1. Chapter 4
Investments

2. Learning Objectives
Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.
Understand the procedures for discount and premium amortization on bond investments.
Identify the categories of equity securities and describe the accounting and reporting treatment for each category.
Explain the equity method of accounting and compare it to the fair value method for equity securities.
Describe the disclosure requirements for investments in debt and equity securities.
Discuss the accounting for impairments of debt and equity investments.
Describe the accounting for transfer of investment securities between categories.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

3. Temporary Investments
Use of idle cash
Low risk investments
Quickly and easily converted to cash
Securities of federal, state, and local government agencies 3 3 3 3

4. Long-Term Investments
Develop beneficial intercompany relationships.
May indirectly improve profitability of investing company.
May represent ownership interest. 4 4 4 4

5. Accounting Issues Classification
-- Management’s intended holding period for the security
Valuation and investment income measurement
-- Cost vs. fair value
-- Treatment of holding gains & losses
Disclosure 5 5 5 5

6. Classifying Investments
Debt or equity security?
Fair value readily determinable?
Management’s intended holding period?
Influence or control over investee?
-- Only for equity securities with voting
rights 6 6 6 6

7. Debt Securities Represent creditor relationship with an entity.
-- US Treasury securities, municipal securities, corporate bonds, convertible debt, commercial paper, and redeemable preferred stock 7 7 7 7

8. Equity Securities
Represent ownership interest in an entity or the right to acquire or to dispose of an ownership right at a fixed price.
-- Common stock, preferred stock, warrants, rights, and options 8 8 8 8

9. Securities 8 8 8 9

10. Securities
Trading securities (TS) are bought and held primarily to be sold in the near term. 8 8 11 8

11. Securities
Securities available for sale (SAS) are expected to be held for an unspecified period of time. 8 8 12 8

12. Securities
Held to maturity (HTM) securities are those where the investor intends and has the ability to hold the security to maturity date. 8 8 10 8

13. Equity Securities Fair Value
Amount at which a financial instrument could be exchanged in a current transaction between a willing buyer and willing seller 12 12 13 12

14. TS and SAS Fair Value Recorded at cost when acquired.
Purchase price and incidental costs
Basket purchase requires allocation of the total cost to each class of security purchased.
Based on relative market values 16 16 14 16

15. TS and SAS Fair Value
Kent Company purchases the following securities on May 1, 2006, as an investment in available-for-sale securities:
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
Total $68,000

16. TS and SAS Fair Value
Investment in Available-for-Sale Securities ,000
Interest Revenue
Cash ,625

17. TS and SAS Fair Value Interest Revenue 750
Accrued interest on the D Company bond from November 30, 2005, to May 31, 2006
$15,000 x 0.10 x 6/12
May 31, 2006
Cash 750
Interest Revenue 750

18. TS and SAS Fair Value December 31, 2006 Interest Receivable 125
Interest Revenue 125
$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.
Cash 3,000
Dividend Revenue 3,000

19. TS and SAS Fair Value
TS and SAS are reported at fair value on the balance sheet.
The difference between the fair value and the carrying value from the previous balance sheet date (or the cost if acquisition occurred in the current period) is an unrealized holding gain or loss. 17 17 15 17

20. TS and SAS Fair Value
The unrealized holding gain or loss must be determined for individual securities.
Each security has a valuation allowance account (Allowance for Change in Value of Investment). 18 18 16 18

21. TS and SAS Fair Value
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
12/31/06
100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000
300 shares of B Co. common stock 24,000 23,500 (500)
200 shares of C Co. preferred stock 24,000 26,000 2,000
D Company 10% bonds 15,000 15,
Totals $68,000 $71,000 $3,000

22. TS and SAS Fair Value
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
Valuation Allowance 3,000
Unrealized Holding Gain of Loss 3,000
12/31/06
100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000
300 shares of B Co. common stock 24,000 23,500 (500)
200 shares of C Co. preferred stock 24,000 26,000 2,000
D Company 10% bonds 15,000 15,
Totals $68,000 $71,000 $3,000

23. The same securities are held on December 31, 2007.
TS and SAS Fair Value
The same securities are held on December 31, 2007.
Cumulative
Change
Fair in Fair
Security Cost Value Value
12/31/07
100 shares of A Co. common stock $ 5,000 $ 6,100 $1,100
300 shares of B Co. common stock 24,000 22,700 (1,300)
200 shares of C Co. preferred stock 24,000 23,200 (800)
D Company 10% bonds 15,000 14,000 (1,000)
Totals $68,000 $66,000 $(2,000)

24. TS and SAS Fair Value
12/31/06 3,000
5,000 adjusting entry
2, /31/07
Unrealized Holding Gain of Loss 5,000
Valuation Allowance 5,000

25. TS and SAS Fair Value
The individual unrealized holding gains and losses are added together to arrive at the net portfolio unrealized holding gain or loss.
Net unrealized holding gains and losses are calculated separately for the TS portfolio and the SAS portfolio. 19 19 17 19

26. TS and SAS Fair Value
Cars Ltd. purchased the following securities in The fair value of the securities at December 31, 2004 is also indicated. 20 20 18 20

27. TS and SAS Fair Value
Prepare the necessary journal entries for Cars Ltd. to adjust the securities to fair market value at December 31, 2004. 21 21 19 21

28. TS and SAS Fair Value 22 22 22 20

29. TS and SAS Fair Value 23 23 23 21

30. Net Unrealized Holding Gains and Losses
Trading securities:
The net unrealized holding gain or loss is treated as a component of investment income and is included on the income statement for the period. 24 24 22 24

31. Net Unrealized Holding Gains and Losses
Securities available for sale:
The net unrealized holding gain or loss is not included in earnings for the period but rather is closed to a separately reported component of stockholders’ equity. 25 25 23 25

32. TS and SAS Investment Income
Investment income (interest and dividends) is included in the earnings of the current period. 26 26 24 26

33. TS and SAS Example
Cars Ltd. TS and SAS portfolios were as follows on December 31, ×5. 27 27 25 27

34. TS and SAS Example
Determine the unrealized holding gains or losses for Cars Ltd.’s TS and SAS portfolios at December 31, X5. 28 28 26 28

35. TS and SAS Example
Cars Ltd. TS and SAS portfolios were as follows on December 31, X5. 29 29 27 29

36. TS and SAS Debt Securities
Investment income for debt securities includes interest plus the amortized portion of any premium or discount related to the debt.
The amortized cost of the debt is compared with the fair value to determine the unrealized holding gain or loss. 31 31 28 31

37. MacTrucks TS and SAS Example
On 1/1/X5 MacTrucks acquired $100,000 face value bonds of Engines, Inc. The bonds mature in 8 years and pay interest annually on 12/31 at a rate of 8%. MacTrucks acquired the bonds at 96 and intends to sell the bonds in the near term. Prepare the entry for 1/1/X5.
MacTrucks 32 32 29 32

38. TS and SAS Example 33 33 33 30

39. MacTrucks TS and SAS Example
On 12/31/X5 MacTrucks received the annual dividend. The bonds had a fair value of 97 on 12/31/X5. Prepare the entry to record the investment income and the unrealized holding gain or loss.
MacTrucks 34 34 31 34

40. TS and SAS Example 35 35 35 32

41. Investment in Engines, Inc.
TS and SAS Example
Investment in Engines, Inc.
$ 96,000
500
96,500
Amortized Cost
Fair Value $97,000 - $96,500 = $500 Unrealized Gain 37 37 33 37

42. TS and SAS Example 38 38 38 34

43. TS and SAS Transfers
Transfers are accounted for at fair value on the transfer date.
Fair value at the reclassification date is regarded as cost of the security for accounting purposes. 39 39 35 39

44. TS and SAS Example
The Pet Shop has the following investment classified as available for sale. On 12/31/X8, Pet Shop’s intent changes and the security is reclassified as a trading security. Prepare the reclassification entry. 44 44 39 44

45. TS and SAS Example 45 45 45 40

46. Holding gain not recognized on previous income statements
TS and SAS Example
Fair Value
Cost
Holding gain not recognized on previous income statements 46 46 41 46

47. TS and SAS Example
The Pet Shop has the following investment classified as a trading security. On 12/31/X8, Pet Shop’s intent changes and the security is reclassified as available for sale. Prepare the reclassification entry. 41 41 36 41

48. TS and SAS Example 42 42 42 37

49. Holding gain not recognized on previous income statements
TS and SAS Example
Fair Value
Cost
Holding gain not recognized on previous income statements 43 43 38 43

50. TS and SAS Sales
Sales are accounted for in a manner similar to transfers.
The only difference is that Cash is debited instead of the fair value of the securities. 47 47 42 47

51. TS and SAS Sales
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.
Cash 6,000
Investment in SAS 5,000
Gain on Sale of SAS 1,000
The Unrealized Holding Gain of Loss (DR) and the allowance (CR) account are reduced by $1,100.
Unrealized Holding Gain of Loss ,100
Valuation Allowance ,100

52. TS and SAS Impaired Value
A decline in fair value below cost that is not expected to be recovered. Trading securities: Any impairment in fair value is included in the unrealized holding gain or loss that is already included in periodic income. 48 48 43 48

53. TS and SAS Impaired Value
Securities available for sale:
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. 49 49 44 49

54. TS and SAS Disclosures
For SAS, disclose gross unrealized holding gains and gross unrealized holding losses.
For debt securities classified as SAS, disclose contractual maturities. 50 50 45 50

55. TS and SAS Disclosures For each period covered by income statement:
Net proceeds from sales of SAS and gross realized gains and gross realized losses
Basis on which cost was determined
Gross gains and gross losses included in income from transfers from SAS
Amount of net unrealized gain or loss for SAS that is included in equity
Amount of net unrealized holding gain or loss on TS included in earnings 51 51 46 51

56. Cost Method Equity Amortized Fair Value52 52 52 47

57. Securities 8 8 8 48

58. Securities
For securities without a fair market value, dividends are included in investment income. 8 8 49 8

59. Securities For HTM securities: Amortize any premium or discount to
investment income.
Include interest received in investment income. 8 8 50 8

60. Securities
The equity method is used for investments in equity securities resulting in significant influence, but not controlling interest. 8 8 51 8

61. 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. 56 56 52 56

62. Equity Method
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 Company 125,000
Cash 125,000
S Company pays a $20,000 dividend.
Cash 5,000
Investment in Stock: S Company 5,000

63. Equity Method
S Company reported net income for 2007 of $81,000, consisting of ordinary income of $73,000 and an extraordinary gain of $8,000.
25% of $81,000
25% of $73,000
Investment in Stock: S Company 20,250
Investment Income: Ordinary 18,250
Investment Income: Extraordinary 2,000
25% of 8,000

64. Investment Book Value Difference X
Equity Method
Investment Book Value Difference X
% of Investment
50,000 X 25% = ,500
Balance Sheet
Book Value Fair Value
Depreciable assets $400,000 $450,000
(remaining life, 10 yrs)
Other nondepreciable assets 190, ,000
(e.g., land)
Total $590,000 $696,000
Liabilities $200,000 $220,000
Common Stock 250,000
Retained earnings 140,000
Total $590,000

65. Equity Method
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: Ordinary 1,250
Investment in Stock: S Company 1,250
$12,500 /
10 years
Note that this entry results in a deduction from ordinary income.

66. Equity Method Summary
Record proportionate share of investee’s reported earnings.
Record dividends received from investee.
Record proportionate share of additional expense items if investor paid more than book value.
Record any gain or loss on the sale of portions of the investment.
-- Carrying value - proceeds
Eliminate any intercompany profits or losses arising from transactions between the investor and the investee firms. 63 63 59 63

67. Changing From Equity to Fair Value
When ownership level falls below a significant influence, the investor must change to the fair value method.
At the transfer date, the carrying value of the investment under the equity method is regarded as cost. 65 65 61 65

68. Changing From Equity to Fair Value
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. 66 66 62 66

69. Changing From Fair Value to Equity
When ownership level increases to a significant influence, the investor must 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. 67 67 63 67

70. Changing From Fair Value 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.
From this point on, the equity method is applied as usual. 68 68 64 68

71. Equity Method Disclosures
Investee name and percent ownership
Investor accounting policy
Amount and accounting for any difference between carrying value and investee’s net assets
Quoted market price of common stock investments
For material investments, summarized information regarding investee’s assets, liabilities and results of operations 69 69 65 69

72. Equity Investments Special Issues
Stock dividends and stock splits
-- Not included in investment revenue.
-- Increase in number of shares reduces carrying value per share. 74 74 70 74

73. Equity Investments Special Issues
Stock rights
-- Allocate investment cost between stock and stock rights based on market value of stock and stock rights.
-- Reported at fair market value. 75 75 71 75

74. We’re in the Home Stretch!!76 76 76 72

75. C 4
hapter
The End
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