chapter 4 investments. 1.identify the three categories of debt securities and describe the...

Chapter 4

InvestmentsInvestments

1. Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.

2. Understand the procedures for discount and premium amortization on bond investments.

3. Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

4. Explain the equity method of accounting and compare it to the fair value method for equity securities.

5. Describe the disclosure requirements for investments in debt and equity securities.

6. Discuss the accounting for impairments of debt and equity investments.

7. Describe the accounting for transfer of investment securities between categories.

Use of idle cash

Low risk investments

Quickly and easily converted to cash

Securities of federal, state, and local government agencies

Temporary InvestmentsTemporary InvestmentsTemporary InvestmentsTemporary Investments

Develop beneficial intercompany relationships.

May indirectly improve profitability of investing company.

May represent ownership interest.

Long-Term InvestmentsLong-Term InvestmentsLong-Term InvestmentsLong-Term Investments

Classification

-- Management’s intended holding period for the security

Valuation and investment income measurement

-- Cost vs. fair value

-- Treatment of holding gains & losses

Disclosure

Accounting IssuesAccounting IssuesAccounting IssuesAccounting Issues

Debt or equity security?

Fair value readily determinable?

Management’s intended holding period?

Influence or control over investee?

-- Only for equity securities with voting

rights

Classifying InvestmentsClassifying InvestmentsClassifying InvestmentsClassifying Investments

Represent creditor relationship with an entity.-- US Treasury securities, municipal securities,

corporate bonds, convertible debt, commercial paper, and redeemable preferred stock

Debt SecuritiesDebt SecuritiesDebt SecuritiesDebt Securities

Represent ownership interest in an entity or the right to acquire or to dispose of an ownership right at a fixed price.-- Common stock, preferred stock, warrants, rights,

and options

Equity SecuritiesEquity SecuritiesEquity SecuritiesEquity Securities

ClassificationInvestment in

Debt SecuritiesInvestment in

Equity SecuritiesControl--greater than 50% ownership of voting stock.

Not applicable Consolidation

Significant influence--generally, 20% to 50% ownership of voting stock.

Not applicable Equity method

Debt securities classified as held to maturity, and equity securities for which fair value is not readily determinable.

Amortized cost method

Cost method

Debt and equity securities classified as trading securities.

Fair value method, with unrealized holding gain or loss included in earnings

Debt and equity securities classified as available for sale.

Fair value method, with unrealized holding gain or loss included as a component of stockholders' equity

SecuritiesSecuritiesSecuritiesSecurities









Cost method





Trading securities (TS) are bought and held primarily to be sold in the near term.










Cost method





Securities available for sale (SAS) are expected to be held for an unspecified period of time.










Cost method





Held to maturity (HTM) securities are those where the investor intends and has the ability to hold the security to maturity date.


Amount at which a financial instrument could be exchanged in a current transaction between a willing buyer and willing seller

Equity SecuritiesEquity SecuritiesFair ValueFair Value

Equity SecuritiesEquity SecuritiesFair ValueFair Value

Recorded at cost when acquired.Purchase price and incidental costs

Basket purchase requires allocation of the total cost to each class of security purchased.Based on relative market values

TS and SASTS and SASFair ValueFair Value


• 100 shares of A Company common stock at $50 per share

• 300 shares of B Company common stock at $80 per share

• 200 shares of Company C preferred stock at $120 per share.

• $15,000 Company D 10% bonds

• 100 shares of A Company common stock at $50 per share

• 300 shares of B Company common stock at $80 per share

• 200 shares of Company C preferred stock at $120 per share.

• $15,000 Company D 10% bonds

$ 5,000

24,000

24,00015,000

$ 5,000

24,000

24,00015,000

Kent Company purchases the following securities on May 1, 2006, as an investment in available-for-sale securities:

Total $68,000



Investment in Available-for-Sale Securities 68,000

Interest Revenue 625

Cash 68,625



Accrued interest on the D Company bond from

November 30, 2005, to May 31, 2006

Accrued interest on the D Company bond from

November 30, 2005, to May 31, 2006

May 31, 2006


$15,000 $15,000 x 0.10 x 6/12x 0.10 x 6/12

Cash 750



December 31, 2006

Interest Receivable 125


Cash 3,000

Dividend Revenue 3,000

$15,000 $15,000 x 0.10 x 1/12x 0.10 x 1/12$15,000 $15,000 x 0.10 x 1/12x 0.10 x 1/12

During 2006 Kent Company receives dividends of $3,000 from its investment in the stocks of A, B, and C Companies.

During 2006 Kent Company receives dividends of $3,000 from its investment in the stocks of A, B, and C Companies.



TS and SAS are reported at fair value on the balance sheet.

The difference between the fair value and the carrying value from the previous balance sheet date (or the cost if acquisition occurred in the current period) is an unrealized holding gain or loss.



The unrealized holding gain or loss must be determined for individual securities.

Each security has a valuation allowance account (Allowance for Change in Value of Investment).



The cost and fair value of the available-for-sale securities

held by the Kent Company is as follows:



CumulativeChange

Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000 300 shares of B Co. common stock 24,000 23,500 (500)200 shares of C Co. preferred stock 24,000 26,000 2,000 D Company 10% bonds 15,000 15,500 500 Totals $68,000 $71,000 $3,000

12/31/06







CumulativeChange

Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000 300 shares of B Co. common stock 24,000 23,500 (500)200 shares of C Co. preferred stock 24,000 26,000 2,000 D Company 10% bonds 15,000 15,500 500 Totals $68,000 $71,000 $3,000

12/31/06Valuation Allowance Valuation Allowance 3,0003,000

Unrealized Holding Gain of LossUnrealized Holding Gain of Loss 3,0003,000

Valuation Allowance Valuation Allowance 3,0003,000

Unrealized Holding Gain of LossUnrealized Holding Gain of Loss 3,0003,000



The same securities are held on December 31, 2007.The same securities are held on December 31, 2007.

Cumulative Change Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,100 $1,100 300 shares of B Co. common stock 24,000 22,700 (1,300)200 shares of C Co. preferred stock 24,000 23,200 (800)D Company 10% bonds 15,000 14,000 (1,000) Totals $68,000 $66,000 $(2,000)

12/31/07



12/31/06 3,000 5,000 adjusting entry

2,000 12/31/07

Unrealized Holding Gain of Loss Unrealized Holding Gain of Loss 5,0005,000


Unrealized Holding Gain of Loss Unrealized Holding Gain of Loss 5,0005,000




The individual unrealized holding gains and losses are added together to arrive at the net portfolio unrealized holding gain or loss.

Net unrealized holding gains and losses are calculated separately for the TS portfolio and the SAS portfolio.



Cars Ltd. purchased the following securities in 2004. The fair value of the securities at December 31, 2004 is also indicated.

No. of Unit Total FairType Name Shares Cost Cost ValueTS Gloves, Inc. 1,000 $6 $6,000 6,500$ TS SportsWear 1,500 12 18,000 16,000

SAS General Boots 1,000 5 5,000 9,500 SAS Leather Goods 2,000 10 20,000 18,000



Prepare the necessary journal entries for Cars Ltd. to adjust the securities to fair market value at December 31, 2004.



No. of Unit Total Fair Gain orType Name Shares Cost Cost Value (Loss)TS Gloves, Inc. 1,000 $6 $6,000 6,500$ 500$ TS SportsWear 1,500 12 18,000 16,000 (2,000)

Net Unrealized Holding Loss for TS (1,500)$ SAS General Boots 1,000 5 5,000 9,500 4,500$ SAS Leather Goods 2,000 10 20,000 18,000 (2,000)

Net Unrealized Holding Gain for SAS 2,500$



GENERAL JOURNAL Page 34

Date DescriptionPost. Ref. Debit Credit

Dec 31 Valuation Allowance:Gloves, Inc. 500

Net Unrealized Loss on TS 1,500

Valuation Allowance:SportsWear 2,000

To record fair value of TS

31 Valuation Allowance:General Boots 4,500

Net Unrealized Gain on SAS 2,500

Valuation Allowance:Leather Goods 2,000

To record fair value of SAS



Trading securities:

The net unrealized holding gain or loss is treated as a component of investment income and is included on the income statement for the period.

Net Unrealized Holding Gains and LossesNet Unrealized Holding Gains and LossesNet Unrealized Holding Gains and LossesNet Unrealized Holding Gains and Losses

Securities available for sale:

The net unrealized holding gain or loss is not included in earnings for the period but rather is closed to a separately reported component of stockholders’ equity.

Net Unrealized Holding Gains and LossesNet Unrealized Holding Gains and LossesNet Unrealized Holding Gains and LossesNet Unrealized Holding Gains and Losses

Investment income (interest and dividends)

is included in the earnings of the current period.

TS and SASTS and SAS Investment IncomeInvestment Income

TS and SASTS and SAS Investment IncomeInvestment Income

Cars Ltd. TS and SAS portfolios were as follows on December 31, ×5.

12/31/X512/31/X5 Allow. 12/31/X4

Total Fair Needed Allow. Type Name Cost Value dr. (cr.) dr. (cr.)TS Gloves, Inc. $6,000 6,700$ 700$ 500$ TS SportsWear 18,000 17,500 (500) (2,000)

SAS General Boots 5,000 7,000 2,000 4,500 SAS Leather Goods 20,000 19,000 (1,000) (2,000)

TS and SASTS and SAS ExampleExample


Determine the unrealized holding gains or losses for Cars Ltd.’s TS and SAS portfolios at December 31, X5.



Cars Ltd. TS and SAS portfolios were as follows on December 31, X5.

12/31/X512/31/X5 Allow. 12/31/X4 12/31/X5

Total Fair Needed Allow. Adj. EntryType Name Cost Value dr. (cr.) dr. (cr.) dr. (cr.)TS Gloves, Inc. $6,000 6,700$ 700$ 500$ 200$ TS SportsWear 18,000 17,500 (500) (2,000) 1,500

Net Unrealized Holding Gain on TS 1,700$ SAS General Boots 5,000 7,000 2,000 4,500 (2,500)$ SAS Leather Goods 20,000 19,000 (1,000) (2,000) 1,000

Net Unrealized Holding Loss on SAS (1,500)$



Investment income for debt securities includes interest plus the amortized portion of any premium or discount related to the debt.

The amortized cost of the debt is compared with the fair value to determine the unrealized holding gain or loss.

TS and SASTS and SAS Debt SecuritiesDebt Securities

TS and SASTS and SAS Debt SecuritiesDebt Securities

On 1/1/X5 MacTrucks acquired $100,000 face value bonds of Engines, Inc. The bonds mature in 8 years and pay interest annually on 12/31 at a rate of 8%. MacTrucks acquired the bonds at 96 and intends to sell the bonds in the near term.

Prepare the entry for 1/1/X5.

MacTrucks




Date DescriptionPost.Ref. Debit Credit

Jan 1 Investment in Engines, Inc. 96,000

Cash 96,000

To record bond purchase

$100,000 ×96% = $96,000



On 12/31/X5 MacTrucks received the annual dividend. The bonds had a fair value of 97 on 12/31/X5.

Prepare the entry to record the investment income and the unrealized holding gain or loss.

MacTrucks




Date DescriptionPost.Ref. Debit Credit

Dec 31 Cash 8,000

Investment in Engines, Inc. 500

Investment Income 8,500

To record investment income

$4,000 ÷ 8 = $500



$ 96,000

500

96,500

Investment in Engines, Inc.

Amortized Cost

Fair Value $97,000 - $96,500 = $500 Unrealized Gain





Dec 31 Valuation Allowance:Engines, Inc. 500

Unrealized Holding Gain on TS 500

To record bond fair value



Transfers are accounted for at fair value on the transfer date.

Fair value at the reclassification date is regarded as cost of the security for accounting purposes.

TS and SASTS and SAS TransfersTransfers

TS and SASTS and SAS TransfersTransfers

The Pet Shop has the following investment classified as available for sale. On 12/31/X8, Pet Shop’s intent changes and the security is reclassified as a trading security.

Prepare the reclassification entry.

12/31/X8 12/31/X7Total Fair Allow.

Type Name Cost Value dr. (cr.)SAS Exotic Fish, Inc. $5,500 6,700$ 500$





Dec 31 Investment in Exotic Fish 6,700

OE: Accumulated Gain on SAS 500

Valuation Allowance:Exotic Fish 500

Investment in Exotic Fish 5,500

Unrealized Gain on Reclassification 1,200

To record reclassification

from TS to SAS






OE: Accumulated Gain on SAS 500



Unrealized Gain on Reclassification 1,200


from TS to SAS

Fair Value

Cost

Holding gain not recognized on previous income statements



The Pet Shop has the following investment classified as a trading security. On 12/31/X8, Pet Shop’s intent changes and the security is reclassified as available for sale.

Prepare the reclassification entry.

12/31/X8 12/31/X7Total Fair Allow.

Type Name Cost Value dr. (cr.)TS Exotic Fish, Inc. $5,500 6,700$ 500$








Unrealized Gain on Reclassification 700


from TS to SAS








Unrealized Gain on Reclassification 700


from TS to SAS

Fair Value

Cost

Holding gain not recognized on previous income statements



Sales are accounted for in a manner similar to transfers.

The only difference is that Cash is debited instead of the fair value of the securities.

TS and SASTS and SAS SalesSales


On March 1, 2008, the Kent Company sold 100 shares of

A Company stock for $6,000. The stock had a fair value

on Dec. 31, 2007, of $6,100.

On March 1, 2008, the Kent Company sold 100 shares of

A Company stock for $6,000. The stock had a fair value

on Dec. 31, 2007, of $6,100.

Cash 6,000 Investment in SAS 5,000 Gain on Sale of SAS 1,000

The Unrealized Holding Gain of LossUnrealized Holding Gain of Loss (DR) and the allowance (CR) account are reduced by $1,100.

The Unrealized Holding Gain of LossUnrealized Holding Gain of Loss (DR) and the allowance (CR) account are reduced by $1,100.

Unrealized Holding Gain of Loss Unrealized Holding Gain of Loss 1,100 1,100 Valuation Allowance Valuation Allowance 1,100 1,100



A decline in fair value below cost that is not expected to be recovered.

Trading securities:

Any impairment in fair value is included in the unrealized holding gain or loss that is already included in periodic income.

TS and SASTS and SAS Impaired ValueImpaired Value


Securities available for sale:

The recorded cost of the security is reduced to the impaired fair value, and the difference is included in the current period’s income.

The new cost basis (the impaired fair value) is not changed for subsequent recoveries in fair value.



For SAS, disclose gross unrealized holding gains and gross unrealized holding losses.

For debt securities classified as SAS, disclose contractual maturities.

TS and SASTS and SAS DisclosuresDisclosures


For each period covered by income statement: Net proceeds from sales of SAS and gross realized

gains and gross realized losses Basis on which cost was determined Gross gains and gross losses included in income

from transfers from SAS Amount of net unrealized gain or loss for SAS that

is included in equity Amount of net unrealized holding gain or loss on

TS included in earnings



CostMethod

EquityMethod

AmortizedCost

Fair ValueMethod









Cost method














Cost method





For securities without a fair market value, dividends are included in investment income.










Cost method





For HTM securities:

Amortize any premium or discount to

investment income.

Include interest received in investment income.










Cost method





The equity method is used for investments in equity securities resulting in significant influence, but not controlling interest.


The investment account is increased by:-- Original investment cost.

-- Proportionate share of investee’s earnings.

The investment account is decreased by:-- Dividends received.

Equity MethodEquity MethodEquity MethodEquity Method

Cliborn Company purchases 4,200 shares of the S

company’s outstanding stock (25%) on January 1, 2007,

for $125,000 (significant influence).

Cliborn Company purchases 4,200 shares of the S

company’s outstanding stock (25%) on January 1, 2007,

for $125,000 (significant influence).

Investment in Stock: S Company 125,000

Cash 125,000

S Company pays a $20,000 dividend.S Company pays a $20,000 dividend.

Cash 5,000



S Company reported net income for 2007 of $81,000,

consisting of ordinary income of $73,000 and an

extraordinary gain of $8,000.

S Company reported net income for 2007 of $81,000,

consisting of ordinary income of $73,000 and an

extraordinary gain of $8,000.


Investment Income: Ordinary 18,250

Investment Income: Extraordinary 2,000

25% 25% of $81,000of $81,00025% 25% of $73,000of $73,000

25% 25% of 8,000of 8,00025% 25% of 8,000of 8,000


Balance Sheet Book Value Fair Value

Depreciable assets $400,000 $450,000 (remaining life, 10 yrs)Other nondepreciable assets 190,000 246,000 (e.g., land) Total $590,000$696,000

Liabilities $200,000 $220,000Common Stock 250,000 Retained earnings 140,000Total $590,000

Investment Book Value Difference X

% of Investment

50,000 X 25% = 12,500


When acquired by S Company, the investee’s

depreciable assets had a fair market value that

exceeded book value by $50,000 (10-year life).

Cliborn’s share of the depreciable asset value is

$12,500 (25%). Additional depreciation is needed on

December 31.

When acquired by S Company, the investee’s

depreciable assets had a fair market value that

exceeded book value by $50,000 (10-year life).

Cliborn’s share of the depreciable asset value is

$12,500 (25%). Additional depreciation is needed on

December 31.

Investment Income: Ordinary 1,250


Note that this entry results in a deduction

from ordinary income.

Note that this entry results in a deduction

from ordinary income.$12,500 / $12,500 / 10 10 yearsyears


Record proportionate share of investee’s reported earnings.

Record dividends received from investee. Record proportionate share of additional expense

items if investor paid more than book value. Record any gain or loss on the sale of portions of

the investment.

-- Carrying value - proceeds Eliminate any intercompany profits or losses

arising from transactions between the investor and the investee firms.

Equity MethodEquity MethodSummarySummary

Equity MethodEquity MethodSummarySummary

When ownership level falls below a significant influence, the investor must change to the fair value method.

At the transfer date, the carrying value of the investment under the equity method is regarded as cost.

Changing From Equity to Fair ValueChanging From Equity to Fair ValueChanging From Equity to Fair ValueChanging From Equity to Fair Value

Any difference between cost and fair value is recorded in a valuation account and is recognized as an unrealized holding gain or loss.

After the transfer, the investment is treated as a trading security or a security available for sale, depending on management’s intent.

Changing From Equity to Fair ValueChanging From Equity to Fair ValueChanging From Equity to Fair ValueChanging From Equity to Fair Value

When ownership level increases to a significant influence, the investor must change to the equity method.

At the transfer date, the recorded value is the initial cost of the investment adjusted for the investor’s equity in the undistributed earnings of the investee since the original investment.

Changing From Fair Value to EquityChanging From Fair Value to EquityChanging From Fair Value to EquityChanging From Fair Value to Equity

The original cost, the unrealized holding gain or loss, and the valuation account are closed.

A retroactive change is recorded to recognize the investor’s share of the investee’s earnings since the original investment.

From this point on, the equity method is applied as usual.

Changing From Fair Value to EquityChanging From Fair Value to EquityChanging From Fair Value to EquityChanging From Fair Value to Equity

Investee name and percent ownership Investor accounting policy Amount and accounting for any difference

between carrying value and investee’s net assets Quoted market price of common stock

investments For material investments, summarized

information regarding investee’s assets, liabilities and results of operations

Equity MethodEquity MethodDisclosuresDisclosures

Equity MethodEquity MethodDisclosuresDisclosures

Stock dividends and stock splits-- Not included in investment revenue.

-- Increase in number of shares reduces carrying value per share.

Equity InvestmentsEquity InvestmentsSpecial IssuesSpecial Issues


Stock rights-- Allocate investment cost between stock and

stock rights based on market value of stock and stock rights.

-- Reported at fair market value.



Chapter 4

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chapter 4 investments. 1.identify the three categories of debt securities and describe the...

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