Investments C hapter 15 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 1. Explain the classification and valuation of investments. 2. Account for investments in debt and equity trading securities. 3. Account for investments in available- for-sale debt and equity securities. 4. Account for investments in held-to- maturity debt securities, including amortization of bond premiums and discounts. Objectives

3 5.Understand transfers and impairments. 6.Understand disclosures of investments. 7.Explain the conceptual issues regarding investments in marketable securities. 8.Account for investments using the equity method. 9.Describe additional issues for investments. 10.Account for derivatives of financial instruments. (Appendix) Objectives

4 1. Additional revenues from idle cash. 2. Control over another company. 3. Beneficial relationship with another company. Why Companies Invest in Other Companies

5 Classification of Investments 1. Trading securities 2. Available-for-sale securities 3. Held-to-maturity debt securities

6 Trading securities are investments in debt and equity securities that are purchased and held principally for the purpose of selling them in the near term. Classification of Investments

7 Trading securities are investments in debt and equity securities that are purchased and held principally for the purpose of selling them in the near term. These securities are reported at their fair market value on the balance sheet date, and unrealized holding gains and losses are included in net income of the period. Trading Securities

8 Investments in available-for- sale securities are (a) debt securities that are not classified as being held to maturity, and... Available-for-Sale Securities

9 …(b) debt and equity securities that are not classified as trading securities. Available-for-Sale Securities

10 Investments in available-for-sale securities are reported at their fair value on the balance sheet date. The unrealized holding gains or losses are included in other comprehensive income. Available-for-Sale Securities

11 Therefore, the unrealized holding gains and losses for available-for- sale securities are not included in net income. Available-for-Sale Securities

12 Investments in held-to-maturity debt securities are debt securities for which the company has the positive intent and ability to hold until they mature. Held-to-Maturity Securities

13 Investments in held-to-maturity debt securities are reported at their amortized cost on the balance sheet…not their fair value. Held to Maturity Securities

14 Accounting for Investments Reporting of Unrealized Holding Method Gains and Losses Investment in Equity Securities 1. No significant influence a.TradingFair valueNet Income b.Available for saleFair valueOther comprehen- sive income 2.Significant influenceEquity methodNot recognized 3.ControlConsolidationNot recognized

15 Accounting for Investments Reporting of Unrealized Holding Method Gains and Losses Investment in Debt Securities 1.TradingFair valueNet Income 2.Available for saleFair valueOther comprehen- sive income 3.Held to maturityAmortized costNot recognized

16 Investments in Available-for-Sale Debt and Equity Securities 1. The investment is initially recorded at cost. 2. It is subsequently reported at fair value. 3. Unrealized holding gains and losses are reported as a component of other comprehensive income. 4. Interest and dividend revenue, as well as realized gains and losses on sales, are included in net income for the current period.

shares of A Company common stock at $50 per share 300 shares of B Company common stock at $80 per share 200 shares of Company C preferred stock at $120 per share. $15,000 Company D 10% bonds 100 shares of A Company common stock at $50 per share 300 shares of B Company common stock at $80 per share 200 shares of Company C preferred stock at $120 per share. $15,000 Company D 10% bonds $ 5,000 24,000 15,000 $ 5,000 24,000 15,000 Kent Company purchases the following securities on May 1, 2006, as an investment in available-for-sale securities: Total $68,000 Investments in Available-for-Sale Debt and Equity Securities

18 Investment in Available-for-Sale Securities68,000 Interest Revenue625 Cash68,625 See Page 709 Investments in Available-for-Sale Debt and Equity Securities

19 Accrued interest on the D Company bond from November 30, 2005, to May 31, 2006 May 31, 2006 Interest Revenue750 $15,000 x 0.10 x 6/12 Investments in Available-for-Sale Debt and Equity Securities Cash750

20 December 31, 2006 Interest Receivable125 Interest Revenue125 Cash3,000 Dividend Revenue3,000 $15,000 x 0.10 x 1/12 During 2006 Kent Company receives dividends of $3,000 from its investment in the stocks of A, B, and C Companies. Investments in Available-for-Sale Debt and Equity Securities

21 The cost and fair value of the available-for-sale securities held by the Kent Company is as follows: Cumulative Change Fair in Fair Security Cost Value Value 100 shares of A Co. common stock$ 5,000$ 6,000$1, shares of B Co. common stock24,00023,500(500) 200 shares of C Co. preferred stock24,00026,0002,000 D Company 10% bonds15,00015, Totals$68,000$71,000$3,000 Investments in Available-for-Sale Debt and Equity Securities 12/31/06

22 The cost and fair value of the available-for-sale securities held by the Kent Company is as follows: Cumulative Change Fair in Fair Security Cost Value Value 100 shares of A Co. common stock$ 5,000$ 6,000$1, shares of B Co. common stock24,00023,500(500) 200 shares of C Co. preferred stock24,00026,0002,000 D Company 10% bonds15,00015, Totals$68,000$71,000$3,000 Investments in Available-for-Sale Debt and Equity Securities 12/31/06 Allowance for Change in Value of Investment3,000 of Investment3,000 Unrealized Increase/Decrease Unrealized Increase/Decrease in Value of Available-for- in Value of Available-for- Sale Securities3,000 Sale Securities3,000 Allowance for Change in Value of Investment3,000 of Investment3,000 Unrealized Increase/Decrease Unrealized Increase/Decrease in Value of Available-for- in Value of Available-for- Sale Securities3,000 Sale Securities3,000

23 The same securities are held on December 31, Cumulative Change Fair in Fair Security Cost Value Value 100 shares of A Co. common stock$ 5,000$ 6,100$1, shares of B Co. common stock24,00022,700(1,300) 200 shares of C Co. preferred stock24,00023,200(800) D Company 10% bonds15,00014,000(1,000) Totals$68,000$66,000$(2,000) Investments in Available-for-Sale Debt and Equity Securities 12/31/07

24 12/31/06 3,000 5,000 adjusting entry 2,000 12/31/07 Allowance for Change in Value of Investment Unrealized Increase/Decrease in Value of Available-for-Sale Securities5,000 Value of Available-for-Sale Securities5,000 Allowance for Change in Value of Allowance for Change in Value of Investment5,000 Investment5,000 Unrealized Increase/Decrease in Value of Available-for-Sale Securities5,000 Value of Available-for-Sale Securities5,000 Allowance for Change in Value of Allowance for Change in Value of Investment5,000 Investment5,000

25 Sale of Available-for-Sale Securities On March 1, 2008, the Kent Company sold 100 shares of A Company stock for $6,000. The stock had a fair value on Dec. 31, 2007, of $6,100. Cash6,000 Investment in Available-for- Sale Securities5,000 Gain on Sale of Available-for- Sale Securities1,000 The Unrealized Increase/Decrease in Value (DR) and the allowance (CR) account are reduced by $1,100.

26 Cumulative 12/31/08 Change Fair in Fair Security Cost Value Value 300 shares of B Co. common stock$24,000$23,500$(500) 200 shares of C Co. preferred stock24,00024, D Company 10 bonds15,00014,700(300) Totals$63,000$62,300$(700) Available-for-Sale Securities December 2008

/31/08 2,400 adjusting entry 2,000 12/31/07 1,100 3/1/08 Allowance for Change in Value of Investments Allowance for Change in Value of Investment2,400 Unrealized Increase/Decrease in Value of Available-for-Sale Securities2,400 Value of Available-for-Sale Securities2,400 Allowance for Change in Value of Investment2,400 Unrealized Increase/Decrease in Value of Available-for-Sale Securities2,400 Value of Available-for-Sale Securities2,400

28 Classify Recognize Recognize Compute According to Interest and Realized Realized Management Dividend Gain or Gain or Intent as: Revenue in: Loss in: Loss as: Trading Net Income Net Income Selling Price minus Fair Value at Most Recent Balance Sheet Date Available-Net IncomeNet IncomeSelling price minus for-Sale(Amortized) Cost Held-to-Net IncomeNet IncomeSelling Price minus Maturity(Amortized) Cost Accounting for Investments

29 Investments in Held-to- Maturity Debt Securities 1. The investment is initially recorded at cost. 2. It is subsequently reported at amortized cost. 3. Unrealized holding gains and losses are not recorded. 4. Interest revenue and realized gains and losses on sales (if any) are all included in net income.

30 A company purchases 9% bonds with a face value of $100,000 on August 1, 2006, at 99 plus accrued interest, which is payable semiannually. Investment in Held-to-Maturity Debt Securities99,000 Interest Revenue1,500 Cash100,500 $100,000 x 0.99 $100,000 x 0.09 x 2/12 Investments in Held-to- Maturity Debt Securities

31 Accounting for Bond Premiums On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $102, The stated rate is 13% and the effective interest rate is 12%. Investment in Held-to- Maturity Debt Securities102, Cash102,458.71

32 Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method. Cash6, Investment in Held-to- Maturity Debt Securities Interest Revenue6, $100,000 x 0.13 x 1/2 $102, x.12 x 1/2 Accounting for Bond Premiums

33 Accounting for Bond Discounts On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $97, The stated rate is 13% and the effective interest rate is 14%. Investment in Held-to- Maturity Debt Securities97, Cash97,616.71

34 Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method. Cash6, Investment in Held-to- Maturity Debt Securities Interest Revenue6, $97, x.14 x 1/2 Accounting for Bond Discounts

35 Trading Cost Fair Value Net Income Available- Cost Fair Value Other Compre- for-Sale hensive Income Held-to- Cost Amortized --- Maturity Cost Classify Subsequently Recognize According to Report on the Unrealized Management Initially Balance Holding Gains Intent as: Record as: Sheet at: and Losses in: Investment in Securities

36 Tallen Company purchased 13% bonds with a face value of $200,000 for $204, on April 3, Interest on these bonds is payable June 30 and December 31, and the bonds mature on December 31, Investment in Held-to-Maturity Debt Securities204, Interest Revenue6, Cash211, ContinuedContinued Amortization of Bonds Acquired Between Interest Dates $200,000 x 0.13 x 3/12

37 June 30, 2006 Cash13, Interest Revenue12, Investment in Held-to-Maturity Debt Securities $13,000 – $12, Continued Amortization of Bonds Acquired Between Interest Dates ($204, x 0.12 x ¼) + $6,500 ($204, x 0.12 x ¼) + $6,500

38 December 31, 2006 Cash13, Interest Revenue12, Investment in Held-to-Maturity Debt Securities $13,000 – $12, Amortization of Bonds Acquired Between Interest Dates ($204, $362.75) X 0.12 X 1/2 ($204,575.07

39 The $100,000 of 13% bonds purchased by the Colburn Company for $97, were sold on March 31, 2007, for $102,000 plus accrued interest. Investment in Held-to-Maturity Debt Securities Interest Revenue ($2, ÷ 6) x ½ Continued Sale of Investment in Bonds Before Maturity

40 Sale of Investment in Bonds Before Maturity

41 Cash105, Interest Revenue3, Gain on Sale of Debt Securities3, Investment in Held-to-Maturity Debt Securities98, $98, $ Sale of Investment in Bonds Before Maturity $100,000 x 0.13 x ¼ x 0.13 x ¼$100,000 $102,000 + $3,250 $102,000

42 1.A transfer from the trading category. 2.A transfer into the trading category. 3.A transfer into the available for sale category. 4.A transfer of a debt security into the held to maturity category from the available for sale category. Transfers of Investments Between Categories

43 In 2007, Kent transfers the Company A securities into the trading category when the fair value is $6,300. Investment in Trading Securities6,300 Investment in Available-for- Sale Securities5,000 Gain on Transfer of Securities1,300 Unrealized Increase/Decrease in Value of Available-for-Sale Securities1,100 Allowance for Change in Value of Investment1,100 Transfer from Available-for-Sale to Trading Securities

44 Devon Company has $10,000 in bonds that were purchased at par. When the fair value is $9,500, Devon transfers them to the available-for-sale category. Investment in Available-for-Sale Securities10,000 Investment in Held-to- Maturity Debt Securities10,000 Unrealized Increase/Decrease in Value of Available-for-Sale Securities500 Allowance for Change in Value of Investment500 Transfers from Held-to-Maturity to Available-for-Sale

45 Disclosures 1.Trading Securities--A company must disclose the change in the net unrealized holding gain or loss that is included in each income statement. 2.Available-for-Sale Securities--For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses and (amortized cost) by major types. 3.Held-to-Maturity Debt Securities--For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost by major security types.

46 Devon Company classifies its bond investment as available for sale with a previous fair vale of $9,700, and transfers them into the held-to-maturity category when the current market value of the debt securities is $9,500. Investment in Held-to-Maturity Debt Securities9,500 Unrealized Increase/Decrease from Transfer of Securities500 Investment in Available-for- Sale Securities10,000 ContinuedContinued Transfer from Available-for-Sale to Held to Maturity

47 An entry is needed to eliminate the previous $300 ($9,700 – $10,000) amount in the allowance and unrealized increase/decrease accounts. Allowance for Change in Value of Investment 300 Unrealized Increase/Decrease in Value of Available-for-Sale Securities300 Transfer from Available-for-Sale to Held to Maturity

48 Impairments may be an “other than temporary” decline below the amortized cost of an investment in a debt security classified as available for sale or held to maturity. Impairments

49 Tracy Company has a bond investment categorized as held to maturity, which has an unamortized carrying amount of $21,500 and a fair value of $6,500. The investment is considered to be “impaired.” Realized Loss on Decline in Value15,000 Investment in Held-to-Maturity Debt Securities15,000 Impairments

50 Current Assets Temporary investment in available-for-sale securities (at cost)$29,000 Plus: Allowance for change in value of investment 500 Temporary investment in available-for-sale securities (at fair value)$29,500 Noncurrent Assets Investment in available-for-sale securities (at cost)$39,000 Plus: Allowance for change in value of investment2,500 Investment in available-for-sale securities (at fair value)$41,500 Financial Statement Classification

51 1.Fair value is required in the balance sheet for trading securities and available-for-sale securities, whereas amortized cost is required for held-to-maturity securities. 2.Fair value is not required for certain liabilities. 3.Unrealized holding gains and losses are reported in net income for trading securities, but in other comprehensive income for available-for-sale securities. 4.The classification of securities is based on management intent. FASB 115: A Conceptual Evaluation

52 Equity Method When an investor corporation owns a significantly large percentage of common stock, it is able to exert significant influence over the policies of the investee corporation. The equity method is used to account for this investment.

53  Acknowledges the existence of a material economic relationship between the investor and the investee.  Is based upon the requirements of accrual accounting.  Reflects the change in stockholders’ equity of the investee company. Equity Method

54 According to FASB Interpretation No. 35, what are the facts and circumstances that indicate that investors with 20% or more in the investee’s stock should not use the equity method? Equity Method In the absence of evidence to the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influence.

55  Opposition by the investee which challenges the investor’s ability to exercise significant influence.  The investor and investee sign an agreement under which the investor surrenders significant stockholder’s rights.  Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to views of the investor.  Inability to gather information not available to other shareholders.  Failure to obtain representation on investee’s board of directors. Equity Method Not Used

56 Cliborn Company purchases 4,200 shares of the S company’s outstanding stock (25%) on January 1, 2007, for $125,000 (significant influence). Investment in Stock: S Company125,000 Cash125,000 S Company pays a $20,000 dividend. Cash5,000 Investment in Stock: S Company5,000 See Page 731 Equity Method

57 S Company reported net income for 2007 of $81,000, consisting of ordinary income of $73,000 and an extraordinary gain of $8,000. Investment in Stock: S Company20,250 Investment Income: Ordinary18,250 Investment Income: Extraordinary2,000 25% of $81,000 25% of $73,000 25% of 8,000 Equity Method

58 Balance Sheet Book Value Fair Value Depreciable assets$400,000$450,000 (remaining life, 10 yrs) Other nondepreciable assets 190,000246,000 (e.g., land) Total$590,000$696,000 Liabilities$200,000$220,000 Common Stock 250,000 Retained earnings140,000 Total$590,000 Equity Method Investment Book Value Difference X % of Investment 50,000 X 25% = 12,500

59 When acquired by S Company, the investee’s depreciable assets had a fair market value that exceeded book value by $50,000 (10-year life). Cliborn’s share of the depreciable asset value is $12,500 (25%). Additional depreciation is needed on December 31. Investment Income: Ordinary1,250 Investment in Stock: S Company1,250 Note that this entry results in a deduction from ordinary income. Equity Method $12,500 / 10 years

60 Investment125,000 Ordinary income18,250 Extraordinary income2,000 5,000 Dividends received 1,250 Excess depreciation Ending balance 139,000 Disclosure-Carrying Value

61 Disclosure-Equity Income Share of 2007 ordinary income$18,250 Less: excess depreciation1,250 Ordinary investment income$17,000 Plus: investee extraordinary income2,000 Net investment income$19,000

62 Stock Dividends Smith Corporation purchased 2,000 shares of Kell Company common stock for $30 per share. Two months later, Kell issued a 50% stock dividend. Memo: Received 1,000 shares of Kell Company common stock as a stock dividend. The cost of the shares is now $20 per share, computed as follows: $60,000 ÷ 3,000 (2, ,000) shares.

63 Subsequently, Smith Corporation sold 500 of the shares for $25 per share, and the fair value at the most recent balance sheet date was $23 per share. Cash12,500 Investment in Available-for-Sale Securities10,000 Gain on Sale of Investment2,500 Unrealized Increase/Decrease in Value of Available-for Sale Securities1,500 Allowance for Change in Value of Investment1,500 Stock Dividends

64 Merle Corporation paid an annual insurance premium of $5,500 at the beginning of the year to cover the lives of its officers. Prepaid Insurance5,500 Cash5,500 ContinuedContinued Cash Surrender Value of Life Insurance

65 Insurance Expense4,400 Cash Surrender Value of Life Insurance1,100 Prepaid Insurance5,500 $8,300 – $7,200 Cash Surrender Value of Life Insurance According to the terms of the insurance contract, the cash surrender value increases from $7,200 to $8,300 during the year.

66 Appendix-Derivatives  Derivatives are financial instruments, such as forwards and options whose value depends upon the value of an underlying instrument such as a security, commodity, currency or interest rate. Hence, they are "derived" from these underlying instruments.  Derivatives are used to transfer risk, and companies often use them to reduce the risk of adverse changes in interest rates, commodity prices, and foreign currency exchange rates.  The fair value of a derivative fluctuates with movements in the underlying instrument (for example, if interest rates increase, the value of a swap to pay a fixed interest rate increases).

67 Derivatives  The two basic types of derivatives are: –Forward contracts Forwards Futures Swaps –Option contracts Puts Calls

68 Forward or Future Contracts  Contracts to purchase or sell a commodity or stock, such as grain, oil, or livestock, at a given price in the future. The purpose is to lock in a price. A seller wants to guarantee a current price for future delivery and a buyer wants to assure a steady supply of raw materials at a given price. –A forward is a privately-negotiated contract to be satisfied in the future. –A future is a standardized forward contract, that can be traded on an exchange, like the Chicago Board of Trade. –A swap is a bundle of forward contracts, often used by companies to switch floating-rate debt to fixed-rate debt. Each interest payment would, in effect, be covered by an individual forward contract. A swap combines all these small forward contracts into one instrument.

69 Hedges  Fair value hedge – protects against the risk from changes in value caused by fixed terms, rates or prices. –For example, a company with debt that has a fixed interest rate that enters into an interest rate swap to pay a variable rate of interest and receive a fixed rate. –This protects the company against paying more interest than necessary if interest rates decline. –Gains or losses on the market value of these hedges flow through net income.

70 Hedges  Cash flow hedge – protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain –For example, a company with variable rate debt that enters into a swap to pay a fixed rate of interest and receive a variable rate. –This guarantees that the company will pay a fixed rate, no matter what happens to interest rates in the market. –Gains or losses of “effective” cash flow hedges flow through other comprehensive income. –“Effectiveness” is determined by how well the terms of the hedge, such as time period and notional value, match the terms of the underlying debt.

71 Hedges  Foreign currency hedge -to reduce the risk of currency fluctuation for transactions and investments in foreign currencies. –Foreign currency hedges can be structured so that they behave like fair value hedges OR cash flow hedges.

72 Options  A call enables the owner to purchase a commodity, security, or currency at a set price in the future, but is under no obligation to do so. Any gain or loss is included in net income.  A put enables the owner to sell a commodity, security, or currency at a set price in the future, but again is under no obligation to do so. Any gain or loss is included in net income.

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