1. Chapter 13 Investments in Securities

2. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Statement Items Covered Balance SheetIncome Statement Statement of Cash Flows Current Assets Investment securities Derivatives Long-Term Assets Investment securities Stockholders’ Equity Accum unrealized gains/losses from changes in avail for sale securities Accum unrealized gains/losses from derivatives Investment revenue Dividend revenue Realized gains/losses on sale of investment securities Unrealized gains/losses on changes in market value of trading securities Operating Cash received (paid) for sale (purchase) of trading securities Investing Cash received (paid) for sale (purchase) of AFS and HTM securities

3. 3 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Investment Security Issues DeterminePurchaseClassifyEarnMonitorSell the purpose of the investment the investment securities the investment for accounting purposes a return on the securities changes in the market value of the securities the securities

4. Why Companies Invest in Other Companies

5. 5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Companies Invest in Other Companies for... Safety cushion Investments are sometimes made to give a company a ready source of funds as a margin of safety Cyclical cash needs Some companies have a seasonal business cycle requiring large amounts of cash for inventory buildup followed by increased sales and cash collections

6. 6 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Companies Invest in Other Companies for... A return on investment Companies invest simply to earn a rate of return Influence Companies can invest to –Ensure a supply of raw materials –Influence a board of directors –Diversify their product offerings

7. 7 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Companies Invest in Other Companies for... Control –An investment resulting in over 50% ownership of a company’s shares of stock produces a controlling interest –The investing company can control the other company’s operating, investing, and financing decisions

8. Classification of Investment Securities

9. 9 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Debt Securities Debt securities involve a promise of interest payments and repayment of the principal amount of the debt –Debt security investors have priority over equity investors in terms of interest payments and principal in the event of a corporate liquidation

10. 10 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Equity Securities Equity securities represent an actual ownership interest in a corporation –Equity investors have the right to vote in corporate matters such as election of directors –Equity investors may receive a rate of return from dividends and appreciation of stock price

11. 11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting Classification 0f Investment Securities Trading securities are those debt and equity securities purchased with the intent to take advantage of short-term price changes Available-for-sale securities are those debt and equity securities purchased for safety, to hold temporarily excess cash, or to earn a normal long-run return

12. 12 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Held-to-maturity securities are debt securities purchased with the intent of holding the securities until they mature Equity method securities are equity securities purchased in order to exercise ownership influence (at least 20% of the shares) over another company Accounting Classification 0f Investment Securities

13. 13 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting Classification 0f Investment Securities Debt Securities Equity Securities Trading Available for Sale Held To Maturity Equity Method

14. Trading and Available-for-Sale

15. 15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for the Purchase of Securities Investments in securities are recorded at cost Cost includes –The market price –Any additional expenditures required in making the purchase E.g., stockbroker’s fee

16. 16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Interest and Dividends Cash received from interest earned is recorded as Interest Revenue –Interest earned but not received is recorded as Interest Revenue and Interest Receivable Cash received from dividends declared and paid is recorded as Dividend Revenue –Dividends declared but not paid is recorded as Dividend Revenue and Dividend Receivable

17. 17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Realized Gains and Losses on the Sale Of Securities Realized gains and losses from the sale of securities are included in the income statement A gain or loss is realized when it is confirmed and verified through the actual sale of the security

18. Recognizing and Recording Changing Values of Securities

19. 19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Changes in the Value of Trading Securities Changes in the market value (unrealized gains and losses) are recognized in the income statement The market value is reported on the balance sheet as an asset

20. 20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Changes in the Value of Available-for-Sale Securities Changes in the market value are reported as other comprehensive income (not part of net income) The market value is reported on the balance sheet as an asset The accumulated unrealized gain/loss is treated as a stockholders’ equity adjustment

21. 21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Computation of Overall Rate of Return When computing the total return, the numerator includes any dividend revenue, interest revenue, realized gains (losses), and unrealized gains (losses)

22. 22 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Subsequent Changes in Value Unrealized gains (losses) –Measured from beginning of year to end of year –Asset adjusted to end-of-year market value –Gain (Loss) reported Trading portfolio: on income statement Available-for-Sale portfolio: on Balance Sheet (Equity Section) in Accumulated Other Comprehensive Income

23. 23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Subsequent Changes in Value Realized gains (losses) –Measured as the difference between historical cost and the sale proceeds –Gain (Loss) reported Trading portfolio: on income statement Available-for-Sale portfolio: on income statement

24. Held-to-Maturity Securities

25. 25 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Held-to-Maturity Securities Debt securities Intent to hold until maturity date Cash inflows –While owned, interest –At maturity date, maturity value Reported at amortized cost –Unrealized gains and losses are not measured or recognized

26. 26 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Purchase of a Bond DiscountParPremium Purchase price is < face= face> face Market rate of interest is > stated interest rate = stated interest rate < stated interest rate Investment is recorded at cost –Price paid for bonds –Expenditures incurred as part of the purchase

27. 27 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Bond Purchased at a Discount Purchase at a price less than face –By maturity, bond is carried at its face value Purchase to earn a return that is higher –Than the face/stated rate

28. 28 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Amortization of Discount Face amount$20,000Stated interest12% Purchase price$17,381Rate of return16% Cash interest =face amount ×stated rate Interest revenue =investment balance ×rate of return Differenceamortization ofdiscount

29. Equity Securities

30. 30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Equity Method Securities The equity method is used when an investor company has significant influence over an investee company Significant influence is presumed if a company owns between 20% and 50% of the company

31. 31 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Equity Method Securities The investment asset is originally recorded at its acquisition cost Account for activity using the accrual method: –Record revenue as earned, not paid Accrual method prevents manipulation of income by investor entity.

32. 32 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Equity Method Securities The investor’s share of the investee’s reported net income is reported as revenue and increases the carrying value of the Investment account on the balance sheet Cash dividends received are recorded as an increase to Cash and a decrease to the Investment account (return of investment)

33. 33 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Equity Method Summary Balance SheetIncome Statement Cash Investment in Investee Investee Income Investee Loss Purchase Investment (XXX)XXX Investee Reports Net Income XXX Investee Reports Net Loss (XXX)XXX Investor receives dividend XXX(XXX)

34. 34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting For Investment Securities: Summary

35. Consolidated Financial Statements

36. 36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Consolidated Financial Statements When an investor owns a controlling interest (over 50% ownership of the voting stock of the investee) –The investor/parent is able to determine both the financial and operating policies of investee/subsidiary –Consolidated financial statements are required

37. 37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Consolidated Financial Statements Parent/Sub relationship –Each company maintains separate records –The Parent accounts for the Subsidiary by the equity method The consolidated company (parent) represents one economic unit

38. 38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Consolidated Financial Statements The consolidated balance sheet includes all assets and liabilities of the parent and the subsidiaries it controls The consolidated income statement includes all revenues and expenses of the parent and the subsidiaries it controls

39. 39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Consolidated Financial Statements Minority interest reflects the interest of other shareholders for subsidiaries that are not 100% owned by the parent – Balance Sheet : the amount of equity investment made by outside shareholders – Income Statement : the amount of income belonging to outside shareholders

40. Derivatives

41. 41 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Derivatives A contract that derives its value from the movement of the price, exchange rate, or interest rate on some other underlying asset or financial instrument –Does not require a firm to make or take delivery Used as a tool to manage risk

42. 42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Types of Risks Price risk: the uncertainty about the future price of an asset Credit risk: the uncertainty that another party will abide by the terms of an agreement Interest rate risk: the uncertainty about future interest rates and their impact on future cash flows and fair value of assets and liabilities

43. 43 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Derivative: Forward Contract An agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future with a specified price or exchange rate being set now.

44. 44 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Forward Contract Bank MerchantCustomer ¥30,000,000 transaction 11/1/06 when ¥120 = $1 Contract to sell yen to bank on 1/1/07 at ¥120 = $1 At settlement If yen value has fallen, bank pays merchant If yen value has risen, merchant pays bank

45. 45 Financial Accounting, 7e Stice/Stice, 2006 © Thomson A contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate – Interest rate swap : Two parties agree to exchange future interest payments on a given loan amount; one set of payments is based on a fixed interest rate and the other is based on a variable interest rate Derivative: Swap

46. 46 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Interest Rate Swap Lender Pay variable interest Third Party Borrower Pay fixedReceive variable Net effect is to pay fixed interest; swap has protected against rising rates

47. 47 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Traded on an exchange Allows a company to buy a specified quantity of a commodity, currency, or financial security at a specified price on a specified future date Derivative: Futures Contract

48. 48 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Futures Contract Futures Market Buyer On 12/1/06 enter into contract to make a 1/1/07 purchase of 100,000 bushels at $4 At settlement If market price is below strike price, buyer pays If market price is above strike price, payment made to buyer

49. 49 Financial Accounting, 7e Stice/Stice, 2006 © Thomson A transaction entered into to reduce risk; use derivatives to offset changes in the item being hedged Previous Examples: –Forward contract hedged against decline in value of yen –Interest rate swap hedged against increase in variable interest rates –Futures contract hedged against increased wheat prices Hedges & Hedging Activity

50. 50 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Reporting Derivatives (FASB’s U.S. GAAP) Derivatives should be reported on the balance sheet at their fair value Changes in value –Derivatives intended to hedge risk: Gains and losses should be reported in the same year in which the income effects on the hedged item are reported –Speculative derivatives: Recognized in the period of the change

51. 51 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Forward Contract Impact of Change in Yen Exchange Rate 2006 Balance Sheet 2006 Income Statement Underlying item (receivable) Increase in value of A/R¥ Exchange gain DerivativeCreate forward contract liability Loss on forward contract

52. 52 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Interest Rate Swap Impact of Change in Interest Rates 2006 Balance Sheet 2006 Income Statement Underlying item (interest expense) No change in loan balance No ’06 impact but will show up in ’07 interest expense DerivativeCreate a receivable under the interest rate swap Defer gain on swap; recognize in ’07 as offset against higher interest expense

53. 53 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Futures Contract Impact of Change in Wheat Prices 2006 Balance Sheet 2006 Income Statement Underlying item (purchase of wheat) No impact; wheat to be purchased in ’07 No ‘06 impact; higher ’07 cost of goods DerivativeCreate futures contract receivable Defer gain on futures contract; recognize in ’07 as offset against higher cost of goods sold

54. 54 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Notional Amount The amount of dollars that would change hands if the derivative contract was fulfilled to the letter –This almost never happens Notional amounts overstate both the fair value and the potential cash flows of derivatives when reported

55. In Summary... Companies make investments in securities for a variety of reasons Equity investments are classified as trading, available-for-sale, or equity-method; debt security investments are classified as trading, available-for-sale, or held-to-maturity Trading and available-for-sale securities are carried at market value; held-to-maturity bond investments are carried at amortized cost; equity-method investments are carried at adjusted-cost Consolidated financial statements are prepared if the parent owns more than 50% of a subsidiary; minority interest reports the equity of other investors in subsidiaries that are not wholly- owned Derivatives are contracts are often intended to hedge risk