Chapter 13 Investments in Securities. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...

Chapter 13Investments

inSecurities

2

Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Financial Statement Items Covered

Balance SheetIncome

StatementStatement of Cash Flows

Current AssetsInvestment

securitiesDerivatives

Long-Term AssetsInvestment

securitiesStockholders’ Equity

Accum unrealized gains/losses from changes in avail for sale securities

Accum unrealized gains/losses from derivatives

Investment revenueDividend revenueRealized gains/losses

on sale of investment securities

Unrealized gains/losses on changes in market value of trading securities

OperatingCash received

(paid) for sale (purchase) of trading securities

InvestingCash received

(paid) for sale (purchase) of AFS and HTM securities

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Investment Security Issues

Determine Purchase Classify Earn Monitor Sell

the purpose of the

investment

the investment securities

the investment

for accounting purposes

a return on the

securities

changes in the market value of the securities

the securities

Why Companies Investin Other Companies

5


Companies Invest in Other Companies for...

Safety cushionInvestments are sometimes made to give a company a ready source of funds as a margin of safety

Cyclical cash needsSome companies have a seasonal business cycle requiring large amounts of cash for inventory buildup followed by increased sales and cash collections

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A return on investmentCompanies invest simply to earn a rate of return

InfluenceCompanies can invest to

–Ensure a supply of raw materials–Influence a board of directors–Diversify their product offerings

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Control– An investment resulting in over 50%

ownership of a company’s shares of stock produces a controlling interest

– The investing company can control the other company’s operating, investing, and financing decisions

Classification ofInvestment Securities

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Debt Securities

Debt securities involve a promise of interest payments and repayment of the principal amount of the debt

– Debt security investors have priority over equity investors in terms of interest payments and principal in the event of a corporate liquidation

10


Equity Securities

Equity securities represent an actual ownership interest in a corporation

– Equity investors have the right to vote in corporate matters such as election of directors

– Equity investors may receive a rate of return from dividends and appreciation of stock price

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Accounting Classification0f Investment Securities

Trading securities are those debt and equity securities purchased with the intent to take advantage of short-term price changesAvailable-for-sale securities are those debt and equity securities purchased for safety, to hold temporarily excess cash, or to earn a normal long-run return

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Held-to-maturity securities are debt securities purchased with the intent of holding the securities until they matureEquity method securities are equity securities purchased in order to exercise ownership influence (at least 20% of the shares) over another company


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Debt Securities

Equity Securities

Trading Available for Sale Held To Maturity Equity Method

Trading andAvailable-for-Sale

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Accounting for the Purchase

of SecuritiesInvestments in securities are recorded at costCost includes

– The market price– Any additional expenditures

required in making the purchase•E.g., stockbroker’s fee

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Accounting for Interestand Dividends

Cash received from interest earned is recorded as Interest Revenue

– Interest earned but not received is recorded as Interest Revenue and Interest Receivable

Cash received from dividends declared and paid is recorded as Dividend Revenue

– Dividends declared but not paid is recorded as Dividend Revenue and Dividend Receivable

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Realized Gains and Losseson the Sale Of Securities

Realized gains and losses from the sale of securities are included in the income statementA gain or loss is realized when it is confirmed and verified through the actual sale of the security

Recognizing and RecordingChanging Values of Securities

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Changes in the Value ofTrading Securities

• Changes in the market value (unrealized gains and losses) are recognized in the income statement

• The market value is reported on the balance sheet as an asset

20


Changes in the Value ofAvailable-for-Sale

Securities• Changes in the market value are

reported as other comprehensive income (not part of net income)

• The market value is reported on the balance sheet as an asset

• The accumulated unrealized gain/loss is treated as a stockholders’ equity adjustment

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Computation ofOverall Rate of Return

When computing the total return, the numerator includes any dividend revenue, interest revenue, realized gains (losses), and unrealized gains (losses)

Portfolio ReturnOverall Rate of Return =

Portfolio Beginning Balance

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Subsequent Changes in Value

Unrealized gains (losses)– Measured from beginning of year to end

of year– Asset adjusted to end-of-year market

value– Gain (Loss) reported

• Trading portfolio: on income statement• Available-for-Sale portfolio: on Balance

Sheet (Equity Section) in Accumulated Other Comprehensive Income

23


Subsequent Changes in Value

Realized gains (losses)– Measured as the difference between

historical cost and the sale proceeds– Gain (Loss) reported

• Trading portfolio: on income statement• Available-for-Sale portfolio: on income

statement

Held-to-MaturitySecurities

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Held-to-Maturity Securities

•Debt securities•Intent to hold until maturity date•Cash inflows

– While owned, interest– At maturity date, maturity value

•Reported at amortized cost– Unrealized gains and losses are not

measured or recognized

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Purchase of a Bond

Discount Par PremiumPurchase price is < face = face > face

Market rate of interest is

> stated interest rate

= stated interest rate

< stated interest rate

• Investment is recorded at cost– Price paid for bonds– Expenditures incurred as part of the

purchase

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Bond Purchased at a Discount

Purchase at a price less than face– By maturity, bond is carried at its

face value

Purchase to earn a return that is higher

– Than the face/stated rate

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Example: Amortization of Discount

Face amount $20,000 Stated interest 12%

Purchase price $17,381 Rate of return 16%

Cash interest = face amount × stated rateInterest revenue = investment balance × rate of returnDifference amortization of discount

12% Interest Received

16% Interest Revenue

Amort.of Discount

Investment Balance

01/01/2006 17,381 12/31/2006 2,400 2,781 381 17,762 12/31/2007 2,400 2,842 442 18,204 12/31/2008 2,400 2,913 513 18,717 12/31/2009 2,400 2,995 595 19,312 12/31/2010 2,400 3,088 688 20,000

Equity Securities

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Equity Method Securities

The equity method is used when an investor company has significant influence over an investee companySignificant influence is presumed if a company owns between 20% and 50% of the company

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Accounting forEquity Method Securities

The investment asset is originally recorded at its acquisition cost

Account for activity using the accrual method:

– Record revenue as earned, not paid

Accrual method prevents manipulation of income by investor entity.

32


Accounting forEquity Method Securities

The investor’s share of the investee’s reported net income is reported as revenue and increases the carrying value of the Investment account on the balance sheetCash dividends received are recorded as an increase to Cash and a decrease to the Investment account (return of investment)

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Equity Method Summary

Balance Sheet Income Statement

Cash

Investment in

InvesteeInvestee Income

Investee Loss

Purchase Investment (XXX) XXX Investee Reports Net Income

XXX XXX

Investee Reports Net Loss

(XXX) XXX

Investor receives dividend

XXX (XXX)

34


Accounting For Investment Securities: Summary

Classification of Investment

Types of Securities

Balance Sheet Reporting

Reporting of Changes in Market Value

TradingDebt and Equity Market Value

Income Statement

Available for Sale

Debt and Equity Market Value

Equity Adjustment

Held to Maturity Debt onlyAmortized Cost Ignored

Equity Method Equity only Adjusted Cost Ignored

ConsolidatedFinancial Statements

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Consolidated Financial Statements

When an investor owns a controlling interest (over 50% ownership of the voting stock of the investee)

– The investor/parent is able to determine both the financial and operating policies of investee/subsidiary

– Consolidated financial statements are required

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Parent/Sub relationship– Each company maintains separate

records– The Parent accounts for the

Subsidiary by the equity method

The consolidated company (parent) represents one economic unit

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The consolidated balance sheet includes all assets and liabilities of the parent and the subsidiaries it controls

The consolidated income statement includes all revenues and expenses of the parent and the subsidiaries it controls

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Minority interest reflects the interest of other shareholders for subsidiaries that are not 100% owned by the parent

– Balance Sheet: the amount of equity investment made by outside shareholders

– Income Statement: the amount of income belonging to outside shareholders

Derivatives

41


Derivatives

• A contract that derives its value from the movement of the price, exchange rate, or interest rate on some other underlying asset or financial instrument– Does not require a firm to make or

take delivery

• Used as a tool to manage risk

42


Types of Risks

• Price risk: the uncertainty about the future price of an asset

• Credit risk: the uncertainty that another party will abide by the terms of an agreement

• Interest rate risk: the uncertainty about future interest rates and their impact on future cash flows and fair value of assets and liabilities

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Derivative: Forward Contract

An agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future with a specified price or exchange rate being set now.

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Example: Forward Contract

Bank

Merchant Customer¥30,000,000transaction

11/1/06 when ¥120 = $1

Contract to sell yen

to bank on 1/1/07at ¥120 = $1

At settlement• If yen value has fallen, bank pays merchant• If yen value has risen, merchant pays bank

118 Yen = $1 120 Yen = $1 122 Yen = $1

Value of 30,000,000 yen 254,237$ 250,000$ 245,902$ Receipt (payment) to settle (4,237) - 4,098

Net U.S. dollar receipt 250,000$ 250,000$ 250,000$

Exchange Rate on January 1

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A contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate

– Interest rate swap: Two parties agree to exchange future interest payments on a given loan amount; one set of payments is based on a fixed interest rate and the other is based on a variable interest rate

Derivative: Swap

46


Example: Interest Rate Swap

LenderPay variable interest

Third Party

Borrower

Pay

fix

ed

Rec

eive

var

iabl

e

Net effect is to pay fixed interest; swap has protected against rising rates

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• Traded on an exchange• Allows a company to buy a specified

quantity of a commodity, currency, or financial security at a specified price on a specified future date

Derivative: Futures Contract

48


Example: Futures Contract

Futures Market

Buyer

On 12/1/06 enter into contractto make a 1/1/07 purchase of

100,000 bushels at $4

3.80$ 4.00$ 4.20$

Cost to purchase 1,000 bu (3,800)$ (4,000)$ (4,200)$ Payment to settle fwd contract (200) - 200

Net cost of wheat (4,000)$ (4,000)$ (4,000)$

Wheat price January 1

At settlement• If market price is below strike price, buyer pays• If market price is above strike price, payment made to buyer

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A transaction entered into to reduce risk; use derivatives to offset changes in the item being hedgedPrevious Examples:

– Forward contract hedged against decline in value of yen

– Interest rate swap hedged against increase in variable interest rates

– Futures contract hedged against increased wheat prices

Hedges & Hedging Activity

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Reporting Derivatives(FASB’s U.S. GAAP)

• Derivatives should be reported on the balance sheet at their fair value

• Changes in value– Derivatives intended to hedge risk: Gains

and losses should be reported in the same year in which the income effects on the hedged item are reported

– Speculative derivatives: Recognized in the period of the change

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Accounting forForward Contract

Impact of Change in Yen Exchange Rate2006

Balance Sheet2006

Income Statement

Underlying item (receivable)

Increase in value of A/R¥

Exchange gain

Derivative Create forward contract liability

Loss on forward contract

52


Accounting forInterest Rate Swap

Impact of Change in Interest Rates2006

Balance Sheet2006

Income Statement

Underlying item (interest expense)

No change in loan balance

No ’06 impact but will show up in ’07 interest expense

Derivative Create a receivable under the interest rate swap

Defer gain on swap; recognize in ’07 as offset against higher interest expense

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Accounting forFutures Contract

Impact of Change in Wheat Prices2006

Balance Sheet2006

Income Statement

Underlying item (purchase of wheat)

No impact; wheat to be purchased in ’07

No ‘06 impact; higher ’07 cost of goods

Derivative Create futures contract receivable

Defer gain on futures contract; recognize in ’07 as offset against higher cost of goods sold

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Notional Amount

• The amount of dollars that would change hands if the derivative contract was fulfilled to the letter

– This almost never happens

• Notional amounts overstate both the fair value and the potential cash flows of derivatives when reported

In Summary ...

• Companies make investments in securities for a variety of reasons• Equity investments are classified as trading, available-for-sale, or

equity-method; debt security investments are classified as trading, available-for-sale, or held-to-maturity

• Trading and available-for-sale securities are carried at market value; held-to-maturity bond investments are carried at amortized cost; equity-method investments are carried at adjusted-cost

• Consolidated financial statements are prepared if the parent owns more than 50% of a subsidiary; minority interest reports the equity of other investors in subsidiaries that are not wholly-owned

• Derivatives are contracts are often intended to hedge risk

Chapter 13 Investments in Securities. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...

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Transcript of Chapter 13 Investments in Securities. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...