Accounting Clinic III

7/31/2019 Accounting Clinic III

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Accounting Clinic III


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Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman

Columbia University


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Why do Firms Hold Debt and

Equity Securities?

To invest idle funds (usually in debt securities)

As part of their operational plan (usually equity

securities)

In an investment portfolio where investments are

bought or sold

As a permanent investment in affiliates and subsidiaries


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Classifying Debt and Equity Securities

by their Accounting Treatment

Debt

Held to Maturity

Available for Sale

Trading

Equity

Less than

20%

ownership

Greater than

20%

ownership

Available for

Sale

Trading

Go to

clinic V


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What are Marketable Securities?

Debt securities

Equity securities representing less then 20%

interest in another corporationFor the accounting for equity securities with

greater than 20% ownership go to

Accounting Clinic V


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Classifications of Marketable

Securities

Debt securities are classified into one of threecategories:

held-to-maturity

available-for-saletrading.

Equity securities (representing less then 20%ownership) are classified into one of two categories:

available-for-saletrading.

The appropriateness of the classification should bereassessed at each reporting date.


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Held-to-Maturity Debt Securities

Investments in debt securities should be classified

as held-to-maturity only if the reporting enterprise

has the positive intent and ability to hold those

securities to maturity.

An enterprise should not classify a debt security as

held-to-maturity if it intends to hold the security

for only an indefinite period.


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Held-to-Maturity Debt Securities

The Accounting Rule

Held to maturity are measured at their

historical cost.

If debt were purchased at a discount orpremium over par value, the discount of

premium is amortized to the income

statement.


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The Effective Interest Rate Method

The effective interest rate is the internal rate of

return or yield to maturity at the time of issue.

Under the effective interest rate method, the

interest expense for a period is calculated as the

effective interest rate times the bonds book value

at the beginning of the period. Thus, under this

method, the implied interest rate is constant.


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Trading Securities

Securities that are bought and held principally

for the purpose of selling them in the near term

(thus held for only a short period of time)

should be classified as trading securities.

Trading generally reflectsactive andfrequent

buying and selling, and trading securities are

generally used with the objective of generatingprofits on short-term differences in price.


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Available-for-Sale Securities

Investments not classified as trading

securities (nor as held-to-maturity

securities) should be classified asavailable-for-sale securities.


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Reporting Changes in Fair Value -

Unrealized

Unrealized holding gains and losses for trading

securities should be included in earnings.

Unrealized holding gains and losses for available-

for-sale securities (including those classified as

current assets) should be excluded from net

income and reported as a net amount in other

comprehensive income within shareholders' equityuntil realized.


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Reporting Changes in Fair Value -

Realized

Dividend and interest income, including

amortization of the premium and discount

arising at acquisition, should be included innet income (for all securities).

Realized gains and losses should be

included in net income (for all securities).


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Financial Statement Presentation

An enterprise that presents a classified

statement of financial position should report

all trading securities as current assets andshould report individual held-to-maturity

securities and individual available-for-sale

securities as either current or noncurrent, as

appropriate.


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Statement of Cash Flows

Cash flows from purchases, sales, and maturities

of available-for-sale securities and held-to-

maturity securities should be classified as cash

flows from investing activities and reported grossfor each security classification in the statement of

cash flows.

Cash flows from purchases, sales, and maturitiesof trading securities should be classified as cash

flows from operating activities.


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Example : Marketable Equity Securities

Journal Entries

Alexis Co. purchased 100 common shares of Ball

Co. on February 1, 2004, for $500,000. The

market value of the shares on December 31, 2004,

was $560,000. Alexis Co. sold these shares onJune 30, 2005, for $600,000.

Give the journal entries to record this transaction

assuming:the shares are classified as trading securities

the shares are classified as available for sale securities


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If the shares were classified as

trading securities

February 1, 2004

Marketable Securities 500,000

Cash 500,000

December 31, 2004


Unrealized Holding Gain 60,000

on Trading Securities

The unrealized gain is reported in the income statement


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June 30, 2005

Cash 600,000

Marketable Securities 560,000Realized Gain on Sale 40,000

of Trading Securities

The realized gain is reported in the income statement


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If the shares were classified as

available for sale securities

February 1, 2004


Cash 500,000

December 31, 2004Marketable Securities 60,000


on Available for sale Securities

The unrealized holding gain is reported in othercomprehensive income


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June 30, 2005

Cash 600,000


Realized Gain on Sale 100,000

of Trading Securities

The realized gain is reported in the income statement


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At December 31, 2005 the security adjustmentaccount had a debit balance of $60,000 ($560,000-$500,000). The adjustment entry is as follows:


on Available for sale Securities


To remove the unrealized gain from shareholdersequity.


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Example : Different Accounting Treatments

for Marketable Equity Securities

Wonder Corporation has the following portfolio ofmarketable equity securities:

Cost in

Dividends

received

Market

Value on

Dec. 31,

Dividends

received

Market

Value on

Dec. 31,

Selling

Price on

June 30,

Security 2003 2003 2003 2004 2004 2004

A $16,000 $1,000 $19,000 $1,200 $17,500 -

B 20,000 1,600 25,000 800 - $28,500

C 15,000 800 12,000 400 - 10,500

$51,000 $3,400 $56,000 $2,400 $17,500 $39,000


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A. Assume that these securities represent tradingsecurities. How much income would be recognized during 2003

and 2004? How would these securities be presented on the

balance sheet on December 31, 2003 and 2004?

B. Assume that these securities represent available

for sale securities by Wonder Corporation. Howwould your answer to part A change?


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Solution2003 2004

Income Statement:

Dividend Revenue

(the total in the dividend column)

Unrealized Holding Gain (Loss):

2003: ($56,000 - $51,000)

2004: ($17,500 - $19,000)

Realized Holding Gain $39,000 -

($12,000 + $25,000)

$3,400

5,000

--

$8,400

$2,400

(1,500)

2,000

$2,900

Balance Sheet:

Current Assets:

Marketable Securities $56,000 $17,500

A. Trading Securities


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2003 2004

Income Statement:

Dividend Revenue

Realized Holding Gain:[$39,000($15,000 + $20,000)]

$3,400

--

$3,400

$2,400

4,000

$6,400

B. Securities Available for Sale


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2003 2004

Balance Sheet:

Current Assets:

Marketable Securities $56,000 $17,500

Shareholders Equity:

Net Unrealized Holding Gain (Loss) on

Securities Available for Sale:

($56,000 - $51,000)($17,500 - $16,000)

5,000--

--(1,500)

B. Securities Available for Sale


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Disclosures About Securities

FASB Statement No. 115 requires the following

disclosures each period:

The aggregate market value, gross unrealized holding

gains, gross unrealized holding losses, and amortizedcost for debt securities held to maturity and debt and

equity securities available for sale

The proceeds from sales of securities available for sale

and the gross realized gains and gross realized losses onthose sales


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Disclosures About Securities

The change during the period in the net

unrealized holding gain or loss on securities

available for sale included in a separate

shareholders equity account

The change during the period in the net

unrealized holding gain or loss on trading

securities included in earnings


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Controversy Surrounding the Accounting

for Marketable Securities

The accounting for marketable securities has been

controversial. The accounting issues are as

follows:

Whether to report the investments at historical cost or atmarket value on the balance sheet date

If reported at market value, when to record the gain/loss

from the change in market value in the income

statement Each period?

Only when the firm disposes of the investments?


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Keep in mind

We have seen that there are two

measurement basis for recording

securities:Amortized cost

Market value

Which method gives us the a betterestimate of the value of the securities?


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Amortized cost is based on the historical cost

measurement rule and avoids manipulation in the

financial statements. But historical cost does not

capture any change in value since acquisition.Market prices give the change in value since

acquisition. But (fair) market values can be biased

if market values are estimated. Actual marketprices can be bubble prices which are not fair

value.

Documents

Accounting Clinic III