BUS780 Chapter 11 Marketable Securities, Derivatives and Investments

BUS780

Chapter 11

Marketable Securities, Derivatives and

Investments

Marketable Securities, Derivatives, and Investments 2

Objectives of the Chapter

1.Classifications of Investments for financial reporting purposes.

2. Using market value method to account for minority, passive investments.

3. Using equity method to account for minority, active investments (i.e., holding 20% or more of investee’s voting shares) .

4. To learn the accounting for consolidated financial statements for majority, active investments (i.e., holding more than 50% investee’s voting shares).


1. Securities for Investments

Investments in debt securities: include U.S. treasury securities, municipal securities, corporate bonds, commercial papers, etc.

Investments in equity securities: include common stock, preferred stock, stock warrants, stock rights, call and put stock options.


Securities for Investments(cont.)

For reporting purposes, all investments in securities must be classified into one of the following three categories at the reporting date:

1. Trading securities;

2. Available-for-sale securities (SAS); or

3. Held-to-maturity (HTM) securities.


Classification of Investments

1.Trading securities: investments in debt and equity securities held for the purpose of selling them in the near future.

2. Available-for-sale securities: Investments in debt and equity securities that are not classified as trading securities and not classified as held-to-maturity securities.


Classification of Investments (cont.)

3.Held-to-maturity securities: investments in debt securities with positive intent and ability to hold these securities to maturity.


Classification of Investments (cont.)

Classifications of investments in securities into these three categories and the subsequent reclassification are based on management’s intent and judgment.


2. Investments - initial recording and end of period reporting (valuation)

1.Initial Recording of all investments: at cost (including commissions).

2. End of Period Reporting:

Trading securities: Reported at their market values on the

balance sheet statement (B/S). The unrealized gains or losses are

included in income statement (I/S) of the current period.


Investments – End of Period Valuation (cont.)

Available-for-sale securities: Reported at their market values on the

B/S. The unrealized gains or losses are

reported as a separate component of stockholders’ equity until realized.

Held-to-maturity securities: Reported at their amortized cost.


Investments - Dividends and Interest revenue Realized dividends, interest revenues

of investments in securities and realized gains or losses from sale of investments are reported on the income statement.


Investments -other valuation methods for equity investments

Other Valuation Methods:

1. Equity method: applied when investments in equity securities with significant influence over the investee (usually owing 20% - 50% of the voting stock). No recognition of unrealized gains or losses.

Equity method results in a partial consolidation statements for the investor.


Investments - other valuation methods for equity investments

2. Consolidated financial statements: applied when the investor(the parent) controls the investee (the subsidiary) through owning over 50% of the investee’s voting stock.

The investor has to issue the consolidated financial statements. No recognition of unrealized gains or losses


Summary of Accounting for Investments (by types of securities)

Reporting of Unrealized HoldingMethod Gains and Losses

A. Invest. In Equity Securities1. No signoficant influencant a. Trading Fair value Income statementb. Available-for-Sale Fair value Stockholders' equity2. Significant influence (20% to 50% ownership) Equity method Not recognized3. Control(more than 50% ownership) Consolidation Not recognizedB. Invest. In Debt Securitiesa. Trading Fair value Income statementb. Available-for-Sale Fair value Stockholders' equityc. Held-to-Maturity Amortized cost Not recognized


Accounting for Investments Classified as Trading Securities

The accounting treatment (SFAS 115)

(a) initial recording: at cost;

(b) end of period reported: at fair value;

(c) unrealized holding gains or losses: reported on the income statement;

(d) interests, dividends, realized gains or losses reported on the income statement


Trading Securities (contd.)

Trading securities are held primarily by banks and stock brokers.

SFAS 115 applies to all industries including specialized industries..


Example A: Trading Securities

Green Company acquired the following securities on 5/1/x5 and reported the investments as trading securities:

Shares $per share

A Company common stock 100 $50


Example A: Trading Securities (contd.)

Initial recording on 5/1/x5:

Marketable Securities 5,000

Cash 5,000

Green received $300 for dividends from investment in A during 20x5:

Cash 300

Invest. Revenue 300



The following info. is available on 12/31/x5:

12/31/x5 Investment ChangeSecurity Cost Fair Value in Fair Value

A $5,000 $6,500 $1,500


Example A: trading Securities (Contd.)

12/31/x5 Adjusting entry (for valuation):


Unrealized Gains**

(losses) on investments 1,500

** reported on the income statement


Example A: trading Securities After the adjusting entry on 12/31/x5:

Marketable Securities Unrealized Gains/Losses

1/1/x5 5,000 1,500a

12/31/x6 1,500

12/31/x6 6,500

a. The unrealized gains of trading securities would be reported on the income statement of 20x5 and closed to income summary on 12/31/20x5




12/31/x5 12/31/x6Security Cost Fair Value Fair Value

A $5,000 $6,500 $6,100


Example A: trading securities (cont.)


Unrealized holding Gains

(losses) on investment** 400

Marketable Securities* 400

** reported on income statement of x6 and will be closed to income summary on 12/31/x6.

* To adjust the balance of marketable securities to $6,100, the market value of A on 12/31/x6.


Example A: trading Securities (contd.) After the adjusting entry on 12/31/x6:


1/1/x6 6,500 400 12/31/x6 400a

12/31/x6 6,100

a. The unrealized losses $400 of trading securities would be reported on the income statement of 20x6 and will be closed to income summary on 12/31/20x6


Example A: trading securities (contd.)

On 2/10/x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction

Cash 6,000Loss on sale of investments 100** Marketable Securities 6,100*

*The marketable securities account is at the fair value as of 12/31/x6.

** for trading securities, the realized loss is the difference between the sales price and the most recent fair value (i.e., $6,100).


Example B: investments classified as available-for-sale securities (SAS)

The accounting treatment of SAS (SFAS 115)

(a) initial recording: at cost;

(b) end of period reported: at fair value;

(c) unrealized holding gains or losses: reported as a separate component of stockholders’ equity on B/S;

(d) interests, dividends, realized gains or losses reported on the I/S


Example B: Accounting for Securities-Available-for-Sale (SAS)

Green Company acquired the following securities and reported them as SAS on 5/1/x5:

Shares $ per share

A Company common stock 100 $50


Example B: SAS (contd.)

Initial recording on 5/1/x5:


Cash 5,000

Green received $300 for dividends from investment in A during 20x5:

Cash 300

Invest. Revenue 300




12/31/x5 Investment ChangeSecurity Cost Fair Value in Fair Value

A $5,000 $6,500 $1,500


Example B: SAS (Contd.)



Unrealized Gains*

(losses) on investments 1,500

* Unlike the reporting for trading securities, this account is to be reported on the balance sheet.


Example B: SAS After the adjusting entry on 12/31/x5:


1/1/x5 5,000 1,500

12/31/x6 1,500

12/31/x6 6,500

a. The unrealized gains of SAS would be reported on the B/S of 20x5 and will be carried over to 20x6.


Balance Sheet Presentation

Balance Sheet 12/31/x5

Assets Liabilities

Investment Securities

at fair value

(cost 5,000) $6,500 Stockholders’ Equity:

Accu. Other Comp. Income

Unrealized gains (losses) on investment 1,500




12/31/x5 12/31/x6Security Cost Fair Value Fair Value

A $5,000 $6,500 $6,100


Example B: SAS (cont.)


Unrealized holding Gains

(losses) on investment** 400

Marketable Securities* 400

* To adjust the balance of marketable securities to $6,100, the market value of A on 12/31/x6.


Example B: SAS (contd.) After the adjusting entry on 12/31/x6:


1/1/x6 6,500 400 12/31/x6 400b 1,500a

12/31/x6 6,100 1,100c

a. The balance on 1/1/x6, carried over from 12/31/x5. b. The adjustment of 12/31/20x6. c. The ending balance on 12/31/06 and is reported on the B/S of 2006.


Balance Sheet Presentation

Balance Sheet 12/31/x6

Assets Liabilities

Investment Securities

at fair value

(cost 5,000) $6,100 Stockholders’ Equity:

Accu. Other Comp. Income

Unrealized holding gains (losses) on investment(1,100)


Example B: SAS (contd.) On 2/10/x7, Green sold 100 shares of A stock for

$6,000. J.E. to record this transaction

Cash 6,000Unrealized holding gains and losses on investments 1,100* Marketable Securities 6,100*

Gain on sale of investments 1,000**

* the balance of unrealized gains and losses on SAS on 2/10/x7.

** The realized gain for SAS is the difference between the sales price and the cost (i.e., $5,000).


Investments in Held to Maturity Securities (debt securities only)

The account treatment (SFAS No. 115):

(a) Initial Recording: at cost*(not using a discount or a premium account);

(b)End of Period Reporting: at amortized cost;

(c)Unrealized Holding Gains or Losses:not recognized.

(d)Interests and realized gains (Losses) on Sale : all included in income.

* the present value


Investments in Held-to-Maturity Securities (HTM)

APB opinion No.21 recommends separate disclosure of face amount ($100,000) and the discount ($1,000).

However, most investors do not use separate accounts for face value and the unamortized discount (or premium).

The discount ($1,000) will be amortized to increase the interest revenue using the effective interest method.


Example C: amortization of discount or premium of investments in held-to-maturity

Assume that Green acquires an investment in bonds that will be held to maturity with a face value of $100,000 for $102,458.71 on 1/1/x5. The stated interest rate is 13% and interests are paid on 6/30 and 12/31. The bonds mature on 12/31/x7. The effective interest rate is 12%*

* 102,458.71 = 100,000 x 0.70496 + 6,500 x 4.91732

semiannual effective interest rate = 6%

6 period 6 period ?%


Example C: (contd.)J.E1/1/x5

Investment in debt securities- HTM 102,458.71

Cash 102,456.71

6/10/x5Cash 6,500

Interest Revenue* 6,147.52 Inv. in HTM 352.48


Example C: (contd.)

* Interest Rev. = Present Value x Effective Rate = 102,458.71 x 6% = 6,147.52

Amortization of Premiums(discounts) on investments decreases (increases) interest revenue.


Bond Investment Interest revenue and Premium Amortization Schedule

Effective Interest MethodInterest Investment in Carrying Value of

Cash Revenue Debt Securities Investment in Date Debita Creditb Creditc Debt Securitiesd

1/1/x5 102,458.71$ 6/30/x5 6,500.00$ 6,147.52$ 352.48$ 102,106.23

12/31/x5 6,500.00 6,126.37 373.63 101,732.606/30/x6 6,500.00 6,103.96 396.04 101,336.56

12/31/x6 6,500.00 6,080.19 419.81 100,916.756/30/x7 6,500.00 6,055.01 444.99 100,471.76

12/31/x7 6,500.00 6028.24c 471.76 100,000.00


Sale of Investment in Securities Held to Maturity Before Maturity

This should not occur unless circumstances changed.

If it does occur, update the interest revenue and the amortization of premium or discount from last interest payment date to the sale date.

To determine the gains or losses, compare selling price (excluding accrued interests) with the updated carrying value.


Transfers Between Reporting Categories

Investment classification is reassessed at each reporting date.Securities investments can be reclassified* at the reporting date if a different reporting category is more appropriate.*an unusual event, disclosures of reasons are required


Transfers (contd.)

At reclassification:1) The security is updated to its fair value.

2) The security is transferred at its fair value.

3) Any unrealized holding gain or loss should be accounted for in a manner consistent with the new reporting category.


Financial Statement Classification

a.Trading securities: current assets.

b.Securities-available-for-sale (SAS): Current or noncurrent depends on whether the securities will be sold in one year or one operating cycle, whichever is longer.

c.Securities-held-to-maturity:current or noncurrent assets.


Financial Statement DisclosureDisclosure notes for investments should

include:

a. Amortized cost (cost basis).

b.Gross unrealized gains.

c. Gross unrealized losses.

d. Estimated fair value.


Impairment of Value

If the decline in the fair value of investment is NOT temporary (i.e., a bankruptcy filing), the value of the securities should be written down to the fair value.

The amount of the write-down should be treated as a realized loss and is included in the income of the year.


Impairment of Value (in Debt Investment) (cont.)

The amount of write down is included in the Income statement as a realized loss.

The fair value becomes the “New” cost and is not changed for the subsequent recovery in the fair value.


3. Equity Method

APB Opinion No.18 requires the use of equity method by an investor who is able to exercise significant influence over the operating and financial policies (i.e., dividends distribution) of an investee.

In the absence to the contrary, an investment of 20% to 50% in the outstanding common stock of the investee leads to the presumption of significant influence.


Equity Method (contd.)

In some cases, the investors hold more than 20% of the outstanding common stock of an investee and do not have significant influence. The equity method should not be used to account for the investment in those cases.


Equity Method (contd.)

A survey of 600 companies conducted by Accounting Trends & Techniques indicated 252 (42%) of the corporations surveyed used the equity method to account for their investments.

The investee companies are referred to as affiliates.


The Accounting Procedures of the Equity Method The investment is originally recorded at

cost of the shares acquired. The investment is subsequently adjusted

each period for the changes in the net assets (equity) of the investee.


The Accounting Procedures of the Equity Method For example, increased (decreased) by

the investors’ proportionate shares of earnings (losses) of the investee and decreased by the dividends received.*

* This is due to investee’s net income will increase investee’s equity while dividends will decrease investee’s equity.


The Accounting Procedures of the Equity Method (contd.)In Summary:

Investment = Acquisition Cost + Investor’s Share of Investee’s Income - Dividends Received


Example D

On 1/1/x9, Clibron Company purchases 4,200 shares of common stock of the Sam Corporation which has 16,800 shares of common stock outstanding on 1/1/x9. Thus, Clibron has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000.

Also, Sam Corp. paid $20,000 dividends on 8/28/x9, and reported net income of 81,000 for 20x9. These events are recorded on Clibron Company’s book as follows:


Example D (contd.)

1. To record the investment on 1/1/x9:

Long-Term Investment 125,000

Cash125,000

2. To record the receipt of dividends on 3/28/x9:

Cash (20,000 x 25%) 5,000

Long-Term Investment (Sam Corp.)5,000


Example D (contd.)

3. To record Clibron Company’s 25% share in the year’s net income:

12/31/x9Long-Term Investment ($81,000 x 25%) 20,250

Investment Revenue20,250


Presentation on the B/S and I/S:

Balance Sheet12/31/x9

AssetsLong-Term Investments, at equity 140,250

Income Statementfor the year ended 12/31/x9

Other Revenue:Investment Revenue20,250


Gain or Loss on Sales of an Equity-Method Investment Gain or loss on sales of an equity-

method investment is measured as the difference between the sale proceeds and the carrying amount of the investment.


Example D (contd.)

On 1/3/00, Clibron Sells 20% of its holding of Sam Corp. for $30,000.

Cash 30,000

Long-Term Investment 28,050*

Gain on Sale of Investment 1,950

* 140,250 x 20% = 28,050


Joint Venture

A joint venture is a separate entity or business project owned by a small group of investors.

Investors of a joint venture usually account for their investments using the equity method even if its share is less than 20%.

This is because these investors usually have significant influence on the joint venture.


Comments Regarding Different Accounting Treatment for Investments Different methods in accounting for

investments will not affect the cash flows, but will affect the earnings.

Reporting investments as SAS can reduce earnings volatility comparing reporting investments as trading securities.


Comments Regarding Different Accounting Treatment for Investments Firms reporting investments as SAS can

cherry pick investments to be sold (i.e., sell the SAS with unrealized gain to report the gain on income statement).

Equity method is to prevent income manipulation by investees who have significant influence on dividends policy.


4. Accounting for Consolidated Subsidiaries When a parent company purchased all or

more than 50% of the outstanding common stock of subsidiary corporations, consolidated financial statements need to be prepared.


4. Accounting for Consolidated Subsidiaries The consolidated statements combine the

balance sheets, income statements and other financial statements of the parent company with those of majority-owned subsidiaries into an overall set of statements as if the parent and its subsidiaries were a single business entity.


Accounting for Consolidated Subsidiaries (contd.) A work sheet is used to combine

financial statements of the parent company and the subsidiaries.

A. Parent corporation owns all of subsidiary’s stock.

B. Parent company owns less than 100% of subsidiary’s stock.


A. Parent Corporation Owns All of Subsidiary’s Stock

Some accounts are eliminated (i.e., the parent company’s investment in subsidiary account and the subsidiary’s equity accounts because the two accounts represent the same thing -- subsidiary equity which is also represented by assets and liabilities of the subsidiary in the combined financial statements).


B. Parent Company Owns Less Than 100% of Subsidiary’s Stock

A minority interest account (on the credit side as a liability) is used to account for the subsidiary’s equity which is held by stockholders other than the parent company.


Exhibit (source: Harrison and Horngren, Exhibit 10-8)

Assets P Company S Company

Cash 33,000 18,000 51,000

Notes receivable from P --- 50,000 (b) 50,000 ---

Accounts receivable, net 54,000 39,000 93,000

Inventory 92,000 66,000 158,000

Investment in S 120,000 --- (a) 120,000 ---

Plant and equipment, net 230,000 123,000 353,000

Total 529,000 296,000 655,000

Liabilities and Stockholders' Equit

Accounts payable 141,000 94,000 235,000

Notes payable 50,000 42,000 (b) 50,000 42,000

Minority interest --- --- (a) 40,000 40,000

Common stock 170,000 100,000 (a) 100,000 170,000

Retained earnings 168,000 60,000 (a) 60,000 168,000

Total 529,000 296,000 210,000 210,000 655,000

Eliminations Consolidated AmountsDebit Credit


Income of A Consolidated Entity

The income of a consolidated entity is the net income of the parent plus the parent’s share (proportion) of the subsidiary’s net income.

Documents

BUS780 Chapter 11 Marketable Securities, Derivatives and Investments