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Financial Instruments
Any contract that Imposes on a 1st entity on potentially unfavorable terms with 2nd entity an obligation to
deliver cash or other financial instrument to the 2nd entity or to exchange financial instrument
Conveys to 2nd entity at potentially favorable termsa contractual right to
receive cash or other financial instrument from 1st entity or to exchange financial instruments
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Equity Investments
0% 20% 50% 100%
What are the important “ownership” percentages when accounting for an investment in another entity?
Significant
influence
No significan
t influence
CONTROL
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Guidelines for Equity Investments
0% 20% 50% 100%
cost orfair value(i.e. FASB115)
equitymethod
consolidate
How does “ownership percentage” affect accounting for an investment in another entity?
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Background - Pre-FASB 115
Inconsistencies – accounting for debt was
either amortized cost or LCM, while
equity as LCM
Income manipulation (cherry picking)
BV irrelevant
Prior to FASB 115, what were the concerns about accounting treatment of investments?
page6
Scope of FASB 115
FASB 115 assumes that market value is readily available, what if its is not?
Record at cost (equity) or amortized cost (debt)
To what Investments does FASB 115 apply?
equity securities with no significant influence debt securities
page7
Classifications Under FASB 115
Trading securities -- debt or equity securities intended to be actively traded Held-to-maturity-- debt securities where the entity has both the intent and ability to hold to maturity Available-for-sale all other debt or equity securities
FASB 115 looks to the intent of management to classify investments, what are the 3 classifications?
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Held-to-Maturity Securities
Interest including discount/premium amortization; no adjustment for FV
How are held-to-maturity investments valued on the balance sheet?
amortized cost using effective interest method to amortize premium/discount
What is considered as income for held-to-maturity investments?
page9
Example - Held to Maturity
Jan. 1, 2004: Acme Co. purchases $100,000 face amount, 7% bonds of Olsen Co. for $96,634, and it intends to hold to maturity, Dec. 31, 2007
Yielding 8% per year when purchased Interest paid June 30 and December 31 Acme uses effective interest rate method to amortize discount FV at December 31, 2004 is $98,000
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Journal Entries
held to maturity 96,634cash 96,634
JE to record purchase at January 1, 2004:
cash (100,000 x 3.5%) 3,500held to maturity (plug) 365
interest income (96,634 x 4%) 3,865
JE to record income at June 30, 2004:
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Journal Entries
Unrealized gain at 12/31/04 not recorded!fair value 98,000cost basis 97,379unrealized gain 621
cash (100,000 x 3.5%) 3,500held to maturity (plug) 380
interest income* 3,880*(96,634 + 365) x 4%
JE to record income at Dec. 31, 2004:
page12
Available for Sale Securities
How are available for sale investments valued on the balance sheet?
Record purchase at cost adjust to fair value at period end Include unrealized gain/loss in equity
not in current year income
page13
Available for Sale Securities
Dividend income Interest received adjusted by premium/discount amortization Upon sale, realized gains and/or losses proceeds - cost basis
What is considered as income for available for sale investments?
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Example - Available for Sale
Jan. 1, 2004: Acme Co. purchases the following:
# Shares Price Total $Red Co. stock 5,000 $12 $60,000Blue Co. stock 1,000 $80 $80,000
March 1, 2004: $5,000 dividends received from Red.
December 31, 2004 FV:Red Co. ($14 x 5,000) $70,000Blue Co. ($75 x 1,000) $75,000
page15
Example - Available for Sale
June 15, 2005: 2,500 shares of Red Co. stock sold for $9/share
December 31, 2005 fair values:Red Co. ($9 x 2,500) $22,500Blue Co. ($78 x 1,000) $78,000
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Journal Entries
available for sale 140,000cash
140,000
JE to record purchase at January 1, 2004:
cash 5,000dividend income
5,000
JE to record income at March 1, 2004:
page17
Journal Entries
December 31, 2004: adjust to FMVfair value 145,000cost basis -140,000unrealized gain 5,000
valuation allowance (AFS) 5,000 unreal. gain/loss - B/S
5,000
What is the adj. JE?
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Calculation for each asset..
Red stockCost $12/share 60,000FMV $14/share 70,000
Valuation allowance $10,000 DR
Blue stockCost $80/share 80,000FMV $75/share 75,000
Valuation allowance $ 5,000 CR
Net valuation 5,000 DR
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Balance sheet presentation
Current assetsInvestments
AFS,at fair value (net) 145,000PPE etc. XXXX
Total Assets XXX,XXX
Total Liabilities XXXXStockholders’ Equity
Unrealized gain on AFS securities 5,000Total stockholders equity XXXXTotal Liabilities and S Equity XXX,XXX
page20
Journal Entries
JE to record sale of shares at June 15, 2005:
sale proceeds (2,500 x $9) 22,500cost basis (2,500 x $12) 30,000realized loss on sale (7,500)
cash 22,500loss on sale 7,500
available for sale30,000
What is the JE for the sale?
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Journal Entries
JE to adjust to FMV at December 31, 2005:fair value 100,500cost basis (2,500@$12; 1,000@$80) 110,000unrealized loss (9,500)
unreal. gain/loss - B/S 14,500valuation allowance (AFS)
14,500
change in valuation allowance: current balance $5,000 debitrequired balance $9,500 credit
What is the adj. JE?
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Calculation for each asset..
Red stockCost $12/share 30,000FMV@ 12/31/04 $14/share 70,000FMV@ 12/31/05 $9/share 22,500
Valuation allowance $ 7,500 CR
Blue stockCost $80/share 80,000FMV@12/31/04 $75/share 75,000FMV@ 12/31/05 $78/share 78,000
Valuation allowance $ 2,000 CR
Net valuation 9,500 CR
compare
compare
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Balance sheet presentation
Current assetsInvestments
AFS sec,at fair value (net) 100,500
PPE etc. XXXXTotal Assets XXX,XXX
Stockholders’ EquityUnrealized gain(loss) on AFS securities (9,500)Total stockholders equity XXXXTotal Liabilities and S Equity XXX,XXX
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Trading Securities
How are Trading Securities investments valued on the balance sheet?
Record purchase at cost adjust to fair value at period end
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Trading Securities
Dividend income (equity) or interest received (debt) NOT adjusted by premium/discount amortization Unrealized gains/losses Upon sale, realized gains and/or losses proceeds - cost basis
What is considered as income for Trading Securities investments?
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Journal Entries
The JE are identical to entries for available for sale securities except
Unrealized gains/losses are taken to the income statement No adjustment to amortize bond discount/premium
page27
Equity method
Situations where the investor has “significant influence,” but not control (>20% and < 50% ownership).
When do we account for investments using the equity method?
Dividends paid by investee is recorded as reduction of asset accountIncome earned by investee is recorded as income by investor
What are the important differences in the way we account for these investments?
page28
Journal Entries
Investment in Red Co. 60,000 cash
60,000
JE to record purchase at January 1, 2004:
cash 5,000Investment in Red Co.
5,000
JE to record income at March 1, 2004:
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Journal Entries
Investment in Red Co. 15,000Revenue from investment 15,000
Assume Acme has a 30% ownership and Red’s reported income is $50,000What is the JE to record Acme’s investment income in 2004?
No entry for FMV adjustment!!
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Current assetsLong term investments
Inv in Red Co 70,000PPE etc. XXXX
Total Assets XXX,XXX
Stockholders’ Equity
Total stockholders equity XXXXTotal Liabilities and S Equity
XXX,XXX
Balance sheet presentationOriginal investment $60,000
Dividends (5,000)
Pro Rata Income 15, 000
page31
Equity Method Stock Sale
Acme sold 1/2 of its investment in Red Company for $25,000.
What is the JE to record Acme’s investment sale?
Cash 25,000Loss on sale 10,000
Investment in Red 35,000
page32
Transfers from one category to another
FV at date of transfer--new cost basis Unrealized gains/losses are recognized
How to you account for transfers from Trading to AFS?
FV at date of transfer--new cost basisUnrealized gains/losses are recognized
How to you account for transfers from AFS to Trading?
Cannot avoid gains/losses by transferring!
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Transfers from one category to another
AFS to HTM FV at date of transfer Unrealized gain/loss is amortized over life of security
How to you account for transfers from Hold to Maturity to AFS?
FV at date of transferUnrealized gain/loss effective at date of transfer
How to you account for transfers from AFS to Hold to Maturity?
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