1. Investments 12
Chapter 12: Investments

2. Accounting for Investment Securities
Bonds and notes
(Debt securities)
Common and preferred stock
(Equity securities)
Investments can be accounted for in a variety of ways depending upon the nature of the investment instrument. We will begin this chapter by looking at the accounting for bonds, or debt securities. Once we’ve completed our discussion of debt securities we will move on to the accounting for equity securities.
Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

3. Reporting Categories for Investments
Investments in securities, that do not represent a significant ownership interest, are placed in one of three categories. Debt securities may be classified as held to maturity, available for sale or trading securities. Equity securities, may only be classified as available for sale or trading securities. Debt securities that are classified as held to maturity are reported on the balance sheet at amortized cost. Debt or equity securities classified as available for sale are shown on the balance sheet at fair value, any unrealized gain or loss associated with the securities is reported in stockholders’ equity. Debt or equity securities classified as trading securities are shown on the balance sheet at fair value, and any unrealized holding gains or losses are reported in current period income.

4. Learning Objectives LO1
Demonstrate how to identify and account for investments classified for reporting purposes as held to maturity.
LO1
Our first learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as held to maturity.

5. Reporting Categories for Investments
Held-to-maturity (HTM) securities are investments in debt the investor intends and has the ability to hold until they mature.
Securities available for sale (SAS) are expected to be held for an unspecified period of time.
Only debt securities may be classified as held to maturity. The investor must intend on holding the securities to maturity and have the ability to do so.
Trading securities (TS) are bought and held primarily to be sold in the near term.

6. Securities to Be Held to Maturity
On January 1, 2006, 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%, so Matrix paid $885,301 for the bonds. Let’s look at the required journal entries.
Part I
On January 1, 2006, Matrix purchased $1 million face amount of 10% bonds with the intent of holding them to maturity. The bonds were purchased for $885,301 cash, to yield Matrix, a 12% return. The bonds mature in 10 years and pay interest semi-annually on June 30th and December 31st. Let’s 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.
$885,301 × (12% ÷ 2) = $53,118

7. Securities to Be Held to Maturity
On January 1, 2006, 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%, so Matrix paid $885,301 for the bonds. Let’s look at the required journal entries.
$114,699 - $3,118 = $111,581 unamortized discount
As of June 30, the discount on 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.

8. Investments Held for an Unspecified Period of Time
When an investment is held for an unspecified period of time, it is reported at the fair value of the security on the reporting date. .
Otherwise, the investment is reported at cost.
When an investment is held for an unspecified period of time, it is recorded on the balance sheet at fair value. If value cannot be readily determined, it is reported at cost.
Must be “readily determinable”

9. Learning Objectives LO2
Demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale.
LO2
Our second learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale.

10. Securities Available-for-Sale
Adjustments to fair value are recorded as:
a direct adjustment to the investment account, and
an allowance account in the equity section of the balance sheet called “Net Unrealized Holding Gains/Losses”.
Adjustments to the fair value of an investment from one period to the next can be made in one of two ways. We can make a direct adjustments to the investment account itself, or we can use an allowance account similar to allowance for bad debts. In either case we’ll recognize and unrealized holding gain or loss. In this presentation, we will treat adjustments to fair value has a direct adjustment to the investment account.

11. Securities Available for Sale Example
Matrix, Inc. purchased the securities listed below in They are classified as Securities Available for Sale (SAS). The fair value of the securities were determined on December 31, Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at December 31, 2006.
During 2006, Matrix purchased two common stocks. The company purchased 1,000 shares of Exxon at $65 per share, and 2,000 shares of Microsoft at $34 per share. Both securities are classified as available for sale. At December 31, 2006, the fair value of the Exxon stock is $70,000, and the fair value of the Microsoft stock is $66,000. The Exxon stock has experienced an unrealized gain of $5,000, the Microsoft stock has experienced an unrealized loss of $2,000. There’s a net unrealized holding gain of $3,000. Let’s see how we account for this net unrealized holding gain.

12. Securities Available for Sale Example.
This net unrealized holding gain is reported as an allowance in the equity section of the balance sheet.
On December 31, we will debit fair value adjustment for $3,000, credit net unrealized holding gains and losses for $3,000.
Because these securities are classified as available for sale, this net unrealized holding gain will be recorded in the equity section of the balance sheet. The amount will be included, with other items, in an account called Other Accumulated Comprehensive Income.

13. Other Comprehensive Income
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.

14. Securities Available for Sale
This partial balance sheet shows how the $3,000 unrealized holding gain will increase the stockholders equity section of Matrix.
Accumulated other comprehensive income from securities available-for-sale are reported in the equity section of the balance sheet as part of Accumulated other comprehensive income.

15. Securities Available for Sale
This is called . . .
Occasionally, an investment’s value will decline for reasons that are “other than temporary”.
Impairment
of Value
Sometimes an investment will incur a permanent decrease in value. We refer to this as an impairment in value.

16. Securities Available for Sale
If the value is impaired . . .
. . . the recorded cost of the security is reduced to the impaired fair value, and the difference is included in the current period’s income.
The new cost basis (the impaired fair value) is not changed for subsequent recoveries in fair value.
When we own the security that has experienced a permanent decline in value, we write down the security to its impaired value and include the difference in the current period income statement. The new cost basis, which is the impaired value, is not changed, if there’s a subsequent temporary change in value.

17. Learning Objectives LO3
Demonstrate how to identify and account for investments classified for reporting purposes as trading securities.
LO3
Our third learning objective in Chapter 12 is to demonstrate how to identify and account for investments classified for reporting purposes as trading securities.

18. Adjustments to fair value are recorded as:
Trading Securities
Adjustments to fair value are recorded as:
a direct adjustment to the investment account, and
a net unrealized holding gain/loss on the Income Statement.
Gains
Losses
Adjustments to fair value for trading securities can be made as a direct adjustments of the investment account. Any net realized holding gain or loss is reported in current period income. Remember, for available for sale securities the net unrealized gains and losses are reported in the balance sheet, and for trading securities, unrealized gains and losses are reported in the income statement.
Income
Statement

19. Trading Securities
Matrix, Inc. purchased the addition securities classified as Trading Securities (TS) in The fair value amounts were determined on December 31, Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at 12/31/06.
At the beginning of 2006, Matrix purchased 1,000 shares of Google and 1,500 shares of Ford Motor to be held as trading securities. The cost of those securities are shown on the table at the bottom of your screen. On December 31, 2006, the fair value of the Google shares is $41,000, and the fair value of Ford Motor shares is $20,000. Let’s see how we record the unrealized holding loss on the securities.

20. The Net Unrealized Holding Loss is reported on the Income Statement.
Trading Securities
At December 31, 2006, the journal entry required is to debit unrealized holding loss for $3,500, credit investment in Google for $1,000, and credit investment in Ford Motor for $2,500. The net unrealized holding loss will be reported in the current period income statement.
The Net Unrealized Holding Loss is reported on the Income Statement.

21. Trading Securities
Unrealized holding gains and losses from trading securities are reported on the income statement.
This slide shows how the unrealized holding loss reduces income from operations.

22. Transfers Between Reporting Categories
Transfers are accounted for at fair value on the transfer date.
Unrealized holding gains or losses at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred.
Transfers between categories of investment should be handled at fair value on the date of transfer. Unrealized holding gains and losses at the date of reclassification, should be accounted for in a manner consistent with the new classification of the security. For example, if we transferred securities from the available-for-sale category to the trading category, the unrealized holding gain or loss would be moved to the income statement.

23. Disclosures Gross Realized & Unrealized Holding Gains & Losses
Aggregate
Fair Value
maturities of
debt securities
The change in
net unrealized
holding gains
& losses
Amortized
cost basis
by major
security type
Listed on this slide are the five disclosures required for investments in securities classified as held-to-maturity, available-for-sale, or trading.

24. Learning Objectives LO4
Explain what constitutes significant influence by the investor over the operating and financial policies of the investee.
LO4
Our fourth learning objective in Chapter 12 is to explain what constitutes significant influence by the investor over the operating and financial policies of the investee.

25. Now we are going to change the accounting for investments dramatically
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. Under these circumstances, the equity method of accounting for the investment is required.

26. The cost method is used for investments in equity securities when significant influence is not present.
The equity method is used for investments in equity securities resulting in significant influence (20%-50%).
When an investment results in the control of the investee (generally > 50%), the subsidiary is consolidated with the parent company.
Part I As an overview we use the cost method for investments in securities, where we do not have significant influence over the operating policies of the other company.
Part II We use the equity method for investments in equity securities, where we own between 20 and 50% of the voting common stock.
Part III If we own more than 50% of the voting common stock, we use another method that is referred to as consolidation.

27. Learning Objectives LO5
Understand the way investments are recorded and reported by the equity method.
LO5
Our fifth learning objective in Chapter 12 is to understand the way investments are recorded and reported by the equity method.

28. Equity Method The investment account is increased by:
Original investment cost.
Proportionate share of investee's earnings.
The investment account is decreased by:
Dividends received.
Under the equity method the investment account is increased by the original investment cost, plus the company’s proportionate share of the investees reported earnings. The investment account is decreased, when dividends are received. 56 56 52 56

29. Equity Method
The investment account is reported on the balance sheet as a single amount.
The investor’s share of the investee’s earnings from date of acquisition is reported as a single item on the investor’s income statement.
When we use the equity method, the investment account has reported on the balance sheet has a single amount. The investor’s proportionate share of the investees earnings is reported as a single amount, in the investor’s income statement. 57 57 53 57

30. Equity Method
On January 1, 2006, Matrix, Inc. acquired 45% of the equity securities of Apex, Inc. for $1,350,000. On the acquisition date, Apex’s net assets had a fair value of $3,000,000. During 2006, Apex cash paid dividends of $150,000 and reported net income of $1,750,000.
What amount will Matrix, Inc. report on the balance sheet as Investment in Apex, Inc.?
Let’s 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 2006, the investee reports earnings of $1,750,000 and pays cash dividends of $150,000. Let’s look at the accounting for this investment under the equity method. 59 59 55 59

31. Equity Method
We can see that the investor paid fair value for the net assets acquired. 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.

32. Equity Method
On December 31, 2006, the company received its proportionate share of the dividends paid by the investee. The journal entry to record the receipt of dividends is to debit cash for $67,500, and credit investment in Apex, Inc. Next the investor recognizes its proportionate share of the reported earnings of the investee. The journal entry is to debit investment in Apex, Inc., and credit investment revenue for $787,500. Notice that the receipt of dividends is not recognized as revenue, but the reported earnings of the investee is recognized as revenue. This concept may be difficult to understand in the beginning, but with a little practice you will be able to master the concept.

33. 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 reduce the investment account, and the 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 be reduced by the investor’s proportionate share of that loss.
If the subsidiary had a loss, the investment account would have been reduced. 62 58 62 62

34. Learning Objectives LO6
Explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceeds their book value at acquisition.
LO6
Our sixth learning objective in Chapter 12 is to explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceed their book value at acquisition.

35. Equity Method
If the investor acquires the equity securities of an investee by paying more than the fair value of net assets . . .
. . . the difference is allocated between GOODWILL and IDENTIFIABLE ASSETS.
If the investor acquires the equity securities at more than the fair value of the net assets acquired, goodwill may be present. 58 58 54 58

36. Equity Method
On January 1, 2006, Matrix, Inc. purchase 25% of the common stock of Apex, Inc. for $200,000. At the date of acquisition, the book value of the net assets of Apex was $480,000, and the net fair value of these assets is $600,000. During 2006, Apex paid cash dividends of $40,000, and reported earnings of $100,000. Let’s prepare the journal entries to reflect the acquisition and other events during 2006.
Part I Please read this information carefully about Matrix’s, 25% purchase of the voting common stock of Apex, Inc.
Part II
The fair value of the net assets acquired by Matrix is $150,000, but the company paid $200,000 for those net assets. In this case we have an excess of cost over fair value of $50,000. On the next slide, we will determine why the company paid in excess of fair value for the net assets Apex. 62 62 58 62

37. Equity Method
Assume that of the $50,000 excess of purchase price over fair value of the net asset acquired, 75% is attributable to depreciable assets with a remaining life of 20 years and the remainder is considered goodwill. Matrix uses the straight-line method of depreciation on similar owned assets.
Of the $50,000 excess of cost over fair value, 75% of that amount is attributable to depreciable assets with the remaining useful life of 20 years. Matrix uses the straight-line method to depreciate similar owned assets. As you can see, Matrix will have to record on its books additional depreciation of $1,875 per year.
The remaining 25% or $12,500 is considered goodwill. As you know goodwill is carried on the books at its unimpaired value. We do not amortize goodwill. 62 62 58 62

38. Remember, goodwill is not amortized.
Equity Method
Matrix will record the following journal entries on its books during We are familiar with the first three entries, that is the purchase of the investment, the recognition of dividends received, and the 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 we must record. The journal entry is to debit investment revenue and credit investment in Apex for $1,875. The additional depreciation reduces the investment revenue we recognized.
Remember, goodwill is not amortized. 62 62 58 62

39. Changing From Equity To Cost
When the investor’s level of influence changes, it may be necessary to change from the equity method to another method.
At the transfer date, the carrying value of the investment under the equity method is regarded as cost.
When we change from the equity method to the cost method, the accounting is quite easy. The carrying value of the investment at the date of transfer, becomes the cost basis under the cost method. 65 61 65 65

40. Changing From Equity To Cost
Any difference between cost and fair value is recorded in a valuation account and is recognized as an unrealized holding gain or loss.
After the transfer, the investment is treated as a trading security or a security available for sale, depending on management’s intent.
At the date of transfer, any difference between cost and fair value will be recognized as an unrealized holding gain or loss. The securities must be classified as available-for-sale or trading, depending upon the intent of management. 66 66 62 66

41. Changing From Cost To Equity
When ownership level increases to a significant influence, the investor may change to the equity method.
At the transfer date, the recorded value is the initial cost of the investment adjusted for the investor’s equity in the undistributed earnings of the investee since the original investment.
Part I When we change from the cost method to the equity method, the accounting can become quite complex. At the date of transfer, we adjust the cost basis of the investment for the total undistributed earnings of the investee since the date of original acquisition.
Part II
Undistributed earnings is defined as reported earnings minus dividends paid. 67 67 63 67

42. Changing From Cost To Equity
The original cost, the unrealized holding gain or loss, and the valuation account are closed.
A retroactive change is recorded to recognize the investor’s share of the investee’s 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. 68 68 64 68

43. Financial Instruments & Derivatives
Cash.
Evidence of an ownership interest in an entity.
Contracts meeting certain conditions.
Derivatives:
Hedges created to offset risks created by other financial investments or transactions.
Value is derived from other securities.
Financial instruments include cash, evidence of ownership interest in an entity, and contracts meeting certain conditions. Derivatives are hedges created to offset risks created by other financial investments or transactions. The value of the derivative is derived from the value of the underlying security.

44. Other Investments Appendix 12A
In the first appendix to chapter 12, we’ll look at special-purpose funds.

45. Special Purpose Funds
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.
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 fair 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.

46. Investment in Life Insurance Policies
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 company’s balance sheet.

47. Impairment of a Receivable Due to a Troubled Debt Restructuring
Appendix 12B
In the second appendix to chapter 12, we will look at the impairment of a receivable as a result of troubled debt restructuring.

48. When the Receivable is Settled Outright
When the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor, the new arrangement is referred to as a troubled debt restructuring.
Sometimes a troubled debt is settled in full when the debtor transfers to the creditor assets or equities. The creditor usually recognized a loss on the settlement. Such a settlement is not considered unusual or infrequent and is not an extraordinary item.
Part I The regional terms of the debt agreement may be changed as a result of financial difficulties experienced by the debtor. When this process occurs, it’s referred to as a troubled debt restructuring.
Part II
A troubled debt restructuring may involve the full settlement of the debt by the transfer of assets for equities from the debtor to the creditor. The creditor usually recognizes a loss on the settlement. The loss is not considered extraordinary.

49. When the Receivable is Settled Outright
Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to accept a parcel of land with a fair market value of $615,000 in full settlement of the debt and the accrued interest.
Part I
Here is an example of a troubled debt restructure where the debt is settled in full by the transfer of land and from the debtor to the creditor. Read through the information carefully, and we will prepare the appropriate journal entry.
Part II
The required general journal entry to record the trouble debt restructuring is to debit land for its fair value of $615, 000, debit loss on troubled debt restructuring for $427,500, credit notes receivable for $1 million, and credit accrued interest receivable for $42,500.

50. When the Receivable is Continued, But with Modified Terms
Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to forgive the accrued interest of $42,500, and reduce the principal amount to $800,000. Interest of $40,000 is due at the end of each year and the principal amount is due in full at the end of five years. Creditor discounts future cash inflows at 6%.
Part I Here is a troubled debt restructuring, where the creditor forgives part of the principal amount and all of the accrued interest. Read through the example, and the first thing we will need to do is to calculate the loss on restructuring.
Part II
The total amount due to the creditor is $1,042,500. The present value of the $40,000 interest payments, discounted at 6%, is $168,495 rounded. The present value of the future principal payment is $597,807 rounded. The present value of the future cash inflows is $766,301. We now know that the loss on restructuring is $276,199.

51. When the Receivable is Continued, But with Modified Terms
The journal entry to record the forgiveness of principal and accrued interest and record the new note is:
The required general journal entry is to debit loss on troubled debt restructuring for $276,199, credit notes receivable for $233,699, and credit accrued interest receivable for $42,500.

52. End of Chapter 12
End of Chapter 12