Luca Merchandising Inc. Suggested Solution

P7-7, P7-16, P7-17, P7-18, P7-19, P7-27, P7-28, P7-31, P7-34, P7-35, Case 3

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Case 3: Luca Merchandising Inc. Suggested Solution:

1. LMI currently accounts for its investment using the equity method. The equity method is a method of accounting whereby the balance sheet value of the investment equals the cost adjusted by the investor’s share of the investee’s post-acquisition changes in net assets, and the income recognized equals the investor’s share of the investee’s net income. Considering LMI has a 22% share in the company, one might assume LMI has significant influence on TNI. However, one should also look into other factors when choosing the appropriate accounting method. Since the company does not have a seat on the board of directors and it does not have any business ties with TNI, it can be argued the influence of LMI on TNI is limited and the investment can be accounted for as held-for-trading or available-for-sale investment. Considering LMI is considering going public in the next year, it would want to show a positive financial position. Hence, it might be more beneficial for the company to classify the investment as held-for-trading, as the company can book the investment of TNI at its current fair value on the balance sheet and it can also recognize unrealized gains related to the changes in the fair value of the TNI investment on its income statement.

1. LMI currently accounts for its investment in ML using FVPL. The FVPL method is a method of accounting that recognizes unrealized gains and losses from investments on income statement. Alternatively, LMI can account for its investment in ML using fair value through OCI. Considering share price of ML has decreased in 2014, unrecognized losses would have to be recorded on the income statement. The company could have provided a better financial picture by classifying the ML investment as available-for-sale investment instead.

1. In real life, many investments are not traded within an efficient market. These investments can create additional financial reporting issues if reported as held-for-trading or available-for-sale securities, because it is difficult to arrive at reliable fair value estimates for these investments. One can argue that they should be accounted for at costs when reasonable fair value estimates cannot be obtained. However, this decision would create a trade-off between relevance and reliability.

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