Chapter 14
18th
Edition
Investments in
Debt and Equity
Securities
Intermediate
Financial Accounting
Earl K. Stice James D. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2012 Cengage Learning
14-1
Why Companies Invest in
Other Companies
•
•
•
•
•
Safety cushion
Cyclical cash needs
Investment for a return
Investment for influence
Purchase for control
14-2
Cyclist Cash Needs
• Some companies operate in seasonal
business environments that need
cyclical inventory buildups requiring
large amounts of cash, followed by lots
of sales and cash collections. Examples
include:
 Toy stores
 Firework retailers
 Halloween retailers
14-3
Investment for Influence
In general, companies can invest in other
companies for many reasons other than to
earn a return. Some reasons are:
•
to ensure a supply of raw materials
(e.g., Coca- Cola)
•
•
to influence the board of directors
to diversify product offerings
14-4
Purchase for Control
•
When a company purchases enough of
another company to be able to control
operating, investing, and financing
decisions, different accounting treatment is
required for that acquisition.
•
For accounting purposes, a parent
company is required to report the results of
all of its subsidiaries of which it owns more
than 50% as if the parent and subsidiaries
are one company.
14-5
Classification of
Investment Securities
• Debt securities are financial instruments
issued by a company that typically have the
following characteristics:
 a maturity value representing the amount
to be repaid to the debt holder at
maturity,
 an interest rate that specifies the periodic
interest payments, and
 a maturity date indicating when the debt
obligation will be redeemed.
(continued)
14-6
Classification of
Investment Securities
• Equity securities represent ownership in a
company.
 These shares of stock typically carry with
them the right to collect dividends and to
vote on corporate matters.
 They are an attractive investment
because of the potential for significant
increases in the price of the security.
(continued)
14-7
Classification of Debt
and Equity Securities
•
Held-to-maturity securities are debt
securities purchased by a company with
the intent and ability to hold those
securities until they mature.
 This category includes only debt
securities because equity securities
typically do not mature.
 The company must have the intention of
holding the security until it matures.
(continued)
14-8
Classification of Debt
and Equity Securities
•
•
Available-for-sale securities are equity
securities that are not considered trading
securities and are not accounted for using the
equity method.
Most of the typical company’s investment
securities are classified as available for sale.
(continued)
14-9
Classification of Debt
and Equity Securities
•
•
Trading securities are debt and equity
securities purchased with the intent of
selling them in the near future.
Trading involves frequent buying and
selling of securities, generally for the
purpose of “generating profits on
short-term differences in price.”
(continued)
14-10
Classification of Debt
and Equity Securities
• Equity method securities are equity
•
securities purchased with the intent of
being able to control or significantly
influence the operations of the investee.
A large block of stock (presumed to be at
least 20% of the outstanding stock unless
there exists evidence to the contrary)
must be owned to be classified as an
equity method security.
(continued)
14-11
The Fair Value Option
•
•
Under the fair value option, a company
has the option to report, at each balance
sheet date, any or all of its financial assets
and liabilities at their fair values on the
balance sheet date.
The election of the fair value option for an
investment security “trumps” the
classification of the security as trading,
available for sale, held to maturity, and
equity method.
14-12
Classification of Investment
Securities According to IFRS
• The classification of investment securities
•
•
under IFRS 9 is very similar to the
classification categories under U.S. GAAP.
The fair value option for financial assets also
exists in IFRS under the provisions of
IFRS 9.
In May 2010, the IASB released an exposure
draft proposing extension of the fair value
option to financial liabilities.
14-13
Purchase of Debt Securities
•
On May 1, $100,000 in U.S. Treasury notes
are purchased at 104¼, including brokerage
fees.
•
Interest is 9%, payable semiannually on
January 1 and July 1 (accrued interest of
$3,000 would be added to the purchase
price).
(continued)
14-14
Purchase of Debt Securities
•
The debt securities are classified by the
purchaser as trading securities because
management will sell the securities if a change
in the price will result in a profit.
•
The entries to record the transactions related
to this purchased using the asset approach,
then the revenue approach are shown in the
following slides.
(continued)
14-15
Purchase of Debt Securities
Asset Approach
May 1 Investment in Trading
Securities
Interest Receivable
Cash
July 1 Cash
Interest Receivable
Interest Revenue
104,250
3,000
107,250
4,500
3,000
1,500
(continued)
14-16
Purchase of Debt Securities
Revenue Approach
May 1 Investment in Trading
Securities
Interest Revenue
Cash
July 1 Cash
Interest Revenue
104,250
3,000
107,250
4,500
4,500
14-17
Purchase of Equity Securities
•
Gondor Enterprises purchased 300 shares
of Boromir Co. stock at $75 per share plus
brokerage fees of $80 (as trading securities)
and 500 shares of Faramir Inc. stock at $50
per share plus brokerage fees of $30 (as
available-for-sale securities).
•
The journal entry to record the purchase is
shown on Slide 14-34.
(continued)
14-18
Purchase of Equity Securities
Investment in Trading Securities—
Boromir Co.
22,500*
Investment in Available-for-Sale
Securities—Faramir Inc.
25,000*
Cash
47,500
*For securities accounted for using the fair value option,
brokerage fees and other upfront costs are expensed
when incurred.
Computations:
$300 x $75 = $22,500
$500 x $50 = $25,000
14-19
Recognition of Revenue
from Debt Securities
•
Assume that on January 1, 2010, Silmaril
Technologies purchased 5-year, 10% bonds
with a face value of $100,000 and interest
payable semiannually on January 1 and
July 1. The market rate on similar bonds is
8%.
•
The first step is to calculate the market
price of the bonds.
(continued)
14-20
Recognition of Revenue
from Debt Securities
Present value of principal:
FV = $100,000; N = 10; I = 4%
Present value of interest payments:
PMT = $5,000; N = 10; I = 4%
Total present value of the bonds
$ 67,556
40,554
$108,110
14-21
Interest Revenue for Debt
Securities Classified as Trading
When trading securities are purchased:
Investment in Trading Securities
Cash
108,110
108,110
When interest is received:
Cash
Interest Revenue
5,000
5,000
14-22
Interest Revenue for Debt Securities
Classified as Held to Maturity
The initial purchase:
Investment in Held-to-Maturity
Securities
Cash
108,110
108,110
To determine the amount of premium to
amortize each period, Silmaril would prepare an
amortization table based on the effectiveinterest method of amortization.
(continued)
14-23
Interest Revenue for Debt Securities
Classified as Held to Maturity
When the first interest payment is received:
Cash
5,000
Interest Revenue
Investment in Held-to-Maturity Securities
(continued)
4,324
676
14-24
Interest Revenue for Debt Securities
Classified as Held to Maturity
When the second interest payment is received:
Cash
5,000
Interest Revenue
Investment in Held-to-Maturity Securities
4,297
703
14-25
Recognition of Revenue from
Equity Securities
•
•
In those instances where the level of
ownership in the investee is such that the
investor is able to control or significantly
influence decisions made by the investee, the
use of the equity method is appropriate.
The ability of the investor to exercise
significant influence over decisions as
dividend distribution and operational and
financial administration may be indicated in
several ways, as listed in Slide 14-44.
(continued)
14-26
Recognition of Revenue from
Equity Securities
Significant influence may be indicated by
decisions affecting:
• Representation on the investee’s board of
directors
• Participation in the policy-making process
• Material Intercompany transactions
• Interchange of management personnel
• Technical dependency of investee on investor
• Percentage of outstanding voting stock owned
14-27
Determining the Appropriate
Accounting Method
Account for as
Equity method and
trading or
consolidation
available-for-sale
procedures
Equity
method
Ownership Percentage
No
significant
influence
0%
20%
Significant
influence
Control
50%
100%
14-28
Revenue for Equity Securities Classified
as Trading and Available for Sale
When an investment in another company’s
stock does not involve either a controlling
interest or significant influence, it is classified
as either trading or available for sale. Assume
that Gondor Enterprises receives the
following dividends from its investees:
(continued)
14-29
Revenue for Equity Securities Classified
as Trading and Available for Sale
The journal entry to record receipt of the
dividends would be:
Cash
Dividend Revenue
2,475
2,475
[(300 × $2.00) + (500 × $3.75) = $2,475]
14-30
Revenue for Securities Classified
As Equity Method Securities
• Under the equity method, the investment is
initially recorded at cost.
• The investment account is periodically adjusted
to reflect changes in the underlying net assets of
the investee.
 Increased to reflect a proportinate share of the
earnings of the investee or decreased to show
any losses reported.
 Preferred dividends declared reduce the
investment account; dividends received also
reduce the investment account.
(continued)
14-31
Revenue for Securities Classified
As Equity Method Securities
BioTech Inc. purchased 40% of the outstanding
stock of Medco Enterprises on January 1 of the
current year by paying $200,000. During the year,
Medco reported net income of $50,000 and paid
dividends of $10,000.
Investment in Medco Enterprise Stock:
Investment in Medco Enterprise Stock
Cash
To record the purchase of 40% of
Medco stock.
200,000
200,000
(continued)
14-32
Revenue for Securities Classified
As Equity Method Securities
Recognize a percentage of net income:
Investment in Medco Enterprise Stock
20,000
Income from Investment in Medco
Enterprises Stock ($50,000 × 0.40)
To record the recognition of revenue
from investment in Medco.
20,000
Record receiving a dividend:
Cash ($10,000 × 0.40)
Investment in Medco Enterprises Stock
To record the receipt of dividend on
Medco stock.
4,000
4,000
14-33
Comparing the Provisions of
FASBS ASC Topics 320 and 323
•
To contrast and illustrate the accounting
entries under various methods, assume that
Powell Corporation purchased 5,000 shares
of San Juan Company common stock on
January 2 at $20 per share, including
commissions and other costs.
•
San Juan has a total of 25,000 shares
outstanding. Compare the two methods in
Exhibit 14-10 on Slide 14-53.
(continued)
14-34
Equity Method: Purchase
for More than Book Value
•
On January 2, 2013, the net assets of Stewart
Inc. was $500,000 at the time Phillips
Manufacturing Co. purchased 40% of the
common shares for $250,000.
•
Based on the ownership interest, the market
value of the net assets of Stewart Inc. would be
$625,000 ($250,000/0.40), which is $125,000
more than the book value. Only $50,000 of this
is attributed to depreciable assets. The
remaining $75,000 is attributed to a special
operating license.
(continued)
14-35
Equity Method: Purchase
for More than Book Value
•
The average remaining life of the depreciable
assets is 10 years and the license is to be
amortized over 20 years. Phillips Manufacturing
Co. would adjust its share of Stewart Inc.’s net
income as follows:
Additional depreciation ($50,000 × 0.40)/10
License amortization ($75,000 × 0.40)/20
$2,000
1,500
$3,500
(continued)
14-36
Equity Method: Purchase
for More than Book Value
Each year for the first 10 years, Phillips would
make the following entry in addition to entries
made to recognize its share of Stewart Inc.’s
income and dividends.
Income from Investments in Stewart Inc.
Stock
Investment in Stewart Inc. Stock
3,500
3,500
To adjust share of income on Stewart
Inc. common stock for proportionate
depreciation on excess of market value
of depreciable property, $2,000, and for
amortization of the unrecorded license,
$1,500.
(continued)
14-37
Equity Method: Purchase
for More than Book Value
•
After the 10th year, the adjustment would be for
$1,500 until the license amount is fully
amortized.
•
Stewart Inc. declared and paid dividends of
$70,000 during 2013 and reported net income
of $150,000 for the year. The investment would
be shown on Phillip’s balance sheet at
$278,500, computed as shown on Slide 14-58.
(continued)
14-38
Equity Method: Purchase
for More than Book Value
The adjustments for additional depreciation
and intangible asset amortization are needed
only when the purchase price is greater than
the underlying book value at the date of
acquisition.
14-39
Equity Method: Joint Venture
•
•
•
A joint venture is a form of off-balancesheet financing.
Joint ventures are accounted for using the
equity method.
Even if the joint venture does not have a
50%–50% ownership structure, the
minority interest will still account for the
joint venture using the equity method.
(continued)
14-40
Equity Method: Joint Venture
Owner A Company and Owner B Company each
own 50% of Ryan Julius Company, which does
research and marketing for the products of both
Owner A and Owner B. Ryan Julius has assets
of $10,000 and liabilities of $9,000.
Owner A Balance Sheet
Investment in Ryan Julius [($10,000 – $9,000)
x 0.50]
$500
Owner B Balance Sheet
Investment in Ryan Julius [($10,000 – $9,000)
x 0.50]
$500
14-41
Equity Method Accounting
According to IFRS
•
Equity method accounting under IFRS is
the same, in all important aspects, as under
U.S. GAAP.
•
•
The relevant standard is IAS 28.
Under IFRS, the term “associate” is used
for what is called an “equity method
investee” under U.S. GAAP.
14-42
Accounting for Temporary Changes
in the Fair Value of Securities
Eastwood Incorporated purchased five different
securities on March 23, 2011. Their fair value is
shown as of December 31, 2013.
(continued)
14-43
Accounting for Temporary Changes
in the Fair Value of Securities
Initial Purchase Entry—2013
Investment in Trading Securities
11,000
Investment in Available-for-Sale Securities 17,000
Investment in Held-to-Maturity
Securities
20,000
Cash
48,000
(continued)
14-44
Trading Securities
At the end of 2013, the value of the trading
securities decreased from $11,000 cost to
$10,500 fair value. As a result, the following
entry would be made:
December 31, 2013:
Unrealized Loss on Trading Securities
Market Adjustment—Trading Securities
500
500
14-45
Available-for-Sale Securities
At the end of 2013, the available-for-sale
portfolio had increased from $17,000 to $17,600.
This increase in fair value of the securities above
their cost would be recorded as follows:
Market Adjustment—Available-for-Sale
Securities
Unrealized Increase/Decrease in Value
of Available-for-Sale Securities
600
600
14-46
Accounting for the Change in
Value of Securities
Trading Securities—2014
By the end of 2014, trading securities have
increased in value from $10,500 to $11,300.
(continued)
14-47
Accounting for the Change in
Value of Securities
The account, “Market Adjustment—Trading
Securities” should have a debit balance of
$300. The “Before Adjustment Balance” is a 500
credit; a carry over from 2013. The adjusting
entry is as follows:
The adjusting entry is as follows:
Market Adjustment—Trading Securities
800
Unrealized Gain on Trading Securities
(continued)
800
14-48
Accounting for the Change in
Value of Securities
The balance in Market Adjustment—Trading
Securities would be added to Investment in
Trading Securities and reported on the balance
sheet.
The $800 unrealized gain would be included in
the computation of net income for 2014.
(continued)
14-49
Accounting for the Change in
Value of Securities
Available-for-Sale Securities—2014
At the end of 2014, the fair value of the
available-for-sale securities has decreased from
$17,600 to $17,200.
(continued)
14-50
Accounting for the Change in
Value of Securities
The market adjustment account should have a
$200 debit balance.
The adjusting entry is as follows:
Unrealized Increase/Decrease in Value of Availablefor-Sale Securities ($17,600 ─ $17,200)
Market Adjustment—Available-for-Sale
Securities
(continued)
400
400
14-51
Accounting for “Other-Than-Temporary”
Declines in the Fair Value of Securities
If a decline in the fair value of an individual
security is judged to be other than temporary,
regardless of whether the security is debt or
equity and regardless of whether it is being
accounted for as a trading, available-for-sale,
held-to-maturity, or equity security, the cost basis
of that security should be reduced by crediting the
investment account.
(continued)
14-52
Accounting for “Other-Than-Temporary”
Declines in the Fair Value of Securities
In Staff Accounting Bulletin No. 59, the SEC
staff suggest that one consider the following in
determining whether a decline in fair value is
other than temporary:
• How long has the fair value of the security been
below its original cost?
•
What is the current financial condition of the
investee and its industry?
•
Will the investor’s plans involve holding the
security long enough for it to recover its value?
14-53
Sale of Securities
•
A realized gain or loss occurs when an arm’slength transaction has occurred and a security
has actually been sold. The gain or loss is
recognized on the income statement.
•
An unrealized gain or loss arises when the fair
value of the security changes, yet the security
is still held by the investor. Unrealized gains or
losses may or may not be recognized,
depending upon the security’s classification or
whether the company has elected the fair
value option.
(continued)
14-54
Sale of Securities
For Silmaril Technologies (Slides 14-36 to 1442), assume that the debt securities are sold on
April 1, 2014, for $103,000, which includes
accrued interest of $2,500. The carrying value of
the debt security on January 1, 2014, is
$105,240. Interest revenue of $2,105 (105,240 x
0.08 x 3/12) would be recorded, and a receivable
relating to interest of $2,500 would be
established.
To go to Slide 14-36, left click on the button using your
mouse. To return, type “78” and press “Enter.”
(continued)
14-55
Sale of Securities
To record accrued revenue and amortize premium:
Interest Receivable
Investment in Held-to-Maturity
Securities
Interest Revenue
2,500
395
2,105
Entry to record sale:
Cash
Realized Loss on Sale of Securities
Interest Receivable
Investment in Held-to-Maturity
Securities
103,000
4,345
2,500
104,845
14-56
Impact of Sale of Securities on
Unrealized Gains and Losses
At the beginning of Year 1, Levi Company
purchased a portfolio of trading securities for
$10. At the end of Year 1, the securities had a
value of $12. At the end of Year 2, the same
securities are sold for $9.
Unrealized Loss—
Trading
2
Market Adjustment—
Trading
2
(continued)
14-57
Impact of Sale of Securities on
Unrealized Gains and Losses
When the securities are sold at the end of
Year 2 for $9, the entry will reflect only a $1
loss.
Year 2
Cash
Realized Loss—Trading
Investment Securities—Trading
9
1
10
Realized loss is the
difference between the
selling price and the original
cost of the securities.
14-58
Derecognition
According to FASB ASC Topic 860, a transfer
of a financial asset is accounted for as a sale
(resulting in derecognition—transferring
assets and corresponding liabilities from
the balance sheet) when the transfers satisfy
each of the following three conditions listed on
Slides 14-83 and 14-84.
(continued)
14-59
Derecognition
1. Legal control: The transferor has given
up legal claim to the assets, meaning that
even if it declares bankruptcy its creditors
cannot go after the transferred assets.
2. Actual control: The transferor cannot
prevent the transferee from using the
transferred assets however desired, such
as selling them or pledging them as
collateral for a loan.
(continued)
14-60
Derecognition
3. Effective control: The transferor does not
have the right to force the transferee to
return the assets, such as with a repurchase
agreement.
14-61
Transferring Debt and Equity Securities
Between Categories
The Eastwood Inc. example used earlier will
serve to demonstrate transferring securities
between categories. As of December 31, 2014,
Eastwood Inc. had the following securities:
Left click the button with your mouse to review the Eastwood
Inc. material. Type “87” and press “Enter” to return.
14-62
(continued)
Transferring Debt and Equity Securities
Between Categories
During 2015, Eastwood Inc. elects to reclassify
certain of its securities. The category being
transferred from, and to, along with the fair value
for each security on the date of the transfer, is
as follows:
14-63
From the Trading
Security Category
Eastwood Inc. elects to reclassify security 2 from
a trading security to an available-for-sale security.
Investment in Available-for-Sale
Securities
Market Adjustment—Trading
Securities
Unrealized Gain on Transfer of
Securities
Investment in Trading Securities
3,800
600
200
3,000
14-64
Into the Trading
Security Category
Eastwood Inc. elects to reclassify security 4 from
an available-for-sale security to a trading security.
Investment in Trading Securities
10,300
Market Adjustment—Available-forSale Securities
1,300
Unrealized Loss on Transfer of
Securities
1,700
Unrealized Increase/Decrease in
Value of Available-for-Sale Securities
1,300
Investment in Available-for-Sale
Securities
12,000
14-65
From the Held-to-Maturity to the
Available-for-Sale Category
Eastwood Inc. has elected to reclassify security 5
from a security being held until maturity to one
that is available to be sold. The security’s fair
value on the date of transfer is $20,400.
Investment in Available-for-Sale
Securities
Unrealized Increase/Decrease in
Value of Available-for-Sale
Securities
Investment in Held-to-Maturity
Securities
20,400
400
20,000
14-66
From the Available-for-Sale to the
Held-to-Maturity Category
Eastwood Inc. elects to reclassify security 3 from
one that is available to be sold to a security that
will be held until maturity. The fair value on the
date of the transfer is $5,900.
Investment in Held-to-Maturity
Securities
5,900
Unrealized Increase/Decrease in Value
of Available-for-Sale Securities
600
Investment in Available-for-Sale
Securities
5,000
Decline in value since
Market Adjustments—Available-forlast balance sheet date
Sale Securities
1,500
14-67
Cash Flows from Gains and Losses
on Available-for-Sale Securities
Caesh Company came into existence with a
$1,000 investment by owners on January 1,
2013, and entered into the following transactions
during 2013.
Cash sales
$ 1,700
Cash expenses
(1,400)
Purchase of investment securities
(600)
Sale of investment securities (costing $200) 170
(continued)
14-68
Cash Flows from Gains and Losses
on Available-for-Sale Securities
The investment securities are classified as
available for sale. The market value of the
remaining securities was $500 on December 31,
2013. Caesh Company’s net income for 2013 can
be computed as follows:
Sales
Expenses
Operating income
Realized loss on sale of investment securities
($200 – $170)
Net income
$1,700
(1,400)
300
(30)
$270
(continued)
14-69
Cash Flows from Gains and Losses
on Available-for-Sale Securities
The statement of cash flows for Caesh
Company for 2013 can be prepared as follows:
14-70
Cash Flows from Gains and
Losses on Trading Securities
If the investment securities purchased by Caesh
Company are classified as trading securities and
are deemed to have been acquired for operating
purposes, the unrealized gain appears in the
Operating Activities section.
Net income is $370
instead of $270 because
the $100 unrealized
increase in the fair value
of the portfolio is
reported as an
unrealized gain on the
income statement.
14-71
Equity Method Securities and
Operating Cash Flows
•
When a company owns equity method
securities, an adjustment to operating cash
flow must be made to reflect the fact that the
cash received from the securities in the form of
dividends is not equal to the income from the
securities included in the computation of net
income.
•
Daltone Company owns 30% of the
outstanding shares of Chase Company. Chase
Company’s net income for the year was
$100,000, and cash dividends were $40,000.
(continued)
14-72
Equity Method Securities and
Operating Cash Flows
•
Daltone would include $30,000 ($100,000 x
0.30) in its income statement as income from
the investment.
•
Daltone received $12,000 ($40,000 x 0.30) in
cash dividends from its investment in Chase.
Daltone would report a subtraction in the
Operating Activities section for the $18,000
($30,000 – $12,000) difference between the
income reported and the cash dividends
received.
14-73
Required Additional Disclosures
1. Trading securities
 The change in net unrealized holding
gain or loss that is included in the
income statement.
2. Available-for-sale securities
 Aggregate fair value, gross unrealized
holding gains and gross unrealized
holding losses, and amortized cost
basis by major security type.
(continued)
14-74
Required Additional Disclosures
 The proceeds from sales of availablefor-sale securities and the gross
realized gains and losses on those
sales and the basis on which cost was
determined in computing realized gains
and losses.
 The change in net unrealized holding
gain or loss on available-for-sale
securities that has been included in
stockholder’s equity during the period.
(continued)
14-75
Required Additional Disclosures
3. Held-to-maturity securities:
 Aggregate fair value, gross unrealized
holding gains and gross unrealized
holding losses, and amortized cost basis
by major security type.
4. Transfer of securities between categories:
 Gross gains and losses included in
earnings from transfer of securities
from available-for-sale into the trading
category.
(continued)
14-76
Required Additional Disclosures
 For securities transferred from held-tomaturity, the company should disclose
the amortized cost amount transferred,
the related realized or unrealized gain
or loss, and the reason for transferring
the security.
14-77
Measurement of Impairment
•
•
A creditor shall measure for impairment for
loans with no market value at the present
value of expected future cash flows
discounted at the loan’s effective interest
rate.
The impairment is recorded by creating a
valuation allowance account and charging the
estimated loss to bad debt expense.
(continued)
14-78
Measurement of Impairment
•
If a loan agreement is restructured in a
troubled debt restructuring, the interest rate
to be used to discount the new modified
contract terms is based on the original
contract rate.
14-79
Nature and Classifications
of Paid-In Capital
•
•
•
A corporation is a legal artificial entity
separate from its owners.
Individuals contribute capital for which the
corporation issues stock certificates
evidencing ownership interests.
Stockholders elect a board of directors
whose members oversee the strategic and
long-run planning of the corporation.
14-80
Chapter 14
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The End
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14-81
14-82