Chapter 11
Marketable Securities,
Derivatives and
Investments
BUS780
Objectives of the Chapter
1.Classifications of Investments for
financial reporting purposes.
2. Using market value method to account
for minority, passive investments.
3. Using equity method to account for
minority, active investments (i.e., holding
20% or more of investee’s voting shares) .
4. To learn the accounting for consolidated
financial statements for majority, active
investments (i.e., holding more than 50%
investee’s voting shares).
Marketable Securities, Derivatives, and Investments
2
1. Securities for Investments


Investments in debt securities: include
U.S. treasury securities, municipal
securities, corporate bonds,
commercial papers, etc.
Investments in equity securities:
include common stock, preferred stock,
stock warrants, stock rights, call and
put stock options.
Marketable Securities, Derivatives, and Investments
3
Securities for Investments(cont.)

For reporting purposes, all investments
in securities must be classified into
one of the following three categories at
the reporting date:
1. Trading securities;
2. Available-for-sale securities (SAS); or
3. Held-to-maturity (HTM) securities.
Marketable Securities, Derivatives, and Investments
4
Classification of Investments
1.Trading securities: investments in debt
and equity securities held for the
purpose of selling them in the near
future.
2. Available-for-sale securities:
Investments in debt and equity
securities that are not classified as
trading securities and not classified as
held-to-maturity securities.
Marketable Securities, Derivatives, and Investments
5
Classification of Investments (cont.)
3.Held-to-maturity securities:
investments in debt securities with
positive intent and ability to hold these
securities to maturity.
Marketable Securities, Derivatives, and Investments
6
Classification of Investments (cont.)

Classifications of investments in
securities into these three categories
and the subsequent reclassification
are based on management’s intent
and judgment.
Marketable Securities, Derivatives, and Investments
7
2. Investments - initial recording and
end of period reporting (valuation)
1.Initial Recording of all investments: at
cost (including commissions).
2. End of Period Reporting:
Trading securities:

Reported at their market values on the
balance sheet statement (B/S).

The unrealized gains or losses are
included in income statement (I/S) of
the current period.
Marketable Securities, Derivatives, and Investments
8
Investments – End of Period
Valuation (cont.)
Available-for-sale securities:


Reported at their market values on the
B/S.
The unrealized gains or losses are
reported as a separate component of
stockholders’ equity until realized.
Held-to-maturity securities:

Reported at their amortized cost.
Marketable Securities, Derivatives, and Investments
9
Investments - Dividends and
Interest revenue

Realized dividends, interest revenues
of investments in securities and
realized gains or losses from sale of
investments are reported on the income
statement.
Marketable Securities, Derivatives, and Investments
10
Investments -other valuation
methods for equity investments
Other Valuation Methods:
1. Equity method: applied when
investments in equity securities with
significant influence over the investee
(usually owing 20% - 50% of the voting
stock). No recognition of unrealized
gains or losses.
Equity method results in a partial
consolidation statements for the
investor.
Marketable Securities, Derivatives, and Investments
11
Investments - other valuation
methods for equity investments
2. Consolidated financial statements:
applied when the investor(the parent)
controls the investee (the subsidiary)
through owning over 50% of the
investee’s voting stock.
The investor has to issue the
consolidated financial statements. No
recognition of unrealized gains or
losses
Marketable Securities, Derivatives, and Investments
12
Summary of Accounting for
Investments (by types of securities)
A. Invest. In Equity Securities
1. No signoficant influencant
a. Trading
b. Available-for-Sale
2. Significant influence
(20% to 50% ownership)
3. Control
(more than 50% ownership)
B. Invest. In Debt Securities
a. Trading
b. Available-for-Sale
c. Held-to-Maturity
Method
Reporting of Unrealized Holding
Gains and Losses
Fair value
Fair value
Income statement
Stockholders' equity
Equity method Not recognized
Consolidation Not recognized
Fair value
Income statement
Fair value
Stockholders' equity
Amortized cost Not recognized
Marketable Securities, Derivatives, and Investments
13
Accounting for Investments Classified as
Trading Securities

The accounting treatment (SFAS 115)
(a) initial recording: at cost;
(b) end of period reported: at fair value;
(c) unrealized holding gains or losses:
reported on the income statement;
(d) interests, dividends, realized gains or
losses reported on the income statement
Marketable Securities, Derivatives, and Investments
14
Trading Securities (contd.)


Trading securities are held primarily by
banks and stock brokers.
SFAS 115 applies to all industries
including specialized industries..
Marketable Securities, Derivatives, and Investments
15
Example A: Trading Securities

Green Company acquired the following
securities on 5/1/x5 and reported the
investments as trading securities:
Shares
A Company common stock
$per share
100
Marketable Securities, Derivatives, and Investments
$50
16
Example A: Trading Securities (contd.)

Initial recording on 5/1/x5:
Marketable Securities
Cash

5,000
5,000
Green received $300 for dividends from
investment in A during 20x5:
Cash
300
Invest. Revenue
300
Marketable Securities, Derivatives, and Investments
17
Example A: Trading Securities (contd.)

The following info. is available on 12/31/x5:
Security Cost
A
$5,000
12/31/x5 Investment Change
Fair Value
in Fair Value
$6,500
$1,500
Marketable Securities, Derivatives, and Investments
18
Example A: trading Securities (Contd.)


12/31/x5 Adjusting entry (for valuation):
Marketable Securities
1,500
Unrealized Gains**
(losses) on investments
1,500
** reported on the income statement
Marketable Securities, Derivatives, and Investments
19
Example A: trading Securities

After the adjusting entry on 12/31/x5:
Marketable Securities
1/1/x5 5,000
12/31/x6
1,500
12/31/x6
6,500
Unrealized Gains/Losses
1,500a
a. The unrealized gains of trading securities would be
reported on the income statement of 20x5 and closed
to income summary on 12/31/20x5
Marketable Securities, Derivatives, and Investments
20
Example A: Trading Securities (contd.)

The following info. is available on 12/31/x6:
Security
A
Cost
$5,000
12/31/x5
Fair Value
$6,500
12/31/x6
Fair Value
$6,100
Marketable Securities, Derivatives, and Investments
21
Example A: trading securities (cont.)

12/31/x6 Adjusting entry (for valuation):
Unrealized holding Gains
(losses) on investment**
400
Marketable Securities*
400
** reported on income statement of x6 and will be
closed to income summary on 12/31/x6.
* To adjust the balance of marketable securities to
$6,100, the market value of A on 12/31/x6.
Marketable Securities, Derivatives, and Investments
22
Example A: trading Securities (contd.)

After the adjusting entry on 12/31/x6:
Marketable Securities
1/1/x6 6,500
12/31/x6
400
Unrealized Gains/Losses
12/31/x6
400a
6,100
a. The unrealized losses $400 of trading securities
would be reported on the income statement of 20x6
and will be closed to income summary on 12/31/20x6
Marketable Securities, Derivatives, and Investments
23
Example A: trading securities (contd.)


On 2/10/x7, Green sold 100 shares of A stock for
$6,000. J.E. to record this transaction
Cash
6,000
Loss on sale of investments 100**
Marketable Securities
6,100*
*The marketable securities account is at the fair
value as of 12/31/x6.
** for trading securities, the realized loss is the
difference between the sales price and the
most recent fair value (i.e., $6,100).
Marketable Securities, Derivatives, and Investments
24
Example B: investments classified as
available-for-sale securities (SAS)
The accounting treatment of SAS (SFAS
115)
(a) initial recording: at cost;
(b) end of period reported: at fair value;
(c) unrealized holding gains or losses:
reported as a separate component of
stockholders’ equity on B/S;
(d) interests, dividends, realized gains or
losses reported on the I/S
Marketable Securities, Derivatives, and Investments
25
Example B: Accounting for SecuritiesAvailable-for-Sale (SAS)

Green Company acquired the following
securities and reported them as SAS on
5/1/x5:
Shares $ per share
A Company common stock
100
$50
Marketable Securities, Derivatives, and Investments
26
Example B: SAS (contd.)

Initial recording on 5/1/x5:
Marketable Securities
Cash

5,000
5,000
Green received $300 for dividends from
investment in A during 20x5:
Cash
300
Invest. Revenue
300
Marketable Securities, Derivatives, and Investments
27
Example B: SAS (contd.)

The following info. is available on 12/31/x5:
Security Cost
A
$5,000
12/31/x5 Investment Change
Fair Value
in Fair Value
$6,500
$1,500
Marketable Securities, Derivatives, and Investments
28
Example B: SAS (Contd.)


12/31/x5 Adjusting entry (for valuation):
Marketable Securities
1,500
Unrealized Gains*
(losses) on investments
1,500
* Unlike the reporting for trading securities, this account is
to be reported on the balance sheet.
Marketable Securities, Derivatives, and Investments
29
Example B: SAS

After the adjusting entry on 12/31/x5:
Marketable Securities
1/1/x5 5,000
12/31/x6
1,500
12/31/x6
6,500
Unrealized Gains/Losses
1,500
a. The unrealized gains of SAS would be reported on the
B/S of 20x5 and will be carried over to 20x6.
Marketable Securities, Derivatives, and Investments
30
Balance Sheet Presentation
Balance Sheet 12/31/x5
Assets
Liabilities
Investment Securities
at fair value
(cost 5,000)
$6,500
Stockholders’ Equity:
Accu. Other Comp. Income
Unrealized gains
(losses) on investment 1,500
Marketable Securities, Derivatives, and Investments
31
Example B: SAS (contd.)

The following info. is available on 12/31/x6:
Security
A
Cost
$5,000
12/31/x5
Fair Value
$6,500
12/31/x6
Fair Value
$6,100
Marketable Securities, Derivatives, and Investments
32
Example B: SAS (cont.)

12/31/x6 Adjusting entry (for valuation):
Unrealized holding Gains
(losses) on investment**
400
Marketable Securities*
400
* To adjust the balance of marketable securities to
$6,100, the market value of A on 12/31/x6.
Marketable Securities, Derivatives, and Investments
33
Example B: SAS (contd.)

After the adjusting entry on 12/31/x6:
Marketable Securities
1/1/x6 6,500
12/31/x6
6,100
400
Unrealized Gains/Losses
12/31/x6
400b
1,500a
1,100c
a. The balance on 1/1/x6, carried over from 12/31/x5.
b. The adjustment of 12/31/20x6.
c. The ending balance on 12/31/06 and is reported on the B/S
of 2006.
Marketable Securities, Derivatives, and Investments
34
Balance Sheet Presentation
Balance Sheet 12/31/x6
Assets
Liabilities
Investment Securities
at fair value
(cost 5,000)
$6,100
Stockholders’ Equity:
Accu. Other Comp. Income
Unrealized holding gains
(losses) on investment(1,100)
Marketable Securities, Derivatives, and Investments
35
Example B: SAS (contd.)


On 2/10/x7, Green sold 100 shares of A stock for
$6,000. J.E. to record this transaction
Cash
6,000
Unrealized holding gains and
losses on investments
1,100*
Marketable Securities
6,100*
Gain on sale of investments 1,000**
* the balance of unrealized gains and losses on SAS
on 2/10/x7.
** The realized gain for SAS is the difference
between the sales price and the cost (i.e., $5,000).
Marketable Securities, Derivatives, and Investments
36
Investments in Held to Maturity
Securities (debt securities only)

The account treatment (SFAS No. 115):
(a) Initial Recording: at cost*(not using a
discount or a premium account);
(b)End of Period Reporting: at amortized
cost;
(c)Unrealized Holding Gains or Losses:not
recognized.
(d)Interests and realized gains (Losses) on
Sale : all included in income.
* the present value
Marketable Securities, Derivatives, and Investments
37
Investments in Held-to-Maturity
Securities (HTM)



APB opinion No.21 recommends separate
disclosure of face amount ($100,000) and
the discount ($1,000).
However, most investors do not use
separate accounts for face value and the
unamortized discount (or premium).
The discount ($1,000) will be amortized to
increase the interest revenue using the
effective interest method.
Marketable Securities, Derivatives, and Investments
38
Example C: amortization of discount or
premium of investments in held-to-maturity

Assume that Green acquires an investment in
bonds that will be held to maturity with a face
value of $100,000 for $102,458.71 on 1/1/x5.
The stated interest rate is 13% and interests
are paid on 6/30 and 12/31. The bonds mature
on 12/31/x7. The effective interest rate is
12%*
* 102,458.71 = 100,000 x 0.70496 + 6,500 x 4.91732
semiannual effective interest rate = 6%
6 period
6 period ?%
Marketable Securities, Derivatives, and Investments
39
Example C: (contd.)
J.E
1/1/x5
Investment in debt securitiesHTM
102,458.71
Cash

6/10/x5
Cash
102,456.71
6,500
Interest Revenue*
Inv. in HTM
6,147.52
352.48
Marketable Securities, Derivatives, and Investments
40
Example C: (contd.)
* Interest Rev. = Present Value x Effective Rate
= 102,458.71 x 6% = 6,147.52
Amortization of Premiums(discounts) on
investments decreases (increases) interest
revenue.

Marketable Securities, Derivatives, and Investments
41
Bond Investment Interest revenue and
Premium Amortization Schedule

Effective Interest Method
Cash
Debita
Interest
Revenue
Creditb
Date
1/1/x5
6/30/x5 $ 6,500.00 $ 6,147.52
12/31/x5
6,500.00
6,126.37
6/30/x6
6,500.00
6,103.96
12/31/x6
6,500.00
6,080.19
6/30/x7
6,500.00
6,055.01
12/31/x7
6,500.00
6028.24c
Investment in Carrying Value of
Debt Securities
Investment in
Creditc
Debt Securitiesd
$
102,458.71
$
352.48
102,106.23
373.63
101,732.60
396.04
101,336.56
419.81
100,916.75
444.99
100,471.76
471.76
100,000.00
Marketable Securities, Derivatives, and Investments
42
Sale of Investment in Securities Held
to Maturity Before Maturity
This should not occur unless circumstances
changed.

If it does occur, update the interest revenue
and the amortization of premium or discount
from last interest payment date to the sale
date.

To determine the gains or losses, compare
selling price (excluding accrued interests)
with the updated carrying value.

Marketable Securities, Derivatives, and Investments
43
Transfers Between Reporting Categories
Investment classification is
reassessed at each reporting date.
Securities investments can be
reclassified* at the reporting date if a
different reporting category is more
appropriate.
*an unusual event, disclosures of
reasons are required

Marketable Securities, Derivatives, and Investments
44
Transfers (contd.)
At reclassification:
1) The security is updated to its fair
value.
2) The security is transferred at its
fair value.
3) Any unrealized holding gain or loss
should be accounted for in a
manner consistent with the new
reporting category.

Marketable Securities, Derivatives, and Investments
45
Financial Statement Classification
a.Trading securities: current assets.
b.Securities-available-for-sale (SAS):
Current or noncurrent depends on
whether the securities will be sold in
one year or one operating cycle,
whichever is longer.
c.Securities-held-to-maturity:current or
noncurrent assets.
Marketable Securities, Derivatives, and Investments
46
Financial Statement Disclosure
Disclosure notes for investments should
include:
a. Amortized cost (cost basis).
b.Gross unrealized gains.
c. Gross unrealized losses.
d. Estimated fair value.
Marketable Securities, Derivatives, and Investments
47
Impairment of Value


If the decline in the fair value of
investment is NOT temporary (i.e., a
bankruptcy filing), the value of the
securities should be written down to the
fair value.
The amount of the write-down should be
treated as a realized loss and is included
in the income of the year.
Marketable Securities, Derivatives, and Investments
48
Impairment of Value (in Debt Investment)
(cont.)
The amount of write down is included
in the Income statement as a realized
loss.
 The fair value becomes the “New”
cost and is not changed for the
subsequent recovery in the fair value.

Marketable Securities, Derivatives, and Investments
49
3. Equity Method


APB Opinion No.18 requires the use of
equity method by an investor who is able to
exercise significant influence over the
operating and financial policies (i.e.,
dividends distribution) of an investee.
In the absence to the contrary, an
investment of 20% to 50% in the outstanding
common stock of the investee leads to the
presumption of significant influence.
Marketable Securities, Derivatives, and Investments
50
Equity Method (contd.)

In some cases, the investors hold more
than 20% of the outstanding common
stock of an investee and do not have
significant influence. The equity method
should not be used to account for the
investment in those cases.
Marketable Securities, Derivatives, and Investments
51
Equity Method (contd.)


A survey of 600 companies conducted
by Accounting Trends & Techniques
indicated 252 (42%) of the corporations
surveyed used the equity method to
account for their investments.
The investee companies are referred to
as affiliates.
Marketable Securities, Derivatives, and Investments
52
The Accounting Procedures of the
Equity Method


The investment is originally recorded at
cost of the shares acquired.
The investment is subsequently adjusted
each period for the changes in the net
assets (equity) of the investee.
Marketable Securities, Derivatives, and Investments
53
The Accounting Procedures of the
Equity Method

For example, increased (decreased) by
the investors’ proportionate shares of
earnings (losses) of the investee and
decreased by the dividends received.*
* This is due to investee’s net income will
increase investee’s equity while
dividends will decrease investee’s
equity.
Marketable Securities, Derivatives, and Investments
54
The Accounting Procedures of the
Equity Method (contd.)
In Summary:
Investment = Acquisition Cost + Investor’s
Share of Investee’s Income Dividends Received
Marketable Securities, Derivatives, and Investments
55
Example D


On 1/1/x9, Clibron Company purchases 4,200
shares of common stock of the Sam
Corporation which has 16,800 shares of
common stock outstanding on 1/1/x9. Thus,
Clibron has 25% of the ownership and
significant influence is presumed to exist. The
acquisition cost for the 4,200 shares is
$125,000.
Also, Sam Corp. paid $20,000 dividends on
8/28/x9, and reported net income of 81,000 for
20x9. These events are recorded on Clibron
Company’s book as follows:
Marketable Securities, Derivatives, and Investments
56
Example D (contd.)
1. To record the investment on 1/1/x9:
Long-Term Investment
125,000
Cash
125,000
2. To record the receipt of dividends on 3/28/x9:
Cash (20,000 x 25%)
5,000
Long-Term Investment (Sam Corp.) 5,000
Marketable Securities, Derivatives, and Investments
57
Example D (contd.)
3. To record Clibron Company’s 25% share in
the year’s net income:
12/31/x9
Long-Term Investment
($81,000 x 25%)
Investment Revenue
20,250
20,250
Marketable Securities, Derivatives, and Investments
58
Presentation on the B/S and I/S:
Balance Sheet
12/31/x9
Assets
Long-Term Investments, at equity
140,250
Income Statement
for the year ended 12/31/x9
Other Revenue:
Investment Revenue
20,250
Marketable Securities, Derivatives, and Investments
59
Gain or Loss on Sales of an EquityMethod Investment

Gain or loss on sales of an equitymethod investment is measured as the
difference between the sale proceeds
and the carrying amount of the
investment.
Marketable Securities, Derivatives, and Investments
60
Example D (contd.)

On 1/3/00, Clibron Sells 20% of its holding of
Sam Corp. for $30,000.
Cash
30,000
Long-Term Investment
28,050*
Gain on Sale of Investment
1,950
* 140,250 x 20% = 28,050
Marketable Securities, Derivatives, and Investments
61
Joint Venture



A joint venture is a separate entity or
business project owned by a small group of
investors.
Investors of a joint venture usually account
for their investments using the equity
method even if its share is less than 20%.
This is because these investors usually
have significant influence on the joint
venture.
Marketable Securities, Derivatives, and Investments
62
Comments Regarding Different
Accounting Treatment for Investments


Different methods in accounting for
investments will not affect the cash flows,
but will affect the earnings.
Reporting investments as SAS can reduce
earnings volatility comparing reporting
investments as trading securities.
Marketable Securities, Derivatives, and Investments
63
Comments Regarding Different
Accounting Treatment for Investments


Firms reporting investments as SAS can
cherry pick investments to be sold (i.e., sell
the SAS with unrealized gain to report the
gain on income statement).
Equity method is to prevent income
manipulation by investees who have
significant influence on dividends policy.
Marketable Securities, Derivatives, and Investments
64
4. Accounting for Consolidated
Subsidiaries

When a parent company purchased all or
more than 50% of the outstanding common
stock of subsidiary corporations,
consolidated financial statements need to be
prepared.
Marketable Securities, Derivatives, and Investments
65
4. Accounting for Consolidated
Subsidiaries

The consolidated statements combine the
balance sheets, income statements and
other financial statements of the parent
company with those of majority-owned
subsidiaries into an overall set of statements
as if the parent and its subsidiaries were a
single business entity.
Marketable Securities, Derivatives, and Investments
66
Accounting for Consolidated
Subsidiaries (contd.)

A work sheet is used to combine
financial statements of the parent
company and the subsidiaries.
A. Parent corporation owns all of
subsidiary’s stock.
B. Parent company owns less than
100% of subsidiary’s stock.
Marketable Securities, Derivatives, and Investments
67
A. Parent Corporation Owns All of
Subsidiary’s Stock

Some accounts are eliminated (i.e., the
parent company’s investment in subsidiary
account and the subsidiary’s equity accounts
because the two accounts represent the
same thing -- subsidiary equity which is also
represented by assets and liabilities of the
subsidiary in the combined financial
statements).
Marketable Securities, Derivatives, and Investments
68
B. Parent Company Owns Less
Than 100% of Subsidiary’s Stock

A minority interest account (on the
credit side as a liability) is used to
account for the subsidiary’s equity
which is held by stockholders other
than the parent company.
Marketable Securities, Derivatives, and Investments
69
Exhibit (source: Harrison and Horngren, Exhibit 10-8)
Assets
P Company S Company
Cash
33,000
18,000
Notes receivable from P
--50,000
Accounts receivable, net
54,000
39,000
Inventory
92,000
66,000
Investment in S
120,000
--Plant and equipment, net
230,000
123,000
Total
529,000
296,000
Liabilities and Stockholders' Equit
Accounts payable
141,000
Notes payable
50,000
Minority interest
--Common stock
170,000
Retained earnings
168,000
Total
529,000
Eliminations
Debit
Credit
(b) 50,000
(a) 120,000
94,000
42,000 (b) 50,000
--(a) 40,000
100,000 (a) 100,000
60,000 (a) 60,000
296,000
210,000
210,000
Marketable Securities, Derivatives, and Investments
Consolidated
Amounts
51,000
--93,000
158,000
--353,000
655,000
235,000
42,000
40,000
170,000
168,000
655,000
70
Income of A Consolidated Entity

The income of a consolidated entity is
the net income of the parent plus the
parent’s share (proportion) of the
subsidiary’s net income.
Marketable Securities, Derivatives, and Investments
71