Chapter 12 Investments 2 Objectives of the Chapter 1.Classification and reporting of Investments:...

Chapter 12

Investments

Investments 2

Objectives of the Chapter

1.Classification and reporting of Investments: trading securities, available-for-sale securities and held-to-maturity securities.

2.Investments recorded and reported using the equity method.

3. The fair value option reporting for investments.

Investments 3

Securities for Investments Investment in debt securities: include

U.S. treasury securities, municipal securities, corporate bonds, commercial papers, pf stock with a mandatory redemption feature or redeemable at the option of the holder.

Investment in equity securities: include common stock, preferred stock, stock warrants, stock rights, call and put options.

Investments 4

Securities for Investments(cont.)

For reporting purposes, all investments must be classified into one of the following three categories at the reporting date:

1. Trading securities;

2. Available-for-sale securities; or

3. Held-to-maturity securities.

Investments 5

Classification of Investments

1.Trading securities: investments in debt and equity securities held for the purpose of selling them in the near future.

2. Available-for-sale securities: Including debt and equity securities that are not classified as trading securities and not classified as held-to-maturity securities.

Investments 6

Classification of Investments (cont.)

3.Held-to-maturity securities: investments in debt securities with positive intent and ability to hold these securities to maturity.

Investments 7

Classification of Investments (cont.)

Classifications of investments in securities into these three categories and the subsequent reclassification are based on management’s intent and judgment.

Investments 8

Investments - initial recording and end of period reporting (valuation)

1.Initial Recording of all investments: at cost.

2. End of Period Reporting (Valuation):

a. Trading securities: reported at their fair market values on the B/S. The unrealized gains or losses are included in income of the current period.

Investments 9

Investments - initial recording and valuation (cont.)

b. Available-for-sale securities: reported at their fair values on the B/S. The unrealized gains or losses are reported as a separate component of stockholders’ equity until realized.

c. Held-to-maturity securities: reported at their amortized cost.

Investments 10

Investments - dividends and Interest revenue Dividends, interest revenues of

investments in securities and realized gains or losses from sale of investments are reported in the income statement.

Investments 11

Investments - other valuation methods

Other Valuation Methods: a. Equity method: Applied when

investments in equity securities with significant influence over the investee (usually owing 20% - 50% of the voting stock). No recognition of unrealized gains or losses.

Results in a partial consolidation statements for the investor.

Investments 12

Investments - other valuation methods (cont.)

b. Consolidated financial statements Applied when the investor(the parent) controls the investee (the subsidiary) through an investment in equity securities (i.e., the investor owing over 50% of the voting common stock).

Investments 13

Investments - other valuation methods (cont.)

The investor has to issue the consolidated financial statements. No recognition of unrealized gains or losses.

Investments 14

Summary of Accounting for Investments

Reporting of Unrealized HoldingMethod Gains and Losses

A. Invest. In Equity Securities1. No signoficant influencant a. Trading Fair value Income statementb. Available-for-Sale Fair value Stockholders' equity2. Significant influence (20% to 50% ownership) Equity method Not recognized3. Control(more than 50% ownership) Consolidation Not recognizedB. Invest. In Debt Securitiesa. Trading Fair value Income statementb. Available-for-Sale Fair value Stockholders' equityc. Held-to-Maturity Amortized cost Not recognized

Investments 15

Example A:investments classified as available-for- sale securities (SAS)

The accounting treatment (SFAS 115)

(a) initial recording: at cost;

(b) end of period reported: at fair value;

(c) unrealized holding gains or losses: reported as a separate component of stockholders’ equity on B/S;

(d) interests, dividends, realized gains or losses reported on the I/S

Investments 16

Example A:(cont.):

Assume that Green Company acquires the following securities on 5/1/x5:

Shares # per share

A Company common stock 100 $50

B Company common stock 300 $80

C Company preferred stock 200 $120

D Company 10% bonds with a face value of $15,000 at par plus accrued interest (interests are paid on 5/31 & 11/30)

Investments 17

Example A:(cont.)

1. Initial recording on 5/1/x5:

Investments in SAS 68,000*

Invest. Rev. 625**

Cash68,625

Cost = 100 x 50 + 300 x 80 + 200 x 120 + 15,000 = 68,000

** Accrued interests = 15,000 x 10% x 5/12 = $625

Investments 18

Example A: cont.

5/31/x5 Cash 750

Invest. Revenue 750

(the net interest revenue = $750 -625= $125; the interest revenue for 5/1/95 ~ 5/31/95)

11/30/x5 Cash 750

Invest. Revenue 750Note: If the bonds were purchased at a discount or

premium, the discount or premium needs to be amortized when interest revenue is recongized.

Investments 19

Example A: cont.

12/31/x5 Invest. Receivable 125

Invest. Revenue125

Assuming Green received $3,000 for dividends in 20x5

Cash 3,000

Invest. Revenue3,000

Investments 20

Example A:(contd.) The following info. is available on 12/31/x5: (Note:

for investment in bonds, the cost is the amortized cost.)

12/31/x5 Investment ChangeSecurity Cost Fair Value in F.V

A $5,000 $6,200 $1,200B $24,000 $25,100 $1,100C $24,000 $23,200 ($800)D $15,000 $16,500 $1,500

total $68,000 $71,000 $3,000

Investments 21

Example A:(contd.):SAS

12/31/x5 Adjusting entry (for valuation):

Fair Value Adjustment 3,000

Unrealized holding Gains**

on investments-OCI 3,000

** Reported in B/S as other comprehensive income of x5

Investments 22

Balance Sheet Presentation :SAS

Balance Sheet 12/31/x5

Assets Liabilities

Inv. Sec. (at cost) $68,000

Fair Value Adjust. $3,000Stockholders’ Equity:

Inv. Sec. ( at fair Value) $71,000 Accu. Other Comp. Income

Unrealized holding gains (losses) on investment 3,000

Investments 23

Example A: SAS(contd.) The following info. is available on 12/31/x6:


A $5,000 $6,100 $1,100B $24,000 $22,700 ($1,300)C $24,000 $23,200 ($800)D $15,000 $14,000 ($1,000)

total $68,000 $66,000 ($2,000)

Investments 24

Example A: (cont.):SAS

12/31/x6 Adjusting entry (for valuation):

Unrealized holding Gains

(losses) on investment**-OCI 5,000

Fair Value Adjustment 5,000

• ** Other comprehensive income of x6

Investments 25

Balance Sheet Presentation:SAS


Assets Liabilities

Inv. Sec. (at cost) $68,000

Fair Value Adj. (2,000)

Inv. Sec. (at fair value) $66,000 Stockholders’ Equity:

Accu. Other Comp. Income

Unrealized holding gains (losses) on investment(2,000)

Investments 26

Realized Gains and Losses from Sale of investments

Realized gains and losses are calculated as the difference between the selling price and the cost and is reported in the income statement.

This is due to the unrealized gain/loss of SAS is never recognized in the income statement.

Investments 27

Example B: SAS In 20x7, Green sold 100 shares of A stock

for $6,000. J.E. to record this transaction

Cash 6,000 Investments in SAS (at cost) 5,000

Gain on sale of investments 1,000

Investments 28

Example B (cont.): SAS Also in 20x7, Green sold 300 share of B for

$22,000J.E. to record this transaction

Cash 22,000 Loss on sale of investments 2,000

Investments (at cost) 24,000

Investments 29

Example B:(cont.) (with a fair value adjustment account) :SAS

Before the adjusting entry on 12/31/x7:

Fair Value adjustment Investment (at cost)

1/1/x7 3,000 5,000 68,000 5,000a

24,000b

2,000

39,000

a. from sale of Stock A

b. From sale of Stock B

Investments 30

Example B:(contd.):SAS The following info. is available on 12/31/x7:


C $24,000 $26,000 $2,000D $15,000 $12,000 -3,000

Total $39,000 $38,000 ($1,000)

Investments 31

Example B:SAS

Investments 32

Balance Sheet Presentation:SAS


Assets Liabilities

Investment Securities

at Cost $39,000

Fair Value Adjus. (1,000) Stockholders’ Equity:

Invest. Sec. (at fair) $38,000 Accu. Other Comp. Income

Unrealized holding gains (losses) on investment(1,000)

Investments 33

Impairment of Securities Available-for-Sale If the decline in the fair value of securities

available-for-sale is NOT temporary (i.e., a bankruptcy filing), the value of the securities should be written down to the fair value.

The amount of the write-down should be treated as a realized loss and is included in the income of the year.

Investments 34

Investments Classified as Trading Securities

The accounting treatment (SFAS 115)

(a) initial recording: at cost;

(b) end of period reported: at fair value;

(c) unrealized holding gains or losses: reported in the income statement;

(d) interests, dividends, realized gains or losses reported in the income statement

Investments Classified as Trading Securities (contd.) Trading securities are held primarily by

banks and stock brokers. FASB 115 applies to all specialized industries.

For trading securities, the realized gains and losses are computed as the difference of the selling price and the fair value (NOT the cost) recorded in the most recent balance sheet date.

This is due to the unrealized holding gain/loss for trading sec. is recognized in the previous income statement.

Investments 35

Example C: same infor. as in Example A on p20 but for Trading Securities Valuation on 12/31/x5

12/31/x5 Adjusting entry for valuation (a direct adjustment to the investment account):

Investment Securities* 3,000

Unrealized holding Gains**

on investments-I/S 3,000*the bal. of the investment securities account

equals $71,000, the fair value, after the adjustment.

** Reported in the income statement of x5 and will be closed to income summary at the end of x5.

Investments 36

Example C(contd.): same as in Example A on p23 Except for Trading Securities Valuation on 12/31/x6

12/31/x6 Valuation adjusting entry (a direct adjustment):

Unrealized holding Gains

on investment * - I/S 5,000

Investment Securities** 5,000• *Reported in the income statement of x6.• **The bal. of investment securities equals

$66,000, the fair value, after the adjustment.

Investments 37

Example D: same as in Example B on p27 Except for Sale of Trading Securities

In 20x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction

Cash 6,000 Loss on Sale of Investment 100

Investments in Trading Sec. 6,100*

*The investment account is at the fair value. Unlike the SAS, the unrealized Gains (Losses) of trading securities have been closed to the Income Summary at the end of 20x6.

Investments 38

Example D (contd.): same as in Example B on p28 Except for Sale of Trading Securities Also in 20x7, Green sold 300 share of B for

$22,000J.E. to record this transaction

Cash 22,000Loss on sale of investments 700

Investments (at fair value) 22,700

* The investment account is at the fair value.

Investments 39

Example D (contd.): same as in Example B on p30

The following info. is available on 12/31/x7: 12/31/x6 12/31/x7 Change cost Fair Value Fair Value in F.V C $24,000 $23,200 $26,000 $2,800 ↑ D $15,000 $14,000 $12,000 (2,000)↓ $39,000 $37,200 $38,000 ($800)↓

Investments 40

Example D (contd.)

The information on p40 indicates that the fair value of securities C and D equals $37,200 and $38,000 on 12/31/x6 and 12/31/x7, respectively.

Since the trading securities account balance is at the fair value (under the direct adjustment), the end of period valuation adjustment is to increase the trading securities investment account by $800.

Investments 41

Example D (Contd.)

The Adjusting entry on 12/31/x7

Investment in Trading Securities* 800

Unrealized Holding Gain**-I/S 800

• *The investment bal. equals $38,000, the fair value, after the adjustment.

• **Reported in the income statement

Investments 42

Investments 43

Investments in Held to Maturity Securities (debt securities only)

The account treatment (SFAS No. 115):

(a) Initial Recording: at cost*(not using a discount or a premium account);

(b)End of Period Reporting: at amortized cost;

(c)Unrealized Holding Gains or Losses:not recognized.

(d)Interests and realized gains (Losses) on Sale : all included in income.

* the present value

Investments 44

Investments in Held-to-Maturity (HTM) Securities

APB opinion No.21 recommends separate disclosure of face amount ($100,000) and the discount ($1,000).

However, most investors do not use separate accounts for face value and the unamortized discount (or premium).

The discount ($1,000) will be amortized to increase the interest revenue using the effective interest method.

Investments 45

Example E: amortization of discount or premium of investments in held-to-maturity

Assume that Green acquires an investment in bonds that will be held to maturity with a face value of $100,000 for $102,458.71 on 1/1/x5. The stated interest rate is 13% and interests are paid on 6/30 and 12/31. The bonds mature on 12/31/x7. The effective interest rate is 12%*

* 102,458.71 = 100,000 x 0.70496 + 6,500 x 4.91732

semiannual effective interest rate = 6%

6 period 6 period ?%

Investments 46

Example E:(contd.)

J.E1/1/x5

Investment in Bonds - held-to-maturity 102,458.71

Cash 102,456.71

6/10/x5Cash 6,500

Interest Revenue* 6,147.52 Inv. in Bonds 352.48

Example E: record the premium in a separate account (An alternative)

J.E1/1/x5

Investment in Bonds 100,000 Prem. on Bond Inv. 2,458.71

Cash 102,456.71

6/10/x5Cash 6,500

Interest Revenue* 6,147.52 Prem. on Bond Inv. 352.48

Investments 47

Investments 48

Example E:(contd.)

* Interest Rev. = Present Value x Effective Rate = 102,458.71 x 6% = 6,147.52

Amortization of Premiums(discounts) on investments decreases (increases) interest revenue.

Investments 49

Bond Investment Interest revenue and Premium Amortization Schedule

Effective Interest MethodInterest Investment in Carrying Value of

Cash Revenue Debt Securities Investment in Date Debita Creditb Creditc Debt Securitiesd

1/1/x5 102,458.71$ 6/30/x5 6,500.00$ 6,147.52$ 352.48$ 102,106.23

12/31/x5 6,500.00 6,126.37 373.63 101,732.606/30/x6 6,500.00 6,103.96 396.04 101,336.56

12/31/x6 6,500.00 6,080.19 419.81 100,916.756/30/x7 6,500.00 6,055.01 444.99 100,471.76

12/31/x7 6,500.00 6028.24c 471.76 100,000.00

Investments 50

Bond Investment Interest revenue and Premium Amortization Schedule:(contd.)

Straight-Line Method

Cash Debt Securities revenue Investment in

Date Debita Creditb Creditc Debt Securitiesd

1/1/x5 102,458.71$ 6/30/x5 6,500.00$ 409.79$ 6,090.21$ 102,106.23

12/31/x6 6,500.00 409.79 6,090.21 101,732.60 6/30/x6 6,500.00 409.79 6,090.21 101,336.56

12/31/x6 6,500.00 409.79 6,090.21 100,916.75 6/30/x7 6,500.00 409.79 6,090.21 100,471.76

12/31/x7 6,500.00 409.79 6,090.21 100,000.00

Investments 51

Example F:Investment in HTM at a Discount

Assume that HTM investments on p45 were acquired at a discount for $97,616.71. The effective interest rate is 14%.1/1/x5 Invest. in Bonds- held to maturity 97,616.71 Cash 97,616.71

6/30 Cash 6,500 Invest. in Bonds 333.17

Interest Revenue* 6833.17

* Interest Revenue = Present value x 14% x 6/12 = 97,616.71 x 14% x 6/12

HTM Example F (contd.): Discount Recorded in a Separate Account1/1/x5 Invest. In Bonds 100,000 Cash 97,616.71 Discount on Bond Inv. 2,383.29

6/30 Cash 6,500 Discount on Bond Inv. 333.17

Interest Revenue* 6833.17

Investments 52

Investments 53

Bond Investment Interest Revenue and Discount Amortization Schedule

Effective Interest Method

Cash Revenue Debt Securities Investment in Date Debita Creditb Debit c Debt Securitiesd1/1/x5 97,616.71$

6/30/x5 6,500.00$ $6,833.17 333.17$ 97,949.88 12/31/x5 6,500.00 6,881.45 356.49 98,306.37 6/30/x6 6,500.00 6,908.15 381.45 98,687.82 12/31/x6 6,500.00 6,908.15 408.15 99,095.97 6/30/x7 6,500.00 6,936.72 436.72 99,532.69 12/31/x7 6,500.00 6,967.31 467.31 100,000.00

Investments 54

Amortization for Bonds Acquired

Between Interest DatesExample G

13% bonds with a face value of $200,000 were purchased for $204,568.5 plus the accrued interest of $6,500 on 4/3/x5.

Interests were paid on 6/30 and 12/31 and the bonds mature on 12/31/x7. The effective rate is 12%

Investments 55


Between Interest DatesExample G(cont.)

Bond Investment Interest Revenue and Premium Amortization Schedule (Effective Interest Method)

Investment Carrying valueInterest in Debt of Investment

Cash Revenue HTM in Debt

Date Debita Creditb Creditc HTMd

1/1/x5 204,921.00$ 6/30/x5 13,000.00$ 12,295.00$ 705.00$ 204,216.00 12/31/x5 13,000 12,252.96 747.04 203,468.96 6/30/x6 13,000 12,208.14 791.86 202,677.10 12/31/x6 13,000 12,160.63 839.37 201,837.73 6/30/x7 13,000 12,110.26 889.74 200,947.99

12/31/x7 13,000 12,052.01e 947.99 200,000.00

Investments 56



a. 200,00 x 13% x6/12.

b Previous investment carrying value x 0.12 x 6/12.

c. a - b.

d. Previous investment carrying value - c.

e. Difference $4.87 due to rounding error.

Investments 57



Verifying the purchase price of example G :Present value of the bond on 1/1/x5 => 200,000 x 0.705 + 13,000 x 4.917 = $204,921

Interest Revenue for 1/1/95 - 6/30/x5 $204,921 x 12% x 6/12 = 12,295

Cash Received for interest (1/1/x5 - 6/30/x5)$200,000 x 13% x 6/12 = 13,000

Premium amortized for the period of 1/1/x5 - 6/30/x5 =>13,000 -12,295 = 705 (for 6 months)Premium amortized for the period of 1/1/x5 - 4/1/x5 =>705 x 3/6 = 352.5 (for 3 months of the first period)Therefore, the P.V. of the bond on 4/1/x5 => $204,921 -352.5 = $204,568.5

Investments 58

Amortization for Bonds Acquired Between Interest Dates

Example G(cont.)4/3/x5Investment in bonds- HTM 204,568.5Interest Receivable 6,500

Cash 211,068.5

6/30/x5Cash 13,000

Interest Receivable 6,500Interest Revenue 6,147.5Investment in bondds- HTM 352.6

Investments 59

Amortization for Bonds Acquired Between Interest Dates

Example G(cont.)12/31/x5

Cash 13,000

Interest Revenue* 12,252.96

Inv. In Bonds- HTM** 747.04* P.V. of bond on 7/1/x5 => P.V. of Bond on 1/1/x5 minus premium amortized for the period of 1/1/x5 - 6/30/x5 => $204,921 - 352.5 -352.5 = $204,216

Interest revenue of the 2nd. Period (7/1/x5 -12/31/x5) =>$204,216 x 0.12 x 6/12 = 12,252.96

** Amortization of Premium for 7/1/x5 - 12/31/x5 period.

Investments 60

Sale of Investment in Securities Held to Maturity Before Maturity

This should not occur unless circumstances changed.

If it does occur, update the interest revenue and the amortization of premium or discount from last interest payment date to the sale date.

To determine the gains or losses, compare selling price (excluding accrued interests) with the updated carrying value.

Investments 61

Sale of Investment in SecuritiesHeld to Maturity Before Maturity

Example H:13% bonds with a face value of $100,000 were purchased on 1/1/x5 for $97,616.71 as in example F. The bonds were sold on 3/31/x6 for $102,000 plus accrued interest effective interest rate is 14%.

(1) (2) (3) (4)Interest Sated Dis. P.V.

Date Revenue Interest Amortized of Invest1/1/x5 - - - 97,616.71

6/30/x5 6833.17 6,500.00 333.17 97,949.88 12/31/x5 6856.49 6,500.00 356.49 98,306.37 6/30/x6 6881.45 6,500.00 381.45 98,687.82

Investments 62


Example H:(contd.)(1) = (4) * 0.07

(2) = face amount * 0.065

(3) = (1) - (2)

(4) = P.V. at beginning + (3)

* Interest Revenue for 1/1/96 - 3/31/96

=> 6881.45 * 3/6 = 3440.72

Dis. Amortized for 1/1/96 - 3/31/96

=> 381.45 * 3/6 = 190.73

Investments 63


Example H:(contd.)Investment in Debt Securities Held to Maturity

97,616.71

6/30/x5 333.17

12/31/x5 356.49

3/31/x6 190.17*

*Interest Revenue= (P.V. on 1/1/x6) x 14% x 3/12= (98,306.39) x 14% x 3/12= 3,440.72

97616.71 + 333.17 + 356.49 = 98,306.37

98,496.54

Investments 64


Example H:(contd.)J.E3/31/x6

Interest Receivable 3,250

Investment in Debt Sector190.73

Interest Revenue 3440.72 Cash (102,000 + 3,250) 105,250

Investment in Debt 98,496.54

Interest receivable 3,250

Gain on Sale of Invest. in Debt 3,503.46

Investments 65


Example H:(contd.)Gains= Selling pirce (excluding accrued interest)- Carrying value (updated with amort. of pemium)

=102,000-98,496.54 =3,503.46

Investments 66

The Fair Value Option for Financial Assets (SFAS 159) SFAS159 allows companies to choose

reporting most financial assets at fair value including security investments classified as available-for-sale (SAS) and held-to-maturity (HTM).

This decision of reporting these investments at fair value is irrevocable.

Once the decision is made for a SAS or a HTM security, the company would report that security as a trading security.

Investments 67

The Fair Value Option (contd.)

When electing the fair value option to account for SAS or HTM, the fair value adjustment for these securities should be made indirectly using a valuation account (i.e., the fair value adjustment account).

The fair value adjustment should not be made directly to the trading security account.

The unrealized gain or loss would be reported in the income statement.

Example I: Same infor. as in Example A on p20, Investment in SAS-Fair Value Option Reporting The fair value option reporting was elected for all

investments in SASa. The following entry would be recorded on 12/31/x5:

Fair Value Adjustmentb 3,000 Unrealized Holding Gain/Lossc 3,000 a The fair value option can be applied on an instrument-by-

instrument basis. bThe adjustment to fair value is made indirectly and the SAS

investment is reported as trading securities on the B/S at the fair value. C Reported in the income statement

Investments 68

Example I: Same infor. as in Example A on p23, Investment in SAS-Fair Value Option Reporting

The following entry would be recorded on 12/31/x6:

Unrealized holding Gain/Loss a 5,000 Fair Value Adjustment b 5,000

a Reported in the income statementB An indirect adjustment; the SAS is reported

as trading securities on the B/S at fair value.

Investments 69

Example J: Same infor. as in Example B on p27, Investment in SAS-Fair Value Option Reporting

In 20x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction

Cash 6,000 Loss on sale of invest. 100

Investments (at cost) 5,000 Fair Value Adjustment * 1,100

*For stock A, the cost is $5000 while the fair value on 12/31/x6 is $6,100 (see P23).

Investments 70

Investments 71

Transfers Between Reporting Categories

Investment classification is reassessed at each reporting date.Securities investments can be reclassified* at the reporting date if a different reporting category is more appropriate.*an unusual event, disclosures of reasons are required

Investments 72

Transfers (contd.)

At reclassification:1) The security is updated to its fair value.2) The security is transferred at its fair value.

3) Any unrealized holding gain or loss should be accounted for in a

manner consistent with the new reporting category.

Investments 73

Transfers :(contd.)

The accounting Treatments for Transfers:

From

SAS,HTM

To

Trading

Treatment

The unrealized gain or loss included in current earnings.

Investments 74

Transfers :(contd.)


From

Trading

To

Available

Held to Maturity

Treatment

No accounting for the unrealized gain or loss (it has been recognized in income)

Investments 75

Transfers :(contd.)

From

Held to Maturity

To

SAS

Treatment

The unrealized gain or loss reported in the balance sheet as a separate component of stockholders’ equity

Investments 76

Transfers :(contd.)


From

SAS

To

HTM

Treatment

Fair value of SAS became the amortized cost of HTM. (amortized the unrealized gain or loss to earnings over the remaining life of the securities.)

Investments 77

Transfers :(contd.)

Example 1: Transfer from SAS to Trading:

Using the example of Green Company and instead of selling security A (cost is $5,000) in 20x7, Green decided to transfer security A from SAS security category to trading security category when security A’s fair value is $6,300 on 12/31/20x7. The transfer is recorded as follows:

Investments 78

Transfers :from SAS to Trading

* (Fair value of security A on 12/31/x6 is $6,100)

1. Fair Value Adjustment 200 Unrealized gain or loss 2002. Investment in Trading 6,300 Unrealized gain/ loss 1,300 Investment in SAS (at cost) 5,000 Fair Value Adjustment (for A) 1,300 Gain on Transfer of Securities 1,300

Investments 79

Transfers : from Trading to SAS

Example 2: From Trading to SAS

Assume the same facts as example 1 expect security A is being transferred from Trading to SAS. The transfer is recorded as:

Investment in Trading 200Unrealized Gain / Loss 200

Investment in SAS 6,300 nvestment in Trading 6,300

Investments 80

Transfers:(contd.)

3.From held-to-maturity to Available (or Trading): Bonds with a face amount of $10,000 was purchased at par and was included in the held-to-maturity category. When the fair value is $9,500, the company transfers the bonds into the available-for- sale category.

Investments 81

Transfers:(contd.)

The transfer is recorded as follows:Investment in SAS 9,500*Unrealized Gain or Loss in Value of Investment in SAS 500 Investment in HTM 10,000*

Note: the new carry value is $9,500. The unrealized gain or loss is reported in the stockholder’s equity section of the Balance Sheet.

Investments 82

Transfers :(contd.)

* or any amortized cost if the bonds were purchased at discount or premium. The unrealized account will be adjusted accordingly.** If the transfer is to Trading category, the gain or loss will be included in income.Alternative J.E. for the transfer:Investment in T. S. 9,500Loss 500Investment in HTM 10,000

Investments 83

Financial Statement Classification

a.Trading securities: current assets.

b.Securities-available-for-sale (SAS): Current or noncurrent depends on whether the securities will be sold in one year or one operating cycle, whichever is longer.

c.Securities-held-to-maturity:current or noncurrent assets.

Investments 84

Financial Statement Classification

Trading securities related cash flows are classified as cash flows of operating activities while cash flows from all other types of securities are reported as cash flows of investing activities.

Investments 85

Financial Statement DisclosureDisclosure notes for investments should

include:

a. Amortized cost (cost basis).

b.Gross unrealized gains.

c. Gross unrealized losses.

d. Estimated fair value.

Investments 86

Impairment of Value

If the decline in the fair value of investment is NOT temporary (I.e., a bankruptcy filing), the value of the securities should be written down to the fair value.

The amount of the write-down should be treated as a realized loss and is included in the income of the year.

Investments 87

Impairment of Value (in Debt Investment)

Impairment occurs for debt securities when company cannot collect all the amount due from debt securities investments.

Investments 88

Impairment of Value (in Debt Investment) (cont.)

The amount of write down is included in the Income statement as a realized loss.

The fair value becomes the “New” cost and is not changed for the subsequent recovery in the fair value.

Investments 89

Impairment:(contd.)

Example a: Tracy company had an investment categorized as held to maturity with an amortized cost of $21,500 and a fair value of $6,500. If the decline is Not temporary, the accounting treatment is:

Loss on Impairment 15,000

Investment in Debt Securities Held to Maturity 15,000

Investments 90

Impairment:(contd.)

Example a(contd.): The $6,500 became the “new” cost. Interest revenue is computed using the effective interest needed based on the new effective rate.

Investments 91

Impairment of Value (contd.):

For investment in debt securities classified as SAS experienced a decline in value other than temporary, the accounting treatments are:

1.Eliminate the unrealized gain or loss related to the securities.

2.Write down to the fair value and recognize the write down as a realized Loss.

Therefore, the fair value becomes the new cost basis.

Investments 92

Impairments:(contd.) Example b: (debt investment classified as SAS)

In 20x7, Hinges' investment in D company had a fair value of $5,000. The cost of this investment is $15,000 and the fair value of D company investment is 13,000 on 12/31/x6. This investment was classified as SAS. The J.E. to record the impairment are :

Impairments:(contd.) Example b: (debt investment classified as SAS)

Fair Value Adjustment 2,000 Unrealized Holding Gain/Loss 2,000 Eliminate the unrealized gain/loss

Loss on Impairment 10,000 Investment in SAS 10,000 Write down to the fair value

Investments 93

Investments 94

Impairments:(contd.) Example c:

If the debt investment is classified as trading securities, the following entry will be recorded for the write-down:

Loss on Impairment 8,000

Investment in Trading 8,000 Securities

Investments 95

Impairment of Value ( in equity securities)

SFAS No. 115 does not provide precise guideline to determine the impairment for equity securities.

Whenever the realizable value is lower than the carrying amount of the investment, an impairment should be considered.

Accounting treatment for the write down is similar to that of the debt securities as in examples b and c.

Investments 96

Equity Method

APB Opinion No.18 requires the use of equity method by an investor who is able to exercise significant influence over the operating and financial policies of an investee. In the absence to the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influence.

Investments 97

Equity Method

Exceptions: there are cases that investors hold 20% or more of the outstanding common stock of an investee but do not have significant influence. In these cases, the equity method should not be used. FASB Interpretation No. 35 provides examples of these cases:

Investments 98

Equity Method:(contd.)

1.The investee challenges the investor's ability to exercise significant influence (through litigation or complaints to regulators).

2.Majority of investee’s ownership is concentrated among a small group of shareholders who operate the investee without regards the views of the investor;

Investments 99


3.The investor tries and fails to obtain representation on the investees board of directors;

4.The investor signs an agreement to give up significant shareholder rights.

5.The investor could not acquire financial information needed to apply the equity method (i.e., fair market value of depreciable assets).

Investments 100


On the other hand, the investor may own less than 20% of the voting shares but is able to exercise significant influence over the investee.The equity method should be applied in this case.

Investments 101

Consolidated Financial Statements and the Equity Method When a company acquires 51% or more of

the voting stock of another company, the acquiring firm has the controlling interest and is called the parent while the investee company is called the subsidiary.

Both companies continue to operate as separate legal entities and report separate financial statements .

The parent company also reports consolidated financial statements (F/S).

Investments 102

Consolidated Financial Statements and the Equity Method (contd.) Consolidated F/S combine the parent and

subsidiary F/S into a single aggregate set of F/S.

When a purchase method is used to account for the acquisition, the acquired company's assets are reported on the consolidated F/S at their fair values, not their book values.

Investments 103

Consolidated Financial Statements and the Equity Method (contd.) If the purchase price is greater than the fair

value of the acquired net assets (fair value of assets - fair value of liabilities), the excess amount is recorded as goodwill.

The depreciation of the acquired company's assets is based on the fair value on the consolidated F/S.

This depreciation expense is greater than that of using the book value as the deprecation base.

Investments 104

Consolidated Financial Statements and the Equity Method (contd.) The goodwill is NOT subject to amortization

on the consolidated F/S (SFAS No.142).a

The incremental depreciation expense will reduce the net income reported on the consolidated F/S.

The investment account of the equity method is to approximate the net outcome of the consolidated F/S for the investor.

a. Effective date for SFAS 142 is for fiscal years beginning after 12/15/2001. SFAS 142 is to apply to all goodwill. Goodwill acquired after 6/30/2001 is subject immediately to nonamortization of SFAS 142.

Investments 105

The Accounting Procedures of the Equity Method

The investment is originally recorded at cost but is subsequently adjusted each period for the changes in the net assets of the investee. The investment is increased (decreased) by the investor's proportionate shares of investee’s net income (loss) and decreased by the dividends received.

Investments 106

The Accounting Procedures of the Equity Method

The Investee’s net income is further adjusted by the following:

1. Elimination of intercompany transaction impact;

2. the depreciation of investee’s assets step-upa (if there is any)

a. fair value of investee’s depreciable assets - book value of these assets

Investments 107

The Accounting Procedures of the Equity Method:(contd.)

Treat the proportionate share of investee extraordinary items as investor's extraordinary items.

Similar principle applies to investee’s discontinued operation results and cumulative effect from accounting method change).

Investments 108

Summary of the Equity Method Procedures:

Investment = Acquisition Cost + Investor’s Share of Investee's Net Income (N/I) - Dividends Received

Where:

Investor’s Share of Investee's Income =

(Investee’s N/I x owner. %) - Adjustments

Dividends Received =

Total Div. Paid by Investee x ownership %

Investments 109

Summary of the Equity Method Procedures (contd.):

Adjustments include:

a. elimination of intercompany transaction impact

b. the depreciation of investee’s depreciable assets step-up

Investments 110


Investment Cost Share of Income Share of dividends Share of depre. on assets step-up

Investments 111

Example: Equity Method Investments

On 1/1/x5, Clibron Company purchases 4,200 shares of common stock of the Sam Corporation which has 16,800 shares of common stock outstanding on 1/1/x5.

Thus, Cliborn has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000.

The following information concerning Sam Corporation is also available on 1/1/x5:

Investments 112

Example:(contd.)

B/S Book Value Fair Market ValueDepreciable assets (remaining life, 10 year) $400,000 $ 450,000Other nondepreciatble assets (e.g., land) $190,000 $ 226,000Total $ 590,000 $ 676,000Liabilities $ 200,000 $ 200,000Common Stock $ 250,000Retained Earnings $ 140,000

$ 590,000

Investments 113

Example:(contd.)

Also, no intercompany transactions occur during the year.

Sam Corp. paid $20,000 dividends on 8/28/x5, and reported net income for 20x5 of $81,000 consisting of ordinary income of $75,000 and an extraordinary gain of $6,000.

These events are recorded on Cliborn Company’s book as follows:

Investments 114

Example:(contd.)

1.To record the investment on 1/1/x5: Investment in Stock 125,000 Cash

125,000

2.To record the receipt of dividends on 8/28/x5:

Cash (20,000 x 25%) 5,000Investment in Stock 5,000

Investments 115

Example:(contd.)

3.To record Cliborn Company’s 25% share in the year’s net income:12/31/x5

Investment in Stock 20,250a

Investment Income: ordinary 18,750b

Investment Income: extra 1,500c

a. $81,000 x 25% b. $75,000 x 25% c. 6,000 x 25%

Investments 116

Example:(contd.)

4. Adjustments: To reduce the investment by the

proportionate depreciation of invstee’s depreciable assets step-up:Investment Income: ordinary 1,250a

Investment in Stock 1,250

a.[(450,000 - 4000,000) x 25%] / 10

Investments 117

Example:(contd.)

Goodwill:Purchase price - fair value of net assets acquired

Fair value of net assets (assets –liabilities) =$676,000 - $200,000= $476,000

Investor's share of the fair value of net assets= $476,000*25% = $119,000

Goodwill = $125,000 - 119,000 = $6,000

Investments 118


Investment (12/31/x5) Cost 125,000 Share of Income 20,250 5,000 Dividends 1,250 Incremental Depr.

Balance 139,000

Investments 119

Financial Statement Disclosures

The Investment in stock account is disclosed in the long-term investment section of the 12/31/x5 Balance Sheet of Cliborn Company as follows:

Investment in Sam Corp. Acquisition Price (1/1/x5) $125,000Add: Shares of 20x5 reported

ordinary Income $18,750 Shares of 20x5 reported extraordinary Income 1,500 20,250 145,000 Less: Dividends Paid (8/28/x5) $5,000Depreciation on Excess Market Value of Acquired Assets 1,250 ($6,250)

Carrying Value $139,000

Investments 120

Financial Statement Disclosures :(contd.)The total amount of Investee income disclosed on Cliborn income statement for 20x5 is $18,700, which consists of $17,200 income from continuing operations and $1,500 of an extraordinary income.The supporting schedule is as follows:Shares of 20x5 Ordinary Income $18,750Less: Depreciation on Excess M.V. of

Acquired Assets ($1,250)

Ordinary Investment Income $17,500Plus: Share of extraordinary Income $1,500Net Investment Income $19,000

Fair Value Option for Investments Accounted for Under the Equity Method

When the fair value option is elected to report investments accounted for under the equity method, the investments are reported at the fair value.

The investments are not reclassified as trading securities as in the case of fair value option reporting for SAS or HTM.

Investments 121

Fair Value Option for Equity Method Investments (Contd.) The investments are reported on a

separate line in the balance sheet or with other equity method investments with the fair value in a parenthesis.

The unrealized holding gain/loss is reported in the income statement.

Investments 122

Example: Fair Value Option for Equity Method Investments Using the example on p111-120, Clibron

Corporation has been applying the equity method to account for its investment in Sam Corporation, the investment account balance under the equity method is $139,000 on 12/31/20x5(see the t-account on p118).

Assuming the fair value of Sam Corporation on 20x5 is $700,000, the fair value of Clibrone’s 25% share of Sam Corp. would be $175,000.

Investments 123

Example: Fair Value Option for Equity Method Investments (Contd.) If Clibron had been using the equity method

to account for its investments in Sam Corp. but elected the fair value option reporting for this investment on 12/31/x5, the following adjustment would be made by Clibron Corp. on 12/31/x5:

Fair Value Adjustment* 36,000 Unrealized Holding Gain** 36,000 *to adjust the investment account to fair value of

$175,000 ** reported in the income statementInvestments 124

Example: Fair Value Option for Equity Method Investments (Contd.) The contribution to the earnings from

investment in Sam Corp equals: $19,000 (net investment income

recognized under the equity method, see p 120) +$36,000 (fair value adjust.) = $55,000

Investments 125

Example: Fair Value Option for Equity Method Investments (Contd): An Alternative If Clibron has been using the fair value

reporting for its investment in Sam and made its fair value adjusting on 12/31/x5, the following entries would have been recorded in 20x5 for this invement:

1/1 Investment 125,000 Cash 125,000 8/28 Cash 5,000 Investment Revenue 5,000

Investments 126

Example: Fair Value Option for Equity Method Investments (Contd): An Alternative

12/31/x5 Fair Value Adjustment * 50,000 Unrealized Holding Gain** 50,000 * to adjust the investment to the fair value of

$175,000 ** reported in the income statement The contribution to the earnings from

investment in Sam equals: $55,000 (i.e., $5,000+50,000).

Investments 127

Investments 128

Change from Equity method:

When the ownership falls below 20%, the investor may lose significant influence over the investee and the use of the equity method is no longerappropriate.

The investment should be accounted for under the fair value method.

Investments 129

Change from Equity method (contd.):

No adjustment is made to the carrying amount of the investment account.

The carrying amount of the investment on the date of change becomes the new cost basis.

The equity method is simply discontinued and the appropriate new method is applied from then on.

Investments 130

Change to Equity method:

Change to Equity method: The investment account is retroactively adjusted to the balance as if the equity method always had been used. An example of changing from accounting the investment as SAS to the equity method:Procedures:

Investments 131

Change to Equity method:

1. Eliminate the unrealized gain or loss (i.e., adjust the investment account to the cost) 2. Adjust the investment account retroactively: Investment in Stock $$

Retained Earnings $$$$ = its previous percentage of( investee's

adjusted income - Dividends) prior to the change.

Investments 132

Change to Equity method (contd.):

Prior financial statements should be restated using the equity method for comparative purposes.The income effect for years prior to those shown in the comparative statements is reported as an adjustment to the beginning retained earnings of the earliest year reported on the R/E statement.

Investments 133

Sale of Equity Method Investment

A gain or loss is recognized as the difference between the selling price and the carrying amount of the investment account.

Investments 134

Conclusion

Different methods in accounting for investments will not affect the cash flows, but only the income number.

Equity method is to prevent income manipulation by investees who have significant influence on dividend policy.

Investments 135

Additional IssuesA. Reporting for non marketable securities: non marketable securities are stock or bonds issued by a privately-held company whose securities are not traded in a “qualifying” market. Reporting for these securities does not follow the guidance of SFAS 115. These securities are typically reported at their historical cost and the unrealized gains and losses are ignored.

Investments 136

Additional Issues (contd.)

B.Stock Dividends and Splits

No journal entry is needed to account for either the stock dividends or the splits. However, a memo is required to indicate that the cost of shares is reduced.

Investments 137

Additional Issues:(contd.) Example of stock dividends:

2,000 shares of Kell Co. common stock were originally purchased for $30 per share by the Smith Co. Two months later, Kell issued a 50% stock dividend. Therefore, Smith received another 1,000 shares. The following memo is to reflect the stock dividend received by Smith:

Investments 138

Additional Issues:(contd.) Example of stock dividends:

memo: Received 1,000 shares of Kell Company common stock as a stock dividend. The cost of the shares is now $20 per share, computed as follows: $60,000 / (2,000 + 1,000) = $20.Subsequently, 500 shares of investment were sold for $25 per share. The fair value at the most recent B/S data was $23 per share. The journal entry to record this transaction is:

Investments 139

Additional Issues:(contd.) Example:(contd.)

Cash 12,500Unrealized Gain and Loss in Value of SAS 1,500

Investment in SAS 11,500Gain on Sale of Investments ** 2,500

* Cost per share has been reduced from $30 to $20 per share due to stock dividends.** ($25 - 20) * 500 = 2,500

Investments 140

Additional Issues:(contd.)

C.Stock Warrants Stock warrants are certificates that enable

their holders to purchase a specific number of shares at a predetermined price.

No additional cost is incurred when the warrants are received by the corporation holding the investment in common stock.

It is necessary to assign a portion of the cost of the stock (investment) to the warrants upon their receipt of warrants.

Investments 141


C.Stock Warrants (contd.) The amount is determined by use of a weighted average based on the market value of the stock ex right and the market value of the warrants.

The accounting for any subsequent purchases of shares (or any sale of warrants) would use the amount assigned to the warrants.

Investments 142


D.Convertible Bonds Investments in convertible bonds would be included in the available for sale (or trading) category and valued at fair value. When these convertible bonds are converted into stocks,memo is required to specify the number of shares that are now owned instead of bonds.

Investments 143


E.Cash Surrender Value of Life Insurance

Portion of insurance premiums paid for executives may be returned to the company upon the cancellation of the policy.

This guaranteed cash returned upon the cancellation of an insurance is called “ Cash Surrender Value” of an insurance plan.

Investments 144


E. (contd.)This portion of the insurance premiums (equal to the cash surrender value) should be reported as a long- term investment on the balance sheet, rather than an insurance expense.

Example: At the beginning of the year, the Mele Co. pays an annual insurance premium of $5,500 to cover the lives of its officers. The following entry is recorded:

Investments 145

Additional Issues:(contd.) Example:

Prepaid Insurance 5,500Cash 5,500

According to the terms of the insurance contract the cash surrender value of the policy increases from $7,200 to 8,300 during that year. The adjusting entry at the end of year to record the insurance expense and the increase in cash surrender value is as follows:

Investments 146

Additional Issues:(contd.) Example:(contd.)

Insurance Expense 4,400 Cash Surr. Value of Life Ins. 1,100 Prepaid Insurance 5,500

Upon the death of any of insurance officer, Mele would debit cash for the proceeds received from the insurance company, credit cash surrender value and any difference will be reported as an ordinary gain.

For tax purchases, the premiums are Not tax deductible and the gain is not taxable.

Investments 147


F.Investments in Funds

Assets (i.e., securities, cash,..) could be placed in special funds for specific purposes (i.e. for the retirement of long-term liabilities (bond sinking fund), etc).

Assets placed in the funds are not available for normal operations because of the contractual arrangement. Therefore, long-term funds are reported as investments on the balance sheet.

Investments 148


F.Investments in Funds (contd.)

The accounts used in connection with a bond sinking fund are:

Sinking Fund Cash, Sinking Fund Securities, Sinking Fund Revenues, Sinking Fund Expenses, Allowance for Change in Value of Sinking Fund Securities, Unrealized Gain/Loss in Value of Sinking Fund Securities, and loss on Sale of Sinking Fund Securities and Loss on Sale of Sinking Fund Securities.

Investments 149

Impairment of Receivable due to Troubled Debt Restructuring The receivable is settled outright (example is from p589 of Spiceland, etc.

textbook) First Prudent is owed $30 million by

Brillard Properties under a 10% note with two years remaining.

The previous year’s interest was not received due to financial difficulties of Brillard.

First Prudent agrees to settle the receivable and the accrued interest in exchange for property with a fair value of $20 million on 1/1/x3.

Impairment of Receivable due to Troubled Debt Restructuring (contd.) J.E. ($ in millions)

Land 20 Loss on T/D restructuring 13 Interest receivable 3

Note receivable 30

Investments 150

Impairment of Receivable due to Troubled Debt Restructuring (contd.)

The receivable is continued but with modified terms: (p589 of Spiceland, etc.)

Same information as on p148, except First Prudent agrees to forgive the interest accrued, reduce the remaining two interest payments to $2 million each and reduce the principal to $25 million.

Investments 151

Investments 152

Impairment of Receivable due to Troubled Debt Restructuring (contd.) Carrying value of the loan: $33 million Present value of future

cash flows of receivable (24,132,330)

Loss from the settlement $8,867,670

PV=$2 millionx1.73554+$25 millionx0.82645

Investments 153

Impairment of Receivable due to Troubled Debt Restructuring (contd.) J.E.(1/1/x3) Loss on T/B restructuring 8,867,670 Interest receivable 3,000,000 Note receivable 5,867,670*

* $30 million-24,132,330 (PV of future cash flows from the settlement)

1/1/x4 Cash 2,000,000 Note Receivable 413,233 Interest Revenue* 2,413,233 *10% interest on the balance of N/R on

1/1/x3


The balance of Note Receivable on 1/1/x4 = 24,132,330 +413,233 = 24,545,563 = present value of Note receivable on 1/1/x4 =

$2 million x0.9091+25,000,000x0.9091

Investments 154


1/1/x5 (receipt of $2 million interest and $25 million of principal)

Cash 2,000,000 Note Receivable 454,570 Interest Revenue 2,454,570* *10% interest on the bal. of N/R on 1/1/x4 Cash 25,000,000 Note Receivable 25,000,000

Investments 155

Chapter 12 Investments 2 Objectives of the Chapter 1.Classification and reporting of Investments:...

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Transcript of Chapter 12 Investments 2 Objectives of the Chapter 1.Classification and reporting of Investments:...