Topic 6
INVESTMENTS
Download Excel file Brief Exercises” in
topic 6 area of Handouts
12-2
Nature of Investments
Bonds and
notes
(Debt
securities)
Common and
preferred stock
(Equity
securities)
Investments can be accounted for in a
variety of ways, depending on the nature
of the investment relationship.
12-3
Reporting Categories for Investments
Reporting Categories for Investments
Control Characteristics of the Investment
Reporting Method Used by the Investor
The investor lacks significant influence over the
operating and financial policies of the investee:
Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at
has the "positive intent and ability" to hold to
amortized cost.*
maturity.
Trading securities (TS) - investment reported at fair
Investment held in an active trading account.
value with unrealized holding gains and losses included
in net income.
Securities available-for-sale (AFS) - investment
reported at fair value with unrealized holding gains and
Other.
losses excluded from net income and reported in other
comprehensive income.*
The investor has significant influence over the
operating and financial policies of the investee:
Typically the investor owns between 20% and 50%
Equity method - investment cost adjusted for
of the voting stock of the investee.
subsequent earnings and dividends of the investee.*
The investor controls the investee:
The investor owns more than 50% of the voting
Consolidation - the financial statements of the investor
stock of the investee.
and investee are combined as if they are a single
company.
* If the investor elects the fair value option , this type of investment also can be accounted for using the same approach that's used for
trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
12-4
Investor Lacks Significant Influence
Reporting Approach
Held-to-maturity (HTM): used for debt
that is planned to be held for its entire
life
Treatment of Unrealized
Holding Gains and Losses
Not recognized
Investment
Reported in the
Balance Sheet at
Amortized Cost
Trading (TS): used for debt or equity
that is held in an active trading
account for immediate resale, or for
which the fair value option had been
elected.
Recognized in net income
and therefore in retained
earnings as part of
stockholders' equity
Fair Value
Available-for-sale (AFS): used for debt
or equity that does not qualify as
held-to-maturity or trading.
Recognized in other
comprehensive income,
and therefore in
accumulated other
comprehensive income
in shareholders' equity
Fair Value
12-5
Securities to Be Held to Maturity
Securities are investments in bonds or other debt security that
have a specified maturity date. The bonds or other debt are
initially recorded at cost. The investor may have the “positive
intent and ability” to hold the securities to maturity and can
therefore be classified as held-to-maturity (HTM).
They are reported on the balance sheet at “amortized cost.”
Amortized cost (Face amount less unamortized
discount, or plus unamortized premium).
Balance
Sheet
12-6
Securities to Be Held to Maturity
On January 1, 2013, Matrix Inc. purchased as an investment
$1,000,000, of 10%, 10-year bonds, interest paid semiannually. The market rate for similar bonds is 12%. Let’s look
at the calculation of the present value of the bond issue.
Present
Amount
PV Factor
Value
Interest $ 50,000 × 11.46992 = $573,496
Principal 1,000,000 × 0.31180 = 311,805
Present value of bonds
$885,301
PV of ordinary annuity of $1, n = 20, i = 6%
PV of $1, n = 20, i = 6%
12-7
Securities to Be Held to Maturity
Partial Bond Amortization Table
Date
1/1/13
6/30/13
12/31/13
6/30/14
12/31/14
Interest
Payment
$
50,000
50,000
50,000
50,000
Interest
Revenue
$
53,118
53,305
53,503
53,714
Discount
Amortization
$
January 1, 2013
Investment in bonds
Discount on bond investment
Cash
June 30, 2013
Cash (stated rate × face amount)
Discount on bond investment
Investment revenue
3,118
3,305
3,503
3,714
Unamortized
Discount
$ 114,699
111,581
108,276
104,772
101,059
Carrying
Value
$ 885,301
888,419
891,724
895,228
898,941
1,000,000
114,699
885,301
50,000
3,118
53,118
12-8
Securities to Be Held to Maturity
This investment would appear on the
June 30, 2013, balance sheet as follows:
June 30, 2013
Investment in bonds
Less: Discount on bond investment
Book value (amortized cost)
$ 1,000,000
111,581
$ 888,419
$114,699 - $3,118 = $111,581 unamortized discount
Unrealized holding gains and losses are not
recognized for HTM investments.
12-9
Securities to Be Held to Maturity
On December 31, 2013, after interest is received by Matrix, all the bonds
are sold for $900,000 cash.
Date
1/1/13
6/30/13
12/31/13
6/30/14
12/31/14
Interest
Payment
$
50,000
50,000
50,000
50,000
Interest
Revenue
$
53,118
53,305
53,503
53,714
December 31, 2013
Cash
Discount on bond investment
Investment revenue
Discount
Amortization
$
3,118
3,305
3,503
3,714
Unamortized
Discount
$ 114,699
111,581
108,276
104,772
101,059
50,000
3,305
December 31, 2013
Cash
900,000
Discount on bond investment
108,276
Investment in bonds
Gain on sale of investment
53,305
1,000,000
8,276
Carrying
Value
$ 885,301
888,419
891,724
895,228
898,941
12-10
Brief Exercise 12-1
Lance Brothers Enterprises acquired $720,000 of 3% bonds,
dated July 1, on July 1, 2013, as a long-term investment.
Management has the positive intent and ability to hold the
bonds until maturity. The market interest rate (yield) was
4% for bonds of similar risk and maturity. Lance Brothers
paid $600,000 for the investment in bonds and will receive
interest semiannually on June 30 and December 31. Prepare
the journal entries (a) to record Lance Brothers’
investment in the bonds on July 1, 2013, and (b) to record
interest on December 31, 2013, using the effective (market)
rate method.
12-11
Trading Securities
Investments in debt or equity securities acquired principally for
the purpose of selling them in the near term.
Adjustments to fair value are recorded
1. in a valuation account called fair value adjustment, or as a
direct adjustment to the investment account.
2. as a net unrealized holding gain/loss on the income statement.
Unrealized Gain
Unrealized Loss
Income
Statement
12-12
Trading Securities
Matrix Inc. purchased securities classified as Trading Securities (TS)
on December 22, 2013. The fair value amounts for these
securities on December 31, 2013, are shown below. Prepare the
journal entries for Matrix Inc. to show the purchase of the
securities, and adjust the securities to fair value at 12/31/13.
Type
TS
TS
Name
Mining Inc
Toys and Things
Totals
No. of
Shares
1,000
1,500
12/22/13
12/31/13 Unrealized
Unit
Total
Fair
Gain or
Cost
Cost
Value
(Loss)
$ 42.00 $ 42,000 $ 41,000 $ (1,000)
15.00
22,500
20,000
(2,500)
$ 64,500
$ 61,000
$
(3,500)
12-13
Trading Securities
December 22, 2013
Investment in Mining Inc. stock
Investment in Toys and Things stock
Cash
Security
Cost
42,000
22,500
64,500
Fair Value
Adjustment
Mining Inc
$ 42,000
$ 41,000
Toys and Things
22,500
20,000
Total
$ 64,500
$ 61,000
Existing balance in fair value adjustment
Change needed in fair value adjustment
$ (1,000)
(2,500)
$ (3,500)
-0$ (3,500)
Reported on the balance sheet as
a adjunct account to the investment.
December 31, 2013
Net unrealized holding gains and losses – I/S
Fair value adjustment
The Net Unrealized Holding Loss is
reported on the Income Statement.
3,500
3,500
12-14
Trading Securities
On January 3, 2014, Matrix sold all trading securities for
$65,000 cash. Let’s record the entry for the sale and the
adjustment to the fair value adjustment account.
January 3, 2014
Cash
Investment in Mining, Inc. stock – T/S
Investment in Toys and Things stock – T/S
Gain on sale of investment
December 31, 2014
Fair value adjustment
Net unrealized holding gains or losses – I/S
65,000
42,000
22,500
500
3,500
3,500
12-15
Financial Statement Presentation
Trading securities are presented on the financial statement as
follows:
1. Income Statement and Statement of Comprehensive Income:
Fair value changes are included in the income statement in the periods in
which they occur, regardless of whether they are realized or unrealized.
Investments in trading securities do not affect other comprehensive
income.
2. Balance Sheet: Securities are reported at fair value, typically as current
assets, and do not affect accumulated other comprehensive income in
shareholders’ equity.
3. Cash Flow Statement: Cash flows from buying and selling trading
securities typically are classified as operating activities, because the investors
that hold trading securities consider them as part of their normal
operations.
12-16
Financial Statement Presentation
Presented below are the partial financial statements showing
the accounting for TS owned by Matrix:
Income Statement
Revenue
Expenses
Other income (expenses):
Gain on sale of investment
Realized and unrealized gains and losses on investments
Total expenses
Net income
Balance Sheet
Assets:
Trading securities
Statement of Cash Flows (direct method)
Operating Activities:
Cash from investment revenue
Purchase of trading securities
Sale of trading securities
2013
2014
t
t
t
t
t
(3,500)
t
t
500
3,500
t
t
61,000
-0-
-0(64,500)
-0-
-0-065,000
12-17
Securities Available-for-Sale
Investments in debt or equity securities that are not for active trading and
not to be held to maturity are classified as available-for-sale (AFS).
Adjustments to fair value are recorded
1. in a valuation account called fair value adjustment, or as a direct
adjustment to the investment account.
2. as a net unrealized holding gain/loss in other comprehensive income
(OCI), which accumulates in accumulated other comprehensive
income (ACOI).
Unrealized Gain
Unrealized Loss
Other Comprehensive
Income (OCI)
12-18
Other Comprehensive Income (OCI)
Other comprehensive income:
Foreign currency translation gains (losses)
Net unrealized holding gains (losses) on investments
Minimum pension liability adjustment
Deferred gains (losses) from derivatives
Less: aggregate income tax expense (benefit)
Other comprehensive income
$ XX,XXX
-12,500
XXX
XXX
$ XX,XXX
X,XXX
$ XX,XXX
When we add other comprehensive income to net
income we refer to the result as “comprehensive income.”
Accumulated Other Comprehensive
Income
Unrealized holding gains and losses on availablefor-sale securities are accumulated in the
shareholders’ equity section of the balance sheet.
Specifically, the account is included in accumulated
other comprehensive income (AOCI).
Net unrealized
holding gains
and losses.
Shareholders’ Equity
Common stock
Paid-in capital in excess of par
Accumulated other comprehensive income
Retained earnings
Total shareholders’ equity
12-19
12-20
Securities Available for Sale Example
Assume the same information for our T/S example for
Matrix Inc., except that the investments are classified as
available-for-sale securities rather than trading
securities.
Security
Cost
Fair Value
Adjustment
Mining Inc
$ 42,000
$ 41,000
Toys and Things
22,500
20,000
Total
$ 64,500
$ 61,000
Existing balance in fair value adjustment
Change needed
$ (1,000)
(2,500)
$ (3,500)
-0$ (3,500)
December 31, 2013
Net unrealized holding gains and losses – OCI
Fair value adjustment
3,500
3,500
12-21
Financial Statement Presentation
AFS securities are presented on the financial statement as
follows:
1. Income Statement and Statement of Comprehensive
Income: Realized gains and losses are shown in net income in
the period in which securities are sold. Unrealized gains and
losses are shown in OCI in the periods in which changes in fair
value occur, and reclassified out of OCI in the periods in which
securities are sold.
2. Balance Sheet: Investments in AFS securities are reported at
fair value. Unrealized gains and losses affect AOCI in
shareholders’ equity, and are reclassified out of AOCI in the
periods in which securities are sold.
3. Cash Flow Statement: Cash flows from buying and selling AFS
securities typically are classified as investing activities.
12-22
Brief Exercise 12-2


S&L Financial buys and sells securities expecting to earn
profits on short-term differences in price. On December
27, 2013, S&L purchased Coca-Cola common shares for
$875,000 and sold the shares on January 3, 2014, for
$880,000. At December 31, the shares had a fair value of
$873,000.
What journal entries would S&L make in 2013 and 2014
as a result of this investment?
12-23
Brief Exercise 12-3



S&L Financial buys and sells securities with the intent of
holding for an extended period of time. Since this is their
intent all securities are reported as available for sale.
On December 27, 2013, S&L purchased Coca-Cola
common shares for $875,000 and sold the shares on
January 3, 2014, for $880,000. At December 31, the
shares had a fair value of $873,000.
What journal entries would S&L make in 2013 and 2014
as a result of this investment?
12-24
Brief Exercise 12-2 & 12-3

For trading securities, unrealized holding gains and losses:

are or are not

included in earnings.

For securities available-for-sale, unrealized holding gains and
losses:


are or are not
included in earnings.
12-25
BE 12-4

For several years Fister Links Products has held shares of
Microsoft common stock, considered by the company to
be securities available-for-sale. The shares were acquired
at a cost of $500,000. Their fair value last year was
$610,000 and is $670,000 this year. At what amount will
the investment be reported in this year’s balance sheet?
What adjusting entry is required to accomplish this
objective?
12-26
Transfers Between Reporting Categories
Any unrealized holding gain or loss at reclassification should be accounted for in a
manner consistent with the classification into which the security is being
transferred. Securities are transferred at fair market value on the date of transfer.
Unrealized Gain or Loss from
Transfer from:
To:
Transfer at Fair Market Value
Either of the other Trading
Include in current net income the total
unrealized gain or loss, as if it all occurred in the
current period.
Trading
Either of the other Include in current net income any unrealized
gain or loss that occurred in the current period
prior to the transfer. (Unrealized gains and
losses that occurred in prior periods already
were included in net income in those periods.)
Held-to-maturity
Available-for-sale No current income effect. Report total unrealized
Available-for-sale Held-to-maturity
gain or loss as a separate component of
shareholders’ equity (in AOCI
No current income effect. Don’t write off any
existing unrealized holding gain or loss in AOCI, but
amortize it to net income over the remaining life
of the security (fair value amount becomes the
security’s amortized cost basis).
Financial Statement Presentation
and Disclosure
Aggregate
Fair Value
Gross realized &
unrealized holding
gains & losses
Maturities of
debt securities
Amortized cost
basis by major
security type
Change in net
unrealized holding
gains and losses
Inputs to fair
value estimates
12-27
12-28
Impairment of Investments
Occasionally, an
investment’s value will
decline for reasons
that are other-thantemporary (OTT).
For HTM and AFS investments, a company recognizes an
impairment loss in earnings. Determining an “other than
temporary” decline for debt securities can be quite complex. For
both equity and debt investments, after an impairment is
recognized, the ordinary treatment of unrealized gains and losses
is resumed.
12-29
Brief Exercise 12-13

LED Corporation owns 100,000 shares of Branch
Pharmaceuticals common stock and classifies its
investment as securities available-for-sale. The market
price of Branch’s stock fell over 30%, by $4.50 per share
when the FDA banned one of the company’s principal
drugs. What journal entry should LED record to account
for the decline in market value? How should the decline
be reported?
12-30
Investor Has Significant Influence
Reporting Categories for Investments
Control Characteristics of the Investment
Reporting Method Used by the Investor
The investor lacks significant influence over the
operating and financial policies of the investee:
Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at
has the "positive intent and ability" to hold to
amortized cost.*
maturity.
Investment held in an active trading account.
Trading securities (TS) - investment reported at fair
value with unrealized holding gains and losses included
in net income.
Other.
Securities available-for-sale (AFS) - investment
reported at fair value with unrealized holding gains and
losses excluded from net income and reported in Other
Comprehensive income.*
The investor has significant influence over the
operating and financial policies of the investee:
Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for
of the voting stock of the investee.
subsequent earnings and dividends of the investee.*
The investor controls the investee:
The investor owns more than 50% of the voting
Consolidation - the financial statements of the investor
stock of the investee.
and investee are combined as if they are a single
company.
* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for
trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
12-31
Investor Has Significant Influence
Extent of Investor Influence
Lack of significant influence
(usually < 20% equity ownership)
Significant influence
(usually 20% - 50% equity ownership)
Has control
(usually > 50% equity ownership)
Reporting Method
Varies depending on classification
previously discussed
Equity method
Consolidation
Criteria for Determining Whether There
is Influence FASC Sec 323
Representation on the investee’s Board of Directors
Participation in the investee’s policy-making process
Material intercompany transactions.
Interchange of managerial personnel.
Technological dependency.
Extent of ownership in relationship to other ownership
percentages.
12-32
12-33
What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is
presumed that the investor has significant influence over the financial
and operating policies of the investee. The presumption can be
overcome if
1. the investee challenges the investor’s ability to exercise significant
influence through litigation or other methods.
2. the investor surrenders significant shareholder rights in a signed
agreement.
3. the investor is unable to acquire sufficient information about the
investee to apply the equity method.
4. the investor tries and fails to obtain representation on the board of
directors of the investee.
12-34
Equity Method
1.
The investment account is increased
by:


2.
Original investment cost.
Proportionate share of investee's
earnings.
The investment account is decreased
by:

Dividends received.
12-35
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.
12-36
Equity Method
On January 1, 2013, Wilmer 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 2013, Apex paid cash dividends of
$150,000 and reported net income of
$1,750,000.
What amount will Wilmer Inc. report on the balance
sheet as Investment in Apex Inc. on December 31,
2013?
12-37
Equity Method
January 1, 2013
Investment in Apex Inc. stock
Cash
1,350,000
1,350,000
$ 3,000,000 Fair value of net assets
×
45% Percentage ownership
$ 1,350,000 Fair value of assets purchased
2013
Investment in Apex Inc. stock
Investment revenue
$
×
$
787,500
787,500
1,750,000 Reported earnings
45% Percentage ownership
787,500 Share of earnings
2013
Cash
67,500
Investment in Apex Inc. stock
$
×
$
150,000 Dividends paid
45% Percentage ownership
67,500 Share of dividends
67,500
12-38
Equity Method
Investment in Apex Inc.
Investment
1,350,000
45% Earnings
787,500
67,500 45% Dividends
Reported amount 2,070,000
If the investee had a loss,
the investment account
would have been
reduced with a credit.
12-39
Equity Method
On January 1, 2013, Wilmer Inc. purchased 25% of the
common stock of Apex Inc. for $180,000. At the date of
acquisition, the book value of the net assets of Apex was
$400,000, and the fair value of these assets is $600,000.
During 2013, Apex paid cash dividends of $40,000, and
reported earnings of $100,000.
Fair value of assets
Percentage ownership
Share of fair value of assets
Cost of investment in Apex
Excess of cost over fair value
$ 600,000
25%
150,000
180,000
$ 30,000
12-40
Equity Method
The excess of the fair value of net assets over book value of
those net assets is 75% attributable to depreciable assets
with a remaining life of 20 years and is 25% attributable to
land. Wilmer uses the straight-line depreciation.
Fair value of net assets
$ 600,000
Book value of net assets
400,000
Difference
200,000
Percentage of net assets acquired
×
25%
Excess
50,000
Amount attributable to land (25% or excess)
12,500
Amount attributable to depreciable assets
37,500
Remaining life of depreciable assets
20 years
Additional depreciation expense per year
$ 1,875
12-41
Equity Method
January 1, 2013
Investment in Apex stock
Cash
2013
Cash
180,000
180,000
10,000
Investment in Apex stock
Investment in Apex stock
Investment revenue
December 31, 2013
Investment revenue
Investment in Apex stock
$ 40,000 Dividends paid
×
25% Percentage ownership
$ 10,000 Share of dividends
10,000
25,000
25,000
1,875
1,875
$ 100,000 Reported earnings
×
25% Percentage ownership
$ 25,000 Share of earnings
12-42
Brief Ex 12-8
Turner Company owns 10% of the outstanding
stock of ICA Company. During the current year,
ICA paid turner a $500,000 cash dividend.
What journal entry is made for the dividend
Turner receives in the current year?
12-43
Brief Ex 12-8 Explanation
Turner should account for the dividends as trading or
available for sale investments, unless they have the ability to
exercise significant influence, then Turner would account for
the investment using the equity method as investment
revenue.
Since Turner holds only 10% of ICA stock, it’s assumed that
it does not have significant influence over the company.
12-44
Brief Exercise 12-7
Turner
Company owns 40% of the outstanding stock of
ICA Company. During the current year, ICA paid a $2
million cash dividend to Turner.
What
journal entry is made for the dividend
Turner receives in the current year?
12-45
Brief Exercise 12-7 Explanation
Turner
is presumed to have the ability to exercise significant
influence over ICA based on the 40% ownership.
Turner should account for ICA’s dividends as a reduction in its
Investment in ICA account. Since investment revenue is
recognized as ICA earns it, it would be inappropriate to again
recognize revenue when earnings are distributed as dividends.
Instead, the dividend distribution is considered to be a reduction
of the investment in ICA’s net assets, reflecting the fact that the
Turner’s ownership interest in those net assets declined
proportionately.
12-46
Brief Ex 12-9
The fair value of Wallis, Inc.’s depreciable assets exceeds
their book value by $50 million. The assets have an average
remaining useful life of 15 years and are being depreciated
by the straight-line method. Park Industries buys 30% of
Wallis’s common shares.
When Park adjusts its investment revenue and the
investment by the equity method, what adjusting journal
entry will be made?
12-47
Brief Ex 12-9 Explanation
The equity method reports acquired net assets at their fair
values. Both the accounts Equity Income and Investment in
Wallis would be reduced by the “extra depreciation” the
higher fair value.
This would equal 30% x $50 million ÷ 15 years = ?
each year for fifteen years.
12-48
End of Required Course Material


The following will be covered in Advanced Accounting
Will not be tested on final.
12-49
Fair Value Option
GAAP allows companies to use a “fair value option” for HTM, AFS,
and equity method investments.
The investment is carried at fair value.
Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the
investments as trading.
For equity method investments, the investment is still classified on
the balance sheet with equity method investments, but the portion at
fair value must be clearly indicated.
The fair value option is determined for each individual investment,
and is irrevocable.
Financial Instruments and
Investment Derivatives
12-50
Financial Instruments:
Investment Derivatives:
1. Cash.
2. Evidence of an
ownership interest in
an entity.
3. Contracts meeting
certain conditions.
1. Value is derived from
other securities.
2. Derivatives are often
used to “hedge” (offset)
risks created by other
investments or
transactions