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Common and preferred stock Nature of Investments Bonds and notes (Debt securities) Common and preferred stock (Equity securities) To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities are purchased as investments by individual investors, mutual funds, and also by other corporations. Our focus in this chapter is on the corporations that invest in securities issued by other corporations as well as those issued by governmental units (bonds, Treasury bills, and Treasury bonds). Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.
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12 Investments Chapter 12: Investments.
In this chapter you will learn about various approaches used to
account for investments that companies make in the debt and equity
of other companies. Depending on the nature of an investment,
investors can use alternative accounting approaches that ignore
most fair value changes (e.g., held-to-maturity investments) or
that include fair value changes only in other comprehensive income
(e.g., available-for-sale-investments).When an equity investor can
significantly influence an investee but does not control it, the
investor can use the equity method of accounting, which ignores
fair valuechanges but includes the investees income when reporting
the investors income. McGraw-Hill/Irwin Copyright 2011 by the
McGraw-Hill Companies, Inc. All rights reserved. Common and
preferred stock
Nature of Investments Bonds and notes (Debt securities) Common and
preferred stock (Equity securities) To finance its operations, and
often the expansion of those operations, a corporation raises funds
by selling equity securities (common and preferred stock) and debt
securities (bonds and notes). These securities are purchased as
investments by individual investors, mutual funds, and also by
other corporations. Our focus in this chapter is on the
corporations that invest in securities issued by other corporations
as well as those issued by governmental units (bonds, Treasury
bills, and Treasury bonds). Investments can be accounted for in a
variety of ways, depending on the nature of the investment
relationship. Reporting Categories for Investments
To finance its operations, and often the expansion of those
operations, a corporation raises funds by selling equity securities
(common and preferred stock) and debt securities (bonds and notes).
These securities are purchased as investments by individual
investors, mutual funds, and also by other corporations. In later
chapters we discuss equity and debt securities from the perspective
of the issuing company. Our focus in this chapter is on the
corporations that invest in debt and equity securities issued by
other corporations as well as debt securities issued by
governmental units (bonds, Treasury bills, and Treasury bonds).
Most companies invest in financial instruments issued by other
companies. For some investors, these investments represent ongoing
affiliations with the companies whose securities are acquired.
Investor Lacks Significant Influence
When the investor lacks significant influence over the investee,
the investment is classified in one of three categories:
held-to-maturity securities (HTM), trading securities (TS), and
available-for-sale securities (AFS). Each type of investment has
its own reporting method. However, regardless of the investment
type, investors can elect the fair value option that we discuss
later in the chapter and classify HTM and AFS securities as TS. The
key difference among the reporting approaches is how we account for
unrealized holding gains and losses. Securities to Be Held to
Maturity
Investments in bonds or other debt security that have a specified
maturity date. The bonds or other debt are initially recorded at
cost. The investor may have the positive intent and ability to hold
the securities to maturity and classified as held-to-maturity
(HTM). They are reported on the balance sheet at amortized cost.
Amortized cost (Face amount less unamortized discount, or plus
unamortized premium). Investments in bonds or other debt security
that have a specified maturity date. The bonds or other debt are
initially recorded at cost. The investor may have the positive
intent and ability to hold the securities to maturity and
classified as held-to-maturity (HTM). They are reported on the
balance sheet at amortized cost.Amortized cost is equal to the face
amount of the debt less any unamortized discount, or plus any
unamortized premium. If management decides to sell the securities
prior to maturity, they will be reclassified to trading securities.
We will discuss trading securities later in the presentation.
Balance Sheet Securities to Be Held to Maturity
On January 1, 2011, Matrix, Inc. purchased as an investment
$1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The
market rate for similar bonds is 12%. Lets look at calculation of
the present value of the bond issue. Present Amount PV Factor Value
Interest $ ,000 = $573,496 Principal 1,000,000 311,805 Present
value of bonds $885,301 On January 1, 2011, Matrix, Inc. purchased
as an investment $1,000,000, of 10%, 10-year bonds, interest paid
semi-annually. The market rate for similar bonds is 12%. Lets look
at calculation of the present value of the bond issue. The interest
annuity is $50,000 ($1,000,000 times 10% equals $100,000, divide
$100,000 by 2 for $50,000 cash interest). Look at the present value
of an ordinary annuity of $1 table. Find the 20 periods row and
move across to the 6% column to find the factor of Go to the
present value of $1 table and follow the same procedures to arrive
at the present value factor of The present value of the bonds at
12% return is $885,301. PV of ordinary annuity of $1, n = 20, i =
6% PV of $1, n = 20, i = 6% Securities to Be Held to Maturity
Partial Bond Amortization Table January 1, 2011 Investment in
bonds1,000,000 Discount on bond investment ,699 Cash ,301 Part I
Here is a partial amortization table for the bonds purchased on
January 1, 2011 with the intent of holding them to maturity.The
bonds were priced as $885,301, to yield Matrix, a 12% return.
Interest semi-annually on June 30th and December 31st. Lets look at
the journal entry to record the initial purchase of the bonds and
the subsequent receipt of the first interest amount. Part II On
January 1, Matrix will debit investment in bonds for the face
amount of $1 million, credit discount on bond investment for
$114,699, and credit cash for $885,301.On June 30, the first at
payment is due to Matrix.The journal entry is to debit cash for
$50,000, debit discount on bonds payable for $3,118 and credit
interest revenue for $53,118.The interest revenue is determined by
taking 6% of the carrying value of the bonds, which is $885,301.
The $50,000 cash received is determined by multiplying the face
amount of the bonds, $1 million, by 5%, the stated rate. The
difference between the calculated interest revenue and the cash
interest received represents the amortization of the bond discount.
June 30, 2011 Cash (stated rate face amount) ,000 Discount on bond
investment ,118 Investmentrevenue ,118 Securities to Be Held to
Maturity
This investment would appear on the June 30, 2011, as follows:
$114,699 - $3,118 = $111,581 unamortized discount As of June 30,
discount on the bond investment account has been reduced to
$111,581.The amortized amount of the investment is $888,419.If a
balance sheet were prepared as of June 30, the investment in bonds
would be shown at $888,419. We do not recognize unrealized holding
gains and losses for HTM investments. Unrealized holding gains and
losses are not recognized for HTM investments. Securities to Be
Held to Maturity
On December 31, 2011, after interest is received by Matrix, all the
bonds are sold for $900,000 cash. December31, 2011 Cash50,000
Discount on bond investment3,305 Investment revenue 53,305 Part I
On December 31, 2011, Matrix receives $50,000 cash interest. The
journal entry to record the receipt is to debit cash for $50,000,
debit discount on bonds payable of $3,305, and credit investment
revenue for the total of $53,305. Part II Immediately after the
receipt of interest, Matrix sells its investment in bonds for
$900,000 cash. The entry to record the sale is to debit cash for
the proceeds of $900,000, eliminate the unamortized discount with a
debit to discount on bonds payable for $108,276, credit the
investment in bonds for $1,000,000, and credit the realized gain on
sale of investment for $8,276 (the difference between the cash
received of $900,000 and the carrying value of the
investment,$891,724). December 31, 2011 Cash ,000 Discount on bond
investment108,276 Investmentin bonds 1,000,000 Gain on sale of
investment ,276 Trading Securities Income Statement Unrealized Gain
Unrealized Loss
Investments in debt or equity securities acquired principally for
the purpose of selling them in the near term. Adjustments to fair
value are recorded: in a valuation account called Fair Value
Adjustment, or as a direct adjustment to the investment account. as
a net unrealized holding gain/loss on the Income Statement. Trading
securities are investments in debt or equity securities acquired
principally for the purpose of selling them in the near term.
Trading securities initially are recorded at cost including any
brokerage fees. Adjustments to fair value for trading securities
are made when the balance sheet is prepared. These adjustments are
typically made to a fair value adjustment account, but could also
be made directly to the investment account. Unrealized Gain
Unrealized Loss Income Statement Trading Securities Matrix, Inc.
purchased securities classified as Trading Securities (TS) on
December 22, The fair value amounts for these securities on
December 31, 2011, are shown below. Prepare the journal entries for
Matrix, Inc. to showing the purchase of the securities, and adjust
the securities to fair value at 12/31/11. On December 22, 2011,
Matrix purchases 1,000 shares of Mining, inc. and 1,500 shares of
Toys and Things to be held as trading securities.The cost of these
securities are shown on the table at the bottom of your screen.On
December 31, 2011, the fair value of the Mining, Inc. shares is
$41,000, and the fair value of Toys and Things shares is
$20,000.Lets see how we record the purchase of the shares and the
unrealized holding loss on the securities. Trading Securities
December22, 2011 Investment in Mining, Inc. stock ,000 Investment
in Toys and Things stock 22,500 Cash ,500 Part I On December 22,
2011, Matrix purchases shares of stock and classified these shares
as trading securities. The journal entry to record the investments
is to debit investment in Mining, Inc. stock for $42,000 and debit
investment in Toys and Things stock for $22,500, with a credit to
cash for the total amount of $64,500. Part II At December 31, 2011,
the journal entry required is to debit net unrealized holding gains
and losses - IS for $3,500, and credit the fair value adjustment
account for the same amount.The net unrealized holding loss will be
reported in the current period income statement. The fair value
adjustment account is an adjunct account included with the
investment account on the balance sheet, so that the investment is
carried at fair value.Also, any interest revenue is handled the
same as with HTM investments, and any dividend revenue is handled
similarly, with a debit to cash and a credit to investment revenue.
Reported on the balance sheet as a adjunct account to the
investment. December 31, 2011 Net unrealized holding gains and
losses I/S3,500 Fair value adjustment ,500 The Net Unrealized
Holding Loss is reported on the Income Statement. Trading
Securities On January 3, 2012, Matrix sold all trading securities
for $65,000 cash. Lets record the entry for the sale and the
adjustment to the fair value adjustment account. January 3, 2012
Cash ,000 Investment in Mining, Inc. stock T/S42,000 Investment in
Toys and Things stock T/S22,500 Gain on sale of investment December
31, 2012 Fair value adjustment ,500 Net unrealized holding gains or
losses I/S3,500 Part I On January 3, 2012, Matrix sold all it
trading securities for $65,000 cash. The entry to record the sale
is to debit cash for $65,000,credit each trading security for its
cost, and credit gain on sale of investments for $500. Part II In
the period of sale, the fair value adjustment associated with the
sold investment is eliminated, typically as part of the normal
valuation process at the end of the period. This also has the
effect of backing out of income any unrealized gains and losses
that were recognized in prior periods, which avoids the double
accounting that would result from including gains and losses both
when unrealized (because fair value changes) and when realized
(because the investment is sold).So, in our example, we eliminate
the fair value adjustment with a debit of $3,500, and credit net
unrealized gain or loss for the same amount. Financial Statement
Presentation
Trading securities are presented on the financial statement as
follows: Income Statement and Comprehensive Income Statement: Fair
value changes are included on the income statement in the periods
in which they occur, regardless of whether they are realized or
unrealized. Investments in trading securities do not affect other
comprehensive income. Balance Sheet: Securities are reported at
fair value, typically as current assets, and do not affect
accumulated other comprehensive income in shareholders equity. Cash
Flow Statement: Cash flows from buying and selling trading
securities typically are classified as operating activities,
because the investor that hold trading securities consider them as
part of their normal operations. Trading securities are presented
on the financial statement as follows: Income Statement and
Comprehensive Income Statement: Fair value changes are included on
the income statement in the periods in which they occur, regardless
of whether they are realized or unrealized. Investments in trading
securities do not affect other comprehensive income. Balance Sheet:
Securities are reported at fair value, typically as current assets,
and do not affect accumulated other comprehensive income in
shareholders equity. Cash Flow Statement: Cash flows from buying
and selling trading securities typically are classified as
operating activities, because the investor that hold trading
securities consider them as part of their normal operations.
Financial Statement Presentation
Presented below are the partial financial statements showing the
accounting for TS owned by United: Presented below are the partial
financial statements of the trading securities owned by United for
the years ended December 31, 2011 and Notice the reporting of
realized and unrealized gains and losses on investments that are
reported on the income statement. The interest and dividends were
received from Masterwear and Arjent. The purchase and sale of the
securities are classified as operating activities in the Statement
of Cash Flows because they will be traded in the near term.
Securities Available-for-Sale
Investments in debt or equity securities that are not for active
trading and not to be held to maturity are classified as
available-for-sale (AFS). Adjustments to fair value are recorded:
in a valuation account called fair value adjustment, or asa direct
adjustment to the investment account. as a net unrealized holding
gain/loss in othercomprehensive income (OCI), which accumulates
inaccumulated other comprehensive income (ACOI). When an investment
is not classified as an HTM or trading security, it is classified
asavailable-for-sale. Available-for-sale securities are recorded on
the balance sheet atfair value subsequent to acquisition.
Adjustments to fair value are recorded in avaluation account called
Fair Value Adjustment, or as a direct adjustment tothe investment
account. The net unrealized holding gains or losses is shown inthe
account Other Comprehensive Income (OCI), which accumulates
inAccumulated Other Comprehensive Income (ACOI). Unrealized Gain
Unrealized Loss Other Comprehensive Income (OCI) Other
Comprehensive Income (OCI)
When we add other comprehensive income to net income we refer to
the result as comprehensive income. Other comprehensive income
consists of the four elements shown and is reported net of
aggregate income tax expense or benefit. Accumulated Other
Comprehensive Income
Unrealized holding gains and losses on available-for-sale
securities are accumulated in the shareholders equity section of
the balance sheet. Specifically, the account is included in
accumulated other comprehensive income (AOCI). Shareholders Equity
Common Stock Paid-in Capital in Excess of par Accumulated other
comprehensive income Retained earnings Total Shareholders Equity
Net unrealized holding gainsand losses. Unrealized holding gains
and losses on available-for-sale securities are reported in the
shareholders equity section of the balance sheet. Specifically, the
account is included in Accumulated Other Comprehensive Income. The
reason for this placement is that many in the business world
believe that including unrealized holding gains and losses on
available-for-sale securities would cause greater volatility in net
income than was appropriate (or at least desired!). Securities
Available for Sale Example
Assume the same information for our T/S example for Matrix, Inc.,
except that the investments are classified as available-for-sale
securities rather than trading securities. Part I Assume the same
information for our T/S example for Matrix, Inc., except that the
investments are classified as available-for-sale securities rather
than trading securities. Recall that on December 31, 2011, we
calculated a net unrealized holding loss of $3,500. Lets see how we
account for this net unrealized holding gain or loss on
available-for-sale securities. Part II The adjusting entry on
December 31, 2011, is to debit the net unrealized holding gains and
losses for other comprehensive income for $3,500, and credit the
fair value adjustment account for the same amount. December 31,
2011 Net unrealized holding gains and losses OCI3,500 Fair value
adjustment ,500 Financial Statement Presentation
AFS securities are presented on the financial statement as follows:
Income Statement and Comprehensive Income Statement: Realized gains
and losses are shown in net income in the period in which
securities are sold. Unrealized gains and losses are shown in OCI
in the periods in which changes in fair value occur, and
reclassified out of OCI in the periods in which securities are
sold. Balance Sheet: Investments in AFS securities are reported at
fair value. Unrealized gains and losses affect AOCI in shareholders
equity, and are reclassified out of AOCI in the periods in which
securities are sold. Cash Flow Statement: Cash flows from buying
and selling AFS securities typically are classified as investing
activities. AFS securities are presented on the financial statement
as follows: Income Statement and Comprehensive Income Statement:
Realized gains and losses are shown in net income in the period in
which securities are sold. Unrealized gains and losses are shown in
OCI in the periods in which changes in fair value occur, and
reclassified out of OCI in the periods in which securities are
sold. Balance Sheet: Investments in AFS securities are reported at
fair value. Unrealized gains and losses affect AOCI in shareholders
equity, and are reclassified out of AOCI in the periods in which
securities are sold. Cash Flow Statement: Cash flows from buying
and selling AFS securities typically are classified as investing
activities. Financial Statement Presentation
Presented below are the partial income statement showing the
accounting for AFS of United: The important items to note in the
income statement of United is the reporting of the realized net
loss on sale of investment in the other income or expense category
and the development of the other comprehensive income or loss
items. Notice that we income both the unrealized holding gains or
losses in AFS investments and any adjustment resulting from the
reclassification of securities in our investment portfolio.
Financial Statement Presentation
Finally, we have the partial balance sheet and statement of cash
flows for the company. Finally, we have the partial balance sheet
and statement of cash flows for the company. Notice that we report
accumulated other comprehensive income in the stockholders equity
section of the companys balance sheet. U. S. GAAP vs. IFRS Until
recently, IFRS did not allow transfers out of their fair value
through profit and loss classification. U.S. GAAP also allows
transfers out of the trading security category. Reclassifications
under U.S. GAAP are rare. IAS No. 39 now allows transfer of debt
investments out of the fair value category into AFS or HTM in rare
circumstances. The current financial crisis qualified as one of
those circumstances. Until recently, IFRS did not allow transfers
out of their fair value through profit and loss classification.
From the perspective of the IFRS, IAS No. 39, now allows transfer
of debt investments out of the fair value category into AFS or HTM
in rare circumstances. The current financial crisis qualified as
one of those circumstances. However, IAS No. 39 increases
convergence to U.S. GAAP, which also allows transfers out of the
trading security category. Reclassifications under U.S. GAAP are
even more rare. U. S. GAAP vs. IFRS IFRS No. 9 eliminates the HTM
and AFS classifications, replaced by new classifications that are
more restrictive. This has the general effect of pushing more
investments into being accounted for at Fair Value Through Profit
& Loss (FVTPL), and thus having unrealized gains and losses
included in net income. U.S. GAAP permits classification as HTM,
AFS, and TS. No significant tests are required to classify a debt
investment. There is no comparable FVTPL or FVTOCI classification.
Investments in debt securities are classified as either Amortized
Cost or FVTPL. To be classified as a debt investment, two important
tests must be met. The current financial crisis qualified as one of
those circumstances. Investments in equity securities are
classified as either FVTPL or FVTOCI (Fair Value through Other
Comprehensive Income). IFRS No. 9 eliminates the HTM and AFS
classifications, replaced by new classifications that are more
restrictive. This has the general effect of pushing more
investments into being accounted for at Fair Value Through Profit
& Loss (FVTPL), and thus having unrealized gains and losses
included in net income. Investments in debt securities are
classified as either Amortized Cost or FVTPL. Like the previous HTM
classification, debt in the amortized cost classification is
accounted for at (you guessed it) amortized cost. However, to be
included in the amortized cost category, a debt investment has to
meet both (a) the cash flow characteristics test (which requires
that the debt instrument consist of only principal and interest
payments) and (b) the business model test (which requires that the
objective of the companys business model is to hold the investment
to collect the contractual cash flows rather than to sell the
investment at a gain). If debt isnt classified in amortized cost,
it is classified in FVTPLthere is no equivalent to AFS accounting
for debt under IFRS No. 9. Investments in equity securities are
classified as either FVTPL or FVTOCI (Fair Value through Other
Comprehensive Income). If the equity is held for trading, it must
be classified as FVTPL, but otherwise the company can irrevocably
elect to classify it as FVTOCI. Like the previous AFS
classification, equity in the FVTOCI category has unrealized gains
and losses included in OCI. However, unlike AFS, realized gains and
losses are not reclassified out of OCI and into net income when
they are later sold. Rather, the accumulated gain or loss
associated with a sold investment is just transferred from AOCI to
retained earnings (both shareholders equity accounts), without
passing through the income statement. Transfers Between Reporting
Categories
Any unrealized holding gain or loss at reclassification should be
accounted for in a manner consistent with the classification into
which the security is being transferred. Securities are transferred
at fair market value on the date of transfer. At each reporting
date, the appropriateness of the classification is reassessed. For
instance, if the investor no longer has the ability to hold certain
securities to maturity and will now hold them for resale, those
securities would be reclassified from HTM to AFS. Reclassifications
are quite unusual, so when they occur, disclosure notes should
describe the circumstances that resulted in the transfers. When a
security is reclassified between two reporting categories, the
security is transferred at its fair value on the date of transfer.
This table illustrates reclassification of securities from one
category to another. We will concentrate of the proper handling of
any unrealized gain or loss from the transfer at fair market value.
Impairment of Investments
Occasionally, aninvestments value willdecline for reasonsthat are
other thantemporary (OTT). Impairment in Value For HTM and AFS
investments, a companyrecognizes an OTT impairment loss in
earnings. Determining an other than temporary decline for debt
securities can be quite complex. For both equity and debt
investments, after an OTT impairment is recognized, the ordinary
treatment of unrealized gains and losses is resumed. Sometimes an
investment will incur an other than temporary (permanent) decrease
in value.We refer to this as an impairment in value. For HTM and
AFS investments, a companyrecognizes an OTT impairment loss in
earnings. Determining an other than temporary decline for debt
securities can be quite complex. For both equity and debt
investments, after an OTT impairment is recognized, the ordinary
treatment of unrealized gains and losses is resumed. U. S. GAAP vs.
IFRS Until recently, IFRS did not allow transfers out of the fair
value through P&L (FVTPL) classification (which is roughly
equivalent to the trading securities classification in U.S. GAAP).
U.S. GAAP has no prohibition against transfers between categories
as long as they can be reasonably justified. In recent changes, IAS
No. 39 allows transfers of debt investments out of the FVTPL
category into AFS or HTM in rare circumstances, The 2008, financial
crisis qualifies as one of those rarecircumstances. Part I Until
recently, IFRS did not allow transfers out of the fair value
through P&L (FVTPL) classification (which is roughly equivalent
to the trading securities classification in U.S. GAAP). From the
perspective of the IFRS, In recent changes, IAS No. 39 to allow
transfers of debt investments out of the FVTPL category into AFS or
HTM in rare circumstances, The 2008, financial crisis qualifies as
one of those rarecircumstances. However, U.S. GAAP has no
prohibition against transfers between categories as long as they
can be reasonably justified. Financial Statement Presentation and
Disclosure
AggregateFair Value Gross realized & unrealized holding gains
& losses Maturities ofdebt securities Amortized cost basis by
major security type Listed on this slide are six disclosures
required for investments in securities classified as
held-to-maturity, available-for-sale, or trading.Additional
disclosures are also required. Change in net unrealized holding
gains and losses Inputs to fairvalue estimates Investor Has
Significant Influence
Now we are going to change the accounting for investments
dramatically.We are going to assume a company has acquired enough
equity securities in another company to exert significant influence
over the operating policies of that company. The presumption is
that if the investor owns between 20 and 50 percent of the voting
stock of the investee company, the investor is able to exert
significant influence over the policies of the investee. Under
these circumstances, the equity method of accounting for the
investment is required. Investor Has Significant Influence
Extent of Investor Influence Reporting Method Lack of significant
influence (usually < 20% equity ownership) Varies depending on
classification previously discussed Significant influence(usually
20% - 50% equity ownership) Equity method Has control (usually >
50% equity ownership) Consolidation We use the equity method for
investments in equity securities that are large enough to allow us
to exert significant influence, typically assumed as occurring when
we own between 20% and 50% of the voting common stock.If we own
more than 50% of the voting common stock, we use consolidation.
Consolidated financial statements combine the separate financial
statements of the parent and the subsidiary each period into a
single aggregate set of financial statements as if there were only
one company. The investor is referred to as the parent; the
investee is termed the subsidiary.In a consolidation, if the
acquisition price is more than the sum of the separate fair values
of the acquired net assets (assets less liabilities), that
difference is recorded as an intangible asset goodwill. What Is
Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is
presumed that the investor has significant influence over the
financial and operating policies of the investee. The presumption
can be overcome if : the investee challenges the investors ability
toexercise significant influence through litigation or other
methods. the investor surrenders significant shareholder rights in
a signed agreement. the investor is unable to acquire sufficient
information about the investee to apply the equity method. the
investor tries and fails to obtain representation on the board of
directors of the investee. If an investor owns 20% of the voting
stock of an investee, it is presumed that the investor has
significant influence over the financial and operating policies of
the investee. The presumption can be overcome if : The investee
challenges the investors ability to exercise significant influence
through litigation or other methods. The investor surrenders
significant shareholder rights in a signed agreement. The investor
is unable to acquire sufficient information about the investee to
apply the equity method. The investor tries and fails to obtain
representation on the board of directors of the investee. A Single
Entity Concept
Under the equity method The investor recognizes investment income
equal to its percentage share (based on stock ownership) of the net
income earned by the investee rather than the portion of that net
income received as cash dividends. Initially, the investment is
recorded at cost. The carrying amount of this investment
subsequently is: Increased by the investors percentage share of the
investees net income (or decreased by its share of a loss).
Decreased by dividends paid. Under the equity method The investor
recognizes investment income equal to its percentage share (based
on stock ownership) of the net income earned by the investee rather
than the portion of that net income received as cash dividends.
Initially, the investment is recorded at cost. The carrying amount
of this investment subsequently is: Increased by the investors
percentage share of the investees net income (or decreased by its
share of a loss). Decreased by dividends paid. Equity Method On
January 1, 2011, Wilmer, Inc. acquired 45% of the equity securities
of Apex, Inc. for $1,350,000.On the acquisition date, Apexs net
assets had a fair value of $3,000,000.During 2011, Apex paid cash
dividends of $150,000 and reported net income of $1,750,000. What
amount will Wilmer, Inc. report on the balance sheet as Investment
in Apex, Inc. on December 31, 2011? Lets look at a rather
straightforward example of the equity method.In this case, the
investor acquires 45% of the voting common stock of the investee.
The investor pays $1,350,000, for its proportionate share of net
assets with a fair value of $3 million. During 2009, the investee
reports earnings of $1,750,000 and pays cash dividends of $150,000.
Lets look at the accounting for this investment under the equity
method. Equity Method January 1, 2011 Investment in Apex, Inc.
stock 1,350,000
Cash ,350,000 2011 Investment in Apex, Inc. stock ,500 Investment
revenue ,500 Part I On January 1, 2011, we paid $1,350,000 cash for
45 percent of the stock of Apex, Inc.The fair value of the net
assets of Apex was $3,000,000, and we acquired 45 percent of these
net assets. The journal entry at date of acquisition will be to
debit investment in Apex, Inc. for $1,350,000, and credit cash for
the same amount. Part II During 2011, Apex reported net earning of
$1,750,000. Our share of the reported earning is $787,500
($1,750,000 45 percent). The journal entry to recognize our share
of the earnings of the investee is to debit the investment in Apex,
Inc. stock for $787,500, and credit investment revenue for the same
amount. Part III During 2011, Apex declared and paid dividends of
$150,000. Our share of the dividends is $67,500 ($150,000 45
percent). The journal entry to record the dividend received is to
debit Cash for $67,500, and to credit investment in Apex, Inc.
stock for the same amount. Note that dividends are not considered
revenue under the equity method. 2011 Cash ,500 Investment in Apex,
Inc. stock ,500 Equity Method Investment in Apex, Inc.
Investment ,350, , % Dividends 45% Earnings ,500 Reported amount
2,070,000 Part I The Investment in Apex, Inc. account will be shown
in the balance sheet of the investor at $2,070,000.Notice that the
dividends received reduces the investment account, and recognition
of the proportionate share of earnings increases the investment
account. Part II If the investee company had reported a loss, the
investment account would have been reduced by the investors
proportionate share of that loss. If the investee had a loss, the
investment account would have been reduced. Equity Method On
January 1, 2011, Wilmer, Inc. purchased 25% of the common stock of
Apex, Inc. for $180,000. At the date of acquisition, the book value
of the net assets of Apex was $400,000, and the fair value of these
assets is $600,000. During 2011, Apex paid cash dividends of
$40,000, and reported earnings of $100,000. Now lets complicate our
discussion of the equity method. Please read this information
carefully, noting that the price Wilmer paid for 25% of Apex
($180,000) is greater than 25% of the fair value of Apexs net
assets ($150,000). That difference of price paid over fair value of
net assets is viewed as a goodwill component of the purchase price.
Notice also that the fair value of Apexs net assets is greater than
25% of the book value of those net assets on Apexs balance sheet
(25% times $400,000 equals $100,000). Equity Method The excess of
the fair value of net assets over book value of those net assets is
75% is attributable to depreciable assets with a remaining life of
20 years and 25% is attributable to land. Wilmer uses the
straight-line depreciation. Of the $50,000 excess of the fair value
over book value of those net assets on Apexs balance sheet, 75% is
attributable to depreciable assets with the remaining useful life
of 20 years.Wilmer, the investor, uses the straight-line method to
depreciate similar owned assets. If Apex carried those net assets
at their fair value on their financial statements, they would have
to record additional depreciation expense, and Wilmers share of
that additional depreciation expense would be $1,875 per year. To
capture this income effect, Wilmer will impute that depreciation
expense and include it as a deduction of investment revenue and the
investment. Note that, because neither goodwill nor land is
amortized, Wilmer makes no adjustment for those items in terms of
imputing additional expense. Equity Method January 1, 2011
Investment in Apex stock 180,000
Cash ,000 2011 Cash ,000 Investment in Apex stock ,000 Investment
in Apex stock ,000 Investment revenue ,000 December 31, 2011
Investment revenue ,875 Investment in Apex stock ,875 Wilmer will
record the following journal entries on its books during We are
familiar with the first three entries: purchase of the investment,
recognition of dividends received, and recording of our
proportionate share of earnings reported by Apex.The only new entry
is the last one.This is the entry to recognize the additional
depreciation that Wilmer must record.The journal entry is to debit
investment revenue and credit investment in Apex stock for
$1,875.The additional depreciation reduces the investment revenue
Matrix recognized. Changing From the Equity Method to Another
Method
When the investors level of influence changes, it may be necessary
to change from the equity method to another method. At the transfer
date,the carrying valueof the investmentunder the equitymethod is
regardedas cost. When we change from the equity method to another
method (TS or AFS), the accounting is quite easy.The carrying value
of the investment at the date of transfer becomes the cost basis
under the new method. Changing From Another Method to the Equity
Method
When the investors ownership level increases to the point where
they can exert significant influence, the investor should change to
the equity method. At the transfer date, the recorded value is the
initialcost of the investment adjusted for the investorsequity in
the undistributed earnings of the investeesince the original
investment. When we change from another method to the equity
method, we adjust the investment to appear as if we had always used
the equity method.Thus, we adjust the cost basis of the investment
for the total undistributed earnings of the investee since the date
of the original acquisition. Undistributed earnings is defined as
reported earnings minus dividends paid. Changing From Another
Method to the Equity Method
The original cost, the unrealized holding gain or loss, and the
valuation account are closed. A retroactive change is recorded to
recognize the investors share of the investees earnings since the
original investment. Any unrealized holding gains or losses
included in a valuation allowance account are closed at the date of
transition from cost to equity.A retroactive adjustment is required
to restate the investment for the total undistributed earnings
since the date of original acquisition. Fair Value Option The
investment is carried at fair value.
GAAP allows companies to use a fair value option for HTM, AFS and
equity method investments. The investment is carried at fair value.
Unrealized gains and losses are included in income. For HTM and AFS
investments, this amounts to classifying the investments as
trading. For equity-method investments, the investment is still
classified on the balance sheet with equity method investments, but
the portion at fair value must be clearly indicated. The fair value
option is determined for each individual investment, and is
irrevocable. GAAP allows companies to use a fair value option for
HTM, AFS and equity method investments. The investment is carried
at fair value. Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the
investments as trading. For equity-method investments, the
investment is still classified on the balance sheet with equity
method investments, but the portion at fair value must be clearly
indicated. The fair value option is determined for each individual
investment, and is irrevocable. Financial Instruments and
Investment Derivatives
Cash. Evidence of an ownership interest in an entity. Contracts
meeting certain conditions. Investment Derivatives: Value is
derived from other securities. Derivatives are often used to hedge
(offset) risks created by other investments or transactions
Financial instruments include cash, evidence of ownership interest
in an entity, and contracts meeting certain conditions.Derivatives
are often used to hedge (offset) risks created by other financial
investments or transactions. Derivatives have values that are
derived from the value of the underlying security. Other
Investments Appendix 12A
It is often convenient for companies to set aside money to be used
for specific purposes. In the short-term, funds may be set aside
for Petty cash funds. Payroll accounts. In the long-run, funds are
often set aside to: Pay long-term debt when it comes due. Acquire
treasury stock. Special purpose funds set aside for the long-term
are classified as investments. Appendix 12AOther Investments Petty
cash is considered a special-purpose fund because it is monies that
are set aside for the payment of small business expenditures that
require cash. We might use the petty cash fund to pay for postage,
cab fare for employees, or meals when employees work overtime. Most
companies establish a payroll account as a special-purpose fund.
The balance in the payroll account shortly after payday should be
zero. The special-purpose funds serve as a control mechanism for
the company. Some companies set up special-purpose funds for
long-term purposes.These funds might include a sinking fund used to
reacquire long-term debt or treasury stock. Appendix 12A Other
Investments
It is a common practice for companies to purchase life insurance
policies on key officers. The company pays the premium and is the
beneficiary of the policy. If the officer dies, the company
receives the proceeds from the policy. Some types of policies build
a portion of each premium as cash surrender value. The cash
surrender value of such a policy is classified as an investment on
the balance sheet of the company. It is a common business practice
for companies to purchase life insurance policies for key officers
and employees.The company pays the premium and is the beneficiary
of the policy. If the policy is a whole life policy, it develops a
cash surrender value. The cash surrender value of the life
insurance policy is treated as an investment on the companys
balance sheet. Appendix 12B Impairment of Investments
If the fair value of an investment declines to a level below cost,
and that decline is not viewed as temporary, companies typically
have to recognize an other-than-temporary (OTT) impairment loss in
earnings. We use a three-step process to determine whether an OTT
impairment loss must be recognized: (1) determine if the investment
is impaired, (2) determine whether any impairment is OTT, and (3)
recognize any OTT impairment in the financial statements. Part I
Appendix 12BImpairment of Investments If the fair value of an
investment declines to a level below cost, and that decline is not
viewed as temporary, companies typically have to recognize an
other-than-temporary (OTT) impairment loss in earnings. We use a
three-step process to determine whether an OTT impairment loss must
be recognized: (1) determine if the investment is impaired, (2)
determine whether any impairment is OTT, and (3) recognize any OTT
impairment in the financial statements. Appendix 12B Impairment of
Investments
On this screen and the one following we will look at the proper
treatment of impairment to an investment. If the fair value of an
investment declines to a level below cost, and that decline is not
viewed as temporary, companies typically have to recognize an
other-than-temporary (OTT) impairment loss in earnings. We dont
need to worry about OTT impairments for trading securities or other
investments for which a company has chosen the fair value option,
because all changes in the fair values of those investments
(whether temporary or OTT) always are recognized in earnings.
However, that is not the case for HTM and AFS investments. Declines
in fair value typically are ignored for HTM investments and
recorded in OCI for AFS investments. Therefore, companies need to
evaluate HTM and AFS investments to determine whether an OTT
impairment loss has occurred. We use a three-step process to
determine whether an OTT impairment loss must be recognized and how
that loss is to be measured and recorded: (1) determine if the
investment is impaired, (2) determine whether any impairment is
OTT, and (3) recognize any OTT impairment in the financial
statements. The graphic on your screen summarizes these steps.
Appendix 12B Impairment of Investments
This is a continuation of the chart shown on the previous screen.
Companies need to evaluate HTM and AFS investments to determine
whether an OTT impairment loss has occurred. We use a three-step
process to determine whether an OTT impairment loss must be
recognized and how that loss is to be measured and recorded: (1)
determine if the investment is impaired, (2) determine whether any
impairment is OTT, and (3) recognize any OTT impairment in the
financial statements. The graphic on your screen summarizes these
steps. Appendix 12B Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity
securities of other companies as investments. Uniteds fiscal
year-end is December 31. The following events during 2011 and 2012
pertain to the investment portfolio. Purchase Investment: July 1,
2011, $1,000,000 of Bendac common stock. Adjust Investment to Fair
Value: December 31, 2011 Valued the Bendac stock at $990,000 and
determined that the decline in FV should not be treated as an OTT
impairment. December 31, 2012 Valued the Bendac stock at $985,000
and determined that the decline in FV should be treated as an OTT
impairment The journal entries to record the adjustments of the
Bendac stock investment to fair value are: United Intergroup, Inc.,
buys and sells both debt and equity securities of other companies
as investments. Uniteds fiscal year-end is December 31. The
following events during 2011 and 2012 pertain to the investment
portfolio. Purchase Investment: July 1, 2011, $1,000,000 of Bendac
common stock. Adjust Investment to Fair Value: December 31, 2011
Valued the Bendac stock at $990,000 and determined that the decline
in FV should not be treated as an OTT impairment. December 31, 2012
Valued the Bendac stock at $985,000 and determined that the decline
in FV should be treated as an OTT impairment The journal entries to
record the adjustment at December 31, 2011, when the impairment in
not to be treated as an OTT impairment is to debit net unrealized
holding gains and losses in other comprehensive income for $10,000,
and credit fair value adjustment for the same amount. December 31,
2011 Net unrealized holding gains and losses OCI10,000 Fair value
adjustment ,000 Appendix 12B Impairment of Investments
December 31, 2012 Other-than-temporary impairment loss I/S15,000
Investment in Bendac15,000 Fair value adjustment10,000 Net
unrealized holding gains and losses OCI10,000 The first 2012
journal entry reduces the Bendac investment to reflect the OTT
impairment and recognizes the entire $15,000 in 2012 earnings.
United adjusts the Bendac investment directly rather than using a
fair value adjustment account because the OTT impairment cannot be
recovered. The second 2012 journal entry reclassifies any
previously recognized unrealized losses associated with the
investment, the same as if the investment had been sold. In 2011
United debited OCI and credited the fair value adjustment for
$10,000 to reflect the decline in Bendacs fair value to $990,000,
so the second 2012 journal entry reverses the 2011 entry to remove
those amounts. Appendix 12B Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity
securities of other companies as investments, and classifies these
investments as AFS. Uniteds fiscal year-end is December 31. The
following events occurred during 2012, Purchase Investment: July 1,
2012, $1,000,000 of Bendac bonds, maturing on December 31, Adjust
Investment to Fair Value: December 31, 2012, valued the Bendac
bonds at $950,000. Of the $50,000, impairment, $30,000 is credit
loss and $20,000 is noncredit loss. Case 1: United either plans to
sell the investment or believes it is more likely than not that it
will have to sell the investment before fair value recovers. Case
2: United does not intend to sell the investment and does not
believe it is more likely than not that it will have to sell the
Bendac investment before fair value recovers, but estimates that
$30,000 of credit losses have occurred. United Intergroup, Inc.,
buys and sells both debt and equity securities of other companies
as investments, and classifies these investments as AFS. Uniteds
fiscal year-end is December 31. The following events occurred
during 2012, Purchase Investment: July 1, 2012, $1,000,000 of
Bendac bonds, maturing on December 31, Adjust Investment to Fair
Value: December 31, 2012, valued the Bendac bonds at $950,000. Of
the $50,000, impairment, $30,000 is credit loss and $20,000 is
noncredit loss. Case 1: United either plans to sell the investment
or believes it is more likely than not that it will have to sell
the investment before fair value recovers. Case 2: United does not
intend to sell the investment and does not believe it is more
likely than not that it will have to sell the Bendac investment
before fair value recovers, but estimates that $30,000 of credit
losses have occurred. Lets look at the necessary journal entries in
these two cases. Lets look at the necessary journal entries in
these two cases. Appendix 12B Impairment of Investments
Case 1 December 31, 2012 OTT impairment loss I/S50,000 Discount on
bond investment50,000 Case 2 December 31, 2012 OTT impairment loss
I/S30,000 Discount on bond investment30,000 OTT impairment loss
-OCI 20,000 Fair value adjustment Noncredit loss20,000 In both
Cases 1 and 2, the amortized cost of the investment is reduced by
the amount of OTT impairment that is recognized in earnings. United
achieves this by crediting a contra-asset, discount on bond
investment, which United amortizes over the remaining life of the
debt the same way it would if it had initially purchased the debt
at that discounted amount. In Case 2, the noncredit-loss component
of the impairment is recognized in OCI, the same way it would be if
it were viewed as an unrealized loss under normal accounting for
fair value declines of AFS investments. In both cases the carrying
value of the debt becomes $950,000, reduced by the entire amount of
the OTT impairment. In Case 1 this occurs via the $50,000 discount,
and in Case 2 via the combination of the $30,000 discount and
$20,000 fair value adjustment. GAAP requires that the entire OTT
impairment be shown in the income statement, and then the portion
attributed to noncredit losses backed out, such that only the
credit loss portion reduces net income. U. S. GAAP vs. IFRS Under
IAS No. 39, companies recognize OTT impairments if there exists
objective evidence of impairment. Objective evidence must relate to
one or more events occurring after initial recognition of the asset
that affect the future cash flows that are going to be generated by
the asset. IFRS, unlike U.S. GAAP, there is no equivalent to
recognizing OCI any non-credit losses on debt investments.
Calculation of the amount of impairment differs depending on the
classification of an investment. Under IFRS, an OTT impairment for
a debt investment is likely to be larger if it is classified as AFS
than if it is classified as HTM, because it includes the entire
decline in fair value if classified as AFS but only the credit loss
if classified as HTM. Part I Under IAS No. 39, companies recognize
OTT impairments if there exists objective evidence of impairment.
Objective evidence must relate to one or more events occurring
after initial recognition of the asset that affect the future cash
flows that are going to be generated by the asset. From the
perspective of the IFRS, Calculation of the amount of impairment
differs depending on the classification of an investment. Under
IFRS, an OTT impairment for a debt investment is likely to be
larger if it is classified as AFS than if it is classified as HTM,
because it includes the entire decline in fair value if classified
as AFS but only the credit loss if classified as HTM. However,
IFRS, unlike U.S. GAAP, there is no equivalent to recognizing OCI
any non-credit losses on debt investments. End of Chapter 12 End of
Chapter 12.