence is generally presumed when the investor holds 20% to 50% of the investee's voting rights. It can also be demonstrated through board representation, participation in policy-making, material transactions with the investee, or interchange of management personnel.

Equity method of accounting

The equity method is required for investments in associates. Here's how it works:

1. Initial recognition: Record the investment at cost.
2. Share of profit or loss: Each period, adjust the carrying amount upward for your share of the investee's net income (or downward for net losses). Recognize this share in your own income statement.
3. Dividends received: Reduce the carrying amount of the investment. Dividends are treated as a return of the investment, not income. This is a common exam trap: under the equity method, dividends do not go through the income statement.
4. Other comprehensive income: Adjust the carrying amount for your share of the investee's OCI, and recognize it in your own OCI.

Adjustments for intercompany transactions

When the investor and associate transact with each other (selling goods, providing services, etc.), profits or losses from those transactions must be eliminated to the extent of the investor's ownership interest. This prevents the investor from inflating its reported earnings through transactions with a company it influences.

For example, if an investor owns 30% of an associate and sells inventory to the associate at a $\$100{,}000$ profit, $\$30{,}000$ of that profit (30% × $\$100{,}000$) must be eliminated. The adjustment reduces both the carrying amount of the investment and the investor's share of the associate's net income.

Impairment of investments in associates

Impairment testing is required when indicators suggest the carrying amount may not be recoverable. Common indicators include:

• Significant financial difficulty of the investee
• Adverse changes in the business or regulatory environment
• A sustained decline in the market value of the investment

The test compares the carrying amount to the recoverable amount, which is the higher of:

• Fair value less costs to sell
• Value in use (present value of expected future cash flows)

If the recoverable amount is lower, you recognize an impairment loss in net income and write down the investment.

Accounting for business combinations

A business combination occurs when an acquirer obtains control of one or more businesses, whether through merger, acquisition, or consolidation. The accounting goal is to reflect the economic substance of the transaction by measuring everything acquired and assumed at fair value on the acquisition date.

Acquisition method of accounting

All business combinations use the acquisition method. The key steps are:

1. Identify the acquirer (the entity that obtains control).
2. Determine the acquisition date (the date control is obtained).
3. Measure the consideration transferred (cash, shares, or other assets given to the seller).
4. Recognize and measure identifiable assets acquired and liabilities assumed at their acquisition-date fair values.
5. Recognize goodwill or a bargain purchase gain.

$\text{Goodwill} = \text{Consideration transferred} + \text{Non-controlling interest} - \text{Net identifiable assets at fair value}$

If this calculation yields a negative number, you have a bargain purchase.

Goodwill vs bargain purchase

Goodwill represents future economic benefits from the combination that can't be individually identified (things like assembled workforce, synergies, and brand reputation). Goodwill is not amortized. Instead, it's tested for impairment at least annually.

A bargain purchase occurs when the fair value of net identifiable assets exceeds the consideration transferred plus any non-controlling interest. Before recognizing a bargain purchase gain, the acquirer must reassess whether all assets and liabilities have been properly identified and measured. If the excess remains after reassessment, the gain is recognized immediately in net income.

Contingent consideration in acquisitions

Contingent consideration is an obligation to transfer additional assets or equity to the former owners if specified future conditions are met (for example, "pay an additional $\$5$ million if revenue targets are hit within two years").

• Measured at acquisition-date fair value and included in the consideration transferred.
• Classified as either a liability or equity based on its nature.
• If classified as a liability, subsequent fair value changes go to net income.
• If classified as equity, no remeasurement occurs after the acquisition date.

Acquisition-related costs

Costs incurred to effect the combination (finder's fees, legal fees, due diligence costs, consulting fees) are expensed as incurred. They are not part of the consideration transferred and are not added to the assets acquired.

One exception to watch: costs of issuing debt or equity securities are not acquisition-related costs. Debt issuance costs reduce the carrying amount of the debt, and equity issuance costs reduce the proceeds of the equity issued.

Accounting for property, plant and equipment

Property, plant and equipment (PP&E) are tangible long-term assets used in operations, rental, or administration, expected to be used for more than one period. The accounting cycle for PP&E covers initial measurement, depreciation, impairment, and disposal.

Initial recognition and measurement

PP&E is initially recognized at cost, which includes:

• Purchase price (net of trade discounts and rebates)
• Costs directly attributable to bringing the asset to its intended location and working condition (site preparation, delivery, installation, testing)
• Initial estimate of dismantling/removal and site restoration costs (asset retirement obligations)

Borrowing costs directly attributable to acquiring, constructing, or producing a qualifying asset are also capitalized as part of cost. A qualifying asset is one that takes a substantial period of time to get ready for use or sale.

Depreciation methods and useful lives

Depreciation systematically allocates the depreciable amount of an asset over its useful life.

$\text{Depreciable amount} = \text{Cost} - \text{Residual value}$

The three main methods are:

• Straight-line: Equal expense each period. $\text{Annual depreciation} = \frac{\text{Cost} - \text{Residual value}}{\text{Useful life}}$
• Diminishing (declining) balance: Higher expense in early years, declining over time. Apply a fixed percentage to the carrying amount each period.
• Units of production: Expense based on actual usage or output. Useful when wear and tear depends on activity level rather than time.

The method chosen should reflect the pattern in which the asset's economic benefits are consumed. The method, useful life, and residual value should be reviewed at least at each financial year-end.

Impairment of long-lived assets

PP&E and intangible assets are tested for impairment when triggering events occur, such as a significant drop in market value, adverse business changes, or physical damage.

The test compares the asset's carrying amount to its recoverable amount (the higher of fair value less costs of disposal and value in use). If the recoverable amount is lower, an impairment loss is recognized in net income and the carrying amount is written down.

Derecognition and disposal of assets

PP&E is derecognized when it's disposed of or when no future economic benefits are expected from its use.

$\text{Gain or loss on disposal} = \text{Net disposal proceeds} - \text{Carrying amount}$

This gain or loss is recognized in net income at the time of derecognition. If an entity owns a property and uses part of it while renting out another part, the portions are accounted for separately only if they could be sold separately. Otherwise, the entire property is classified as PP&E only if the rental portion is insignificant.

Accounting for intangible assets

Intangible assets are identifiable non-monetary assets without physical substance, such as patents, trademarks, copyrights, customer lists, and software. Their accounting follows a similar pattern to PP&E: initial measurement, amortization (for finite-life assets), and impairment testing.

Identifiable vs unidentifiable intangible assets

An intangible asset is identifiable if it meets either of two criteria:

• Separability: It can be separated from the entity and sold, transferred, licensed, rented, or exchanged.
• Contractual-legal: It arises from contractual or other legal rights.

Goodwill is the classic example of an unidentifiable intangible asset. It can only be recognized through a business combination, never on its own.

For internally generated intangibles (like R&D), recognition is only allowed when specific criteria are met: technical feasibility, intention and ability to complete the asset, ability to use or sell it, probable future economic benefits, availability of resources, and ability to reliably measure development costs. Research costs are always expensed; only development costs that meet all criteria can be capitalized.

Amortization of intangible assets

Amortization works the same way conceptually as depreciation:

$\text{Amortizable amount} = \text{Cost} - \text{Residual value}$

• Finite useful life: Amortize systematically over the useful life. The method should reflect the pattern of benefit consumption (straight-line is most common if no other pattern is evident).
• Indefinite useful life: Do not amortize. Instead, test for impairment at least annually. "Indefinite" doesn't mean "infinite"; it means there's no foreseeable limit to the period over which the asset will generate cash flows.

Impairment testing for intangible assets

The impairment test itself is the same as for PP&E: compare carrying amount to recoverable amount (higher of fair value less costs of disposal and value in use). Recognize a loss if the recoverable amount is lower.

Accounting for investment property

Investment property is land or a building (or part of one) held to earn rental income or for capital appreciation, rather than for use in operations or sale in the ordinary course of business. The distinction from PP&E matters because investment property can be measured differently after initial recognition.

Initial recognition and measurement

Investment property is initially recognized at cost, including:

• Purchase price
• Directly attributable expenditure (legal fees, property transfer taxes, transaction costs)

If payment is deferred beyond normal credit terms, cost equals the present value of all future payments. If acquired through a non-exchange transaction (such as a donation), cost is measured at fair value on the acquisition date.

Fair value vs cost model

After initial recognition, an entity chooses one accounting policy for all of its investment property:

Under the cost model, fair value must still be disclosed in the notes. The chosen policy applies to all investment property and generally cannot be changed unless the change results in a more appropriate presentation.

Transfers to and from investment property

Transfers happen only when there's an evidence-based change in use. The accounting depends on direction and measurement model:

• Investment property (at fair value) → Owner-occupied or inventory: The fair value at the transfer date becomes the deemed cost for subsequent accounting.
• Owner-occupied → Investment property (at fair value): Account for it as PP&E up to the transfer date. Any difference between carrying amount and fair value at that date is treated as a revaluation surplus (if a gain) or a loss (if carrying amount exceeds fair value).
• Inventory → Investment property (at fair value): Any difference between fair value at the transfer date and the previous carrying amount is recognized in profit or loss.

Disclosures for investing activities

Entities must provide enough information for users to evaluate the nature and extent of investing activities and related cash flows.

Reconciliation of cash flows from investing activities

The statement of cash flows should separately disclose cash receipts and payments for each major class of investing activity (purchases and sales of PP&E, investments in securities, investments in associates and joint ventures). A reconciliation to related line items on the statement of financial position helps users understand why cash flows and balance sheet changes may differ (due to non-cash items, timing differences, or foreign exchange effects).

Significant non-cash investing transactions

Non-cash investing transactions don't appear on the statement of cash flows because no cash changes hands, but they still affect the company's financial position. Examples include:

• Acquiring assets by assuming directly related liabilities
• Acquiring assets through a lease arrangement
• Converting debt to equity

These must be disclosed separately, typically in the notes, with a description of the nature, amount, and financial statement effect.

Restrictions on investments and assets

Entities must disclose the existence and amounts of any restrictions on the realizability of investments or on the remittance of income and disposal proceeds. These restrictions can arise from legal or contractual arrangements (such as assets pledged as collateral) or from the terms of the investments themselves (such as regulatory restrictions on repatriating funds from foreign subsidiaries).