1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Investments in Debt & Equity Securities Chapter 14 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. Learning Objectives 1.Determine why companies invest in other companies. 2.Understand the varying classifications associated with investment securities. 3.Account for the purchase of debt and equity securities. 4.Account for the recognition of revenue from investment securities.

3. Learning Objectives 5.Account for the change in value of investment securities. 6.Account for the sale of investment securities. 7.Record the transfer of investment securities between categories. 8.Properly report purchases, sales, and changes in value of investment securities in the statement of cash flows.

4. Learning Objectives 9.Explain the proper classification and disclosure of investments in securities. 10.Compare the accounting for investment securities under U.S. GAAP with the international standard in IAS 39. 11.Account for the impairment of a loan receivable.

5. Classifications of Investment Securities Debt securities typically have the following characteristics: 1.A maturity value, representing the amount to be repaid to the debt holder at maturity. 2.An interest rate that specifies the periodic interest payments. 3.A maturity date, indicating when the debt obligation will be redeemed.

6. Classifications of Investment Securities Equity securities represent ownership in a company: 1.These shares of stock typically carry with them the right to collect dividends and vote on corporate matters. 2.Equity securities have the potential for significant increases in price.

7. Equity Method Securities Represents ownership in a company. Includes rights to collect dividends and to vote on corporate matters. Potentially purchased with the intent to control or significantly influence the operations of the investee. Despite the general criteria, a 20% investment does not necessarily guarantee significant influence.

8. Determining the Appropriate Accounting Method Equity securities are classified as trading or available for sale when ownership is less than 20 percent. The equity method is used when the investor has the ability to significantly influence or control the investee’s operations.

9. Revenue for Equity Securities Classified as Trading and AFS Deli Co. announces dividends of $0.25 per share. Assume that Citty Co. owns 1,000 shares Cash250 Dividend Revenue 250

10. Revenue for Equity Securities Classified as Trading and AFS Deli Company announces dividends of $0.25 per share. Assume that Citty Co. owns 100,000 which represents 50 percent of the outstanding voting stock. Cash25,000 Investment in Deli Co Stock25,000

11. Revenue for Equity Securities Classified as Trading and AFS Deli Company reports income for the year, $250,000. Assume Citty owns 50% of outstanding voting stock. Investment in Deli Co Stock125,000 Income from Investment in Deli Co Stock 125,000

12. Equity Method: Purchase for More than Book Value Deli Company reports income for the year, $250,000. Assume Citty owns 50% of outstanding voting stock. Investment in Deli Co Stock125,000 Income from Investment in Deli Co Stock 125,000

13. Equity Method: Purchase for More than Book Value The net assets of Stewart Inc. was $500,000 at the time Phillips Manufacturing Co. purchased 40% of the common shares for $250,000 on January 1, 2005. The market value of the net assets of Stewart Inc. would be $625,000, which is $125,000 more than the book value. Only $50,000 of this is attributed to depreciable assets. $250,000 ÷.40 The average remaining life of the depreciable assets is 10 years and the special operating license is to be amortized over 20 years. Additional depreciation ($50,000 x 0.40)/10$2,000 License amortization ($75,000 x 0.40)/20 1,500 $3,500

14. Equity Method: Purchase for More than Book Value Investment in Stewart Inc. Common Stock Acquisition cost250,000 Share of earnings60,000 Dividends 28,000 Additional depreciation2,000 Additional amortization1,500 310,00031,500 Balance278,500 Stewart Inc. declared and paid dividends of $70,000 to common stockholders during 2005, and it reported net income of $150,000 for the year ended December 31, 2005.

15. Accounting for the Change in Value of Securities FASB No. 115 puts an end to “cherry-picking.” This is the practice of selectively selling securities whose prices have increased, while keeping those that have experienced losses or have maintained their historical cost.

16. Accounting for the Change in Value of Securities Partial Balance Sheet for Eastwood Inc. Assets Invest. in trading securities$11,000 Market adjustment—trading sec. (500) $10,500 Invest. in available-for-sale sec.$17,000 Market adjustment 600 17,600 Invest. in held-to-maturity sec. 20,000 $48,100 Stockholders’ Equity Add unrealized increase in available-for-sale securities $ 600 Partial Income Statement for Eastwood Inc. Other expenses and losses: Unrealized loss on trading securities$500

17. Sale of Securities To record accrued revenue and amortize premium: Apr. 1 Interest Receivable2,500 Investment in Held-to Maturity Securities395 Interest Revenue2,105 Entry to record sale: Apr. 1 Cash 103,000 Realized Loss on Sale of Securities 4,353 Interest Receivable2,500 Investment in Held-to Maturity Securities104,853

18. Cash Flows from Gains and Losses on Available-for-Sale Caesh Company began with a $1,000 investment on January 1, 2007. Cash sales $1,700 Cash expenses (1,400) Purchases of investment securities (600) Sale of investment securities (costing $200) 170 The market value of the remaining securities was $500 on December 31, 2005.

19. Cash Flows from Gains and Losses on Available-for-Sale Sales$1,700 Expenses (1,400) Operating income$ 300 Realized loss on sale of securities (30) Net income$ 270 Caesh Company will report a $100 unrealized increase in the value of it available-for-sale portfolio. This $100 unrealized increase is reported as an increase in Accumulated Other Comprehensive Income.

20. Cash Flows from Gains and Losses on Available-for-Sale The statement of cash flows for Caesh Company for 2007 appear as follows: Operating activities: Net income$ 270 Plus realized loss on sale of securities 30 $ 300 Investing activities: Purchase of investment securities$(600) Sale of investment securities 170(430) Financing activities: Initial investment by owner 1,000 Net increase in cash $ 870

21. Classification and Disclosure Trading securities –The change in net unrealized holding gain or loss that is included in the income statement. Available-for-sale securities –Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type. –The proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales and the basis on which cost was determined in computing realized gains and losses.

22. Available-for-sale securities (continued): –The change in net unrealized holding gain or loss on available-for-sale securities that has been included in stockholders’ equity during the period. Held-to-maturity securities: –Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type. –The company should disclose information about contractual maturities. Classification and Disclosure

23. International Accounting for Investment Securities The differences in U.S. and international accounting standards are disappearing. However, understanding the differences allows the user to better use and interpret the global statements. IAS 39 covers the accounting for investment securities.

24. IAS 39 Provisions 1.All financial assets and financial liabilities are initially measured at cost. 2.After initial recognition, all financial assets are to be remeasured to fair value except for: Debt securities intended to be held until maturity Financial assets whose fair value cannot be reliably determined. 3.After acquisition, financial liabilities are to be measured at the original recorded amount, less repayments and amortization. 4.A company can report unrealized gains and losses in one of two ways: In net income of the period or In net income for unrealized gains and losses on trading securities and as part of equity for “nontrading” securities.

25. Accounting for the Impairment of a Loan Occasionally, market value may not exist for the investment. The investor must assess the collectibility of the investment and if and “impairment exists. An adjustment must be made to the value of the receivable. Impairment is measured by comparing the present value of expected future cash flows with the carrying value of the investment.