copyright © 2007 thomson south-western, a part of the thomson

COPYRIGHT © 2007Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are

trademarks used herein under license.

Investments in Debt & Equity Securities

Chapter 14

S t I c e | S t I c e | S k o u s e n

Intermediate Accounting

16E

Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives

1. Determine why companies invest in other companies.

2. Understand the varying classifications associated with investment securities.

3. Account for the purchase of debt and equity securities.

4. Account for the recognition of revenue from investment securities.

Learning Objectives

5. Account for the change in value of investment securities.

6. Account for the sale of investment securities.

7. Record the transfer of investment securities between categories.

8. Properly report purchases, sales, and changes in value of investment securities in the statement of cash flows.

Learning Objectives

9. Explain the proper classification and disclosure of investments in securities.

10.Compare the accounting for investment securities under U.S. GAAP with the international standard in IAS 39.

11.Account for the impairment of a loan receivable.

Time Line of Issues: Involved with Investment Securities

DETERMINE purpose of investment

?

CLASSIFY investments

a, b, c

Good Buy Corporatio

n$10 par value

PURCHASE securities

Good Buy Corporatio

n$10 par value

EARN and RECOGNIZE a

return

Good Buy Corporatio

n$10 par value

+ +

--

MONITOR changes in

value

Good Buy Corporatio

n$10 par value

SELL securities

TRANSFER securities between

categories

a bc

DISCLOSE status of portfolio

at the end of the period

Time Line of Issues: Involved with Investment

Securities

Why Companies Invest in Other Companies

Safety Cushion

Cyclical Cash Needs

Investment for a Return

Purchase for Control

Investment for Influence

Stop & Think

As of December 31, 2004, Ford Motor owned 33.4% of

Mazda. Which ONE of the following

possible motivations do you think is the primary motivation for this

investment by Ford?

Classifications of Investment Securities

Available-for-sale

TradingHeld-to-maturit

y

DebtDebt

Equity Method

EquityEquity

Cost Method


• Debt securities typically have the following characteristics:

1. A maturity value, representing the amount to be repaid to the debt holder at maturity.

2. An interest rate that specifies the periodic interest payments.

3. A maturity date, indicating when the debt obligation will be redeemed.


• Equity securities represent ownership in a company:

1. These shares of stock typically carry with them the right to collect dividends and vote on corporate matters.

2. Equity securities have the potential for significant increases in price.

Equity Method Securities

• Represents ownership in a company. • Includes rights to collect dividends

and to vote on corporate matters.• Potentially purchased with the intent

to control or significantly influence the operations of the investee.

• Despite the general criteria, a 20% investment does not necessarily guarantee significant influence.

Different Accounting Treatments

• Exhibit 14-8

Purchases of Debt Securities

On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9% payable semiannually on January 1 and July 1. The debt securities are classified

by the purchaser as trading securities.

Accrued interest on May 1 is $3,000, calculated as follows:

$100,000 x .09 x 4/12 = $3,000


Asset ApproachAsset Approach

Investment in Trading Securities 104,250Interest Receivable 3,000

Cash 107,250

Purchase date May 1 :

Revenue ApproachRevenue Approach

Investment in Trading Securities 104,250Interest Revenue 3,000

Cash 107,250


Asset ApproachAsset Approach

Cash 4,500Interest Receivable

3,000Interest Revenue 1,500

Receipt of semiannual payment July 1 :

Revenue ApproachRevenue Approach

Cash 4,500Interest Revenue 4,500

Purchase of Equity Securities

Citty Co. purchased 1,000 shares of Deli Company

common shares at $2 per share.

Available-for-Sale ApproachAvailable-for-Sale Approach

Investment in Available-for- Sale Securities- Deli Co. 2,000

Cash 2,000

Purchase of Equity Securities

Citty Co. purchased 100,000 Citty Co. purchased 100,000 shares of Deli Co. common shares of Deli Co. common

shares at $2 per share.shares at $2 per share.

Assume that the 100,000 shares purchased represents 20 percent of the outstanding voting

stock of Deli Company. This investment gives the investor significant influence over Deli Company.

PV of Debt Securities

On January 1, 2004, Silmaril Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable

semiannually on January 1 and July 1. The market rate on bonds of similar quality and

maturity is 8%.Present value of principal:

FV = $100,000; N = 10; I = 4%

$ 67,556Present value of interest payments:

PMT = $5,000; N = 10; I = 4%

40,554Total present value of the bonds

$108,110Investment in Trading Securities 108,100Cash

108,100

Interest Revenue for Debt Securities (Trading)

When the first interest payment is received from

Silmaril, the following entry would be made:

July 1 Cash 5,000

Interest Revenue 5,000

Interest Revenue for Debt Securities (Held-to-Maturity)

When the first interest payment is received from

Silmaril, the following entry would be made:

July 1 Cash 5,000

Interest Revenue 4,324 Maturity Securities 676

$108,110 x .04

Interest Revenue for Debt Securities (Held-to-Maturity)

When the second interest payment is received, the

interest revenue is determined by the yield times

the bond carrying value.July 1

Cash 5,000Interest Revenue 4,297

Maturity Securities 703

$107,434 x .04

Determining the Appropriate Accounting Method

0% 20% 50% 100%

No significantinfluence

Significantinfluence Control

Ownership Percentage

Account for as trading or

available-for-saleEquity method

Equity method and consolidation

procedures

Stop & Think

Theoretically, we should amortize the discount or premium associated with trading and available-for-sale debt securities just as we do with held to maturity securities. Why don’t we?

Determining the Appropriate Determining the Appropriate Accounting MethodAccounting Method

• Equity securities are classified as trading or available for sale when ownership is less than 20 percent.

• The equity method is used when the investor has the ability to significantly influence or control the investee’s operations.

Determining Accounting Method

• Effect 14-9

Revenue for Equity Securities Classified as Trading and AFS

Deli Co. announces Deli Co. announces dividends of $0.25 dividends of $0.25 per share. Assume per share. Assume that Citty Co. owns that Citty Co. owns

1,000 shares1,000 shares

Cash 250

Dividend Revenue 250


Deli Company Deli Company announces dividends of announces dividends of

$0.25 per share. Assume $0.25 per share. Assume that Citty Co. owns that Citty Co. owns

100,000 which 100,000 which represents 50 percent of represents 50 percent of the outstanding voting the outstanding voting

stock.stock.

Cash 25,000

Investment in Deli Co Stock 25,000


Deli Company reports Deli Company reports income for the year, income for the year,

$250,000. Assume Citty $250,000. Assume Citty owns 50% of owns 50% of

outstanding voting outstanding voting stock.stock.

Investment in Deli Co Stock 125,000Income from Investment in Deli Co Stock 125,000

Equity Method: Purchase for More than Book Value

Deli Company reports Deli Company reports income for the year, income for the year,

$250,000. Assume Citty $250,000. Assume Citty owns 50% of owns 50% of

outstanding voting outstanding voting stock.stock.

Investment in Deli Co Stock 125,000Income from Investment in Deli Co Stock 125,000


The net assets of Stewart Inc. was $500,000 at the time Phillips Manufacturing Co. purchased 40% of the common shares for $250,000 on January 1, 2005. The market value of the net

assets of Stewart Inc. would be $625,000, which is $125,000 more than the book value. Only $50,000 of this is attributed to depreciable

assets.$250,000 $250,000 ÷ .40÷ .40$250,000 $250,000 ÷ .40÷ .40

The average remaining life of the depreciable assets is 10 years and the

special operating license is to be amortized over 20 years.

The average remaining life of the depreciable assets is 10 years and the

special operating license is to be amortized over 20 years.

Additional depreciation ($50,000 x 0.40)/10 $2,000License amortization ($75,000 x 0.40)/20 1,500

$3,500


Investment in Stewart Inc. Common Stock

Acquisition cost 250,000Share of earnings60,000

Dividends 28,000Additional depreciation 2,000Additional amortization 1,500

310,000 31,500Balance 278,500

Stewart Inc. declared and paid dividends of $70,000 to common stockholders during 2005, and it reported net income of $150,000 for the

year ended December 31, 2005.

Accounting for the Change in Value of Securities

Classification

of Security

Disclosedat

Report FMV

TradingFair marketvalue

Incomestatement

Held-to-

maturity

Amortized

cost

Not

recognized

Available-for-sale

Fair marketvalue

Stockholder’sequity

Change On


Eastwood Inc. purchased the following securities on March 23, 2007.

Trading securities:Purchase price (Security #1) $ 8,000Value end of year (#1) $ 7,000

Purchase price (#2) $ 3,000Value end of year (#2) $ 3,500

Available-for-sale securities:Purchase price (#3) $ 5,000Value end of year (#3) $ 6,100


Eastwood Inc. purchased the following securities on March 23, 2007 (cont.)

Available-for-sale securities:Purchase price (#4)$12,000Value end of year (#4)$11,500

Held-to-maturity securities:Purchase price (#5)$20,000Value end of year (#5)$19,000


Initial Purchase EntryInitial Purchase Entry

Investment in Trading Securities 11,000Investment in Available-for-Sale Securities 17,000Investment in Held-to-Maturity Securities 20,000

Cash 48,000

By the end of the year, the value of the trading trading securitiessecurities decreased from $11,000 to $10,500.

December 31, 2005:Unrealized Loss on Trading Securities 500

Market Adjustment—Trading Securities 500


December 31, 2005:Market Adjustment—Available-for-Sale

Securities 600 Unrealized Increase/Decrease in Value of Available-for-Sale Securities

600

By the end of the year, the value of By the end of the year, the value of the available-for-sale securities the available-for-sale securities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.

By the end of the year, the value of By the end of the year, the value of the available-for-sale securities the available-for-sale securities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.


FASB No. 115 puts an end to “cherry-picking.” This is the practice of

selectively selling securities whose prices have increased, while

keeping those that have experienced losses or have maintained their

historical cost.


Partial Balance Sheet for Eastwood Inc.Assets

Invest. in trading securities $11,000 Market adjustment—trading sec. (500)

$10,500Invest. in available-for-sale sec. $17,000 Market adjustment 600 17,600Invest. in held-to-maturity sec. 20,000

$48,100Stockholders’ Equity

Add unrealized increase in available-for-sale securities $ 600

Partial Income Statement for Eastwood Inc.

Other expenses and losses:Unrealized loss on trading

securities $500

Sale of SecuritiesTo record accrued revenue and amortize premium:Apr. 1

Interest Receivable 2,500Investment in Held-to

Maturity Securities 395Interest Revenue 2,105

Entry to record sale:Apr. 1 Cash 103,000Realized Loss on Sale of Securities 4,353

Interest Receivable 2,500Investment in Held-to

Maturity Securities 104,853

Stop & Think

What is the difference between realized and recognized?

Transferring Securities Between Categories

Transferred Treatment of Change in Value

From tradingAny unrealized change in value not previously recognized will be recognized in net income in the current period.

To tradingAny unrealized change in value not previously recognized will be recognized in net income in the current period.

From held to maturity to available for sale

Recognize any unrealized change in value in a stockholders’ equity account.

From available for sale to held to maturity

Any unrealized change in value recorded in a stockholders’ equity account is to be amortized over the security’s remaining life using the effective-interest method.

Statement of Financial Standards No. 115, par. 15d

Stop & Think

Which ONE of the following statements is correct with respect to ALL

transfers of investment securities from one category to another?


Assume:Cost of trading security$3,000Fair market value, end of 2007 3,600Fair market value at transfer date 3,800

Investment in Available-for-Sale Securities 3,800

Market Adjustment--Trading Securities 600

Unrealized Gain on Transferof Securities 200

Investment in Trading Securities 3,000


Assume: Transfer from the available-for-sale category to the trading security category.

Cost of available-for-sale security $12,000Fair market value, end of 2006 10,700

Investment in Trading Securities 10,300Market Adjustment--Trading Securities 1,300Unrealized Loss on Transfer of Securities 1,700

Unrealized Increase/Decrease in Value of Available-for- Sale Securities 1,300Investment in Available-for-

Sale Securities 12,000


Assume: Record a transfer from held-to-maturity to the available-for-sale category.

Cost of held-to-maturity security$20,000Fair market value, Dec. 31, 2006 20,700Investment in Available-for-

Sale Securities 20,400 Unrealized Increase/ Decrease

in Value of Available-for-Sale Securities 400

Investment in Held-to- Maturity Securities 20,000


Assume: Record a transfer from available-for-sale (AFS) to held-to-maturity

Cost of available-for-sale securities$5,000Fair market value, end of 2006 6,500Fair market value at transfer date 5,900

Investment in Held-to-Maturity Securities 5,900Unrealized Increase/Decrease in Value of AFS Securities 600

Investment in AFS Securities 5,000Market Adjustment—AFS

Securities 1,500

Cash Flows from Gains and Losses on Available-for-Sale

Caesh Company began with a $1,000 investment on January 1, 2007.

Cash sales $1,700Cash expenses (1,400)Purchases of investment securities (600)Sale of investment securities (costing $200) 170

The market value of the remaining securities was $500 on December

31, 2005.


Sales $1,700Expenses (1,400

)Operating income $ 300Realized loss on sale of securities (30

) Net income $ 270Caesh Company will report a $100 unrealized increase in the value of it available-for-sale

portfolio.

This $100 unrealized increase is reported as an increase in Accumulated Other Comprehensive

Income.


The statement of cash flows for Caesh Company for 2007 appear as follows:

Operating activities:Net income $ 270Plus realized loss on sale of securities 30 $

300Investing activities:

Purchase of investment securities $(600)Sale of investment securities 170 (430)

Financing activities:Initial investment by owner 1,000

Net increase in cash $ 870

Classification and Disclosure• Trading securities

– The change in net unrealized holding gain or loss that is included in the income statement.• Available-for-sale securities

– Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type.

– The proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales and the basis on which cost was determined in computing realized gains and losses.

• Available-for-sale securities (continued):– The change in net unrealized holding gain

or loss on available-for-sale securities that has been included in stockholders’ equity during the period.

• Held-to-maturity securities:– Aggregate fair value, gross unrealized holding gains

and gross unrealized holding losses, and amortized cost basis by major security type.

– The company should disclose information about contractual maturities.

Classification and Disclosure

International Accounting for Investment Securities

• The differences in U.S. and international accounting standards are disappearing.

• However, understanding the differences allows the user to better use and interpret the global statements.

• IAS 39 covers the accounting for investment securities.

IAS 39 Provisions1. All financial assets and financial liabilities are

initially measured at cost.2. After initial recognition, all financial assets are

to be remeasured to fair value except for:• Debt securities intended to be held until maturity• Financial assets whose fair value cannot be reliably

determined.3. After acquisition, financial liabilities are to be

measured at the original recorded amount, less repayments and amortization.

4. A company can report unrealized gains and losses in one of two ways:

• In net income of the period or• In net income for unrealized gains and losses on

trading securities and as part of equity for “nontrading” securities.

Accounting for the Impairment of a Loan

• Occasionally, market value may not exist for the investment.

• The investor must assess the collectibility of the investment and if and “impairment exists.

• An adjustment must be made to the value of the receivable.

• Impairment is measured by comparing the present value of expected future cash flows with the carrying value of the investment.

copyright © 2007 thomson south-western, a part of the thomson

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