chapter 14
Investment in
Debt and Equity
Securities
An electronic presentation
by Douglas Cloud
Pepperdine University
1
Learning Objectives
1. Determine why companies invest in
other companies.
2. Understand the varying classifications
associated with securities.
3. Account for the purchase of debt and
equity securities.
4. Account for the recognition of revenue
from investments.
Continued
2
Learning Objectives
5. Account for the change in value of
securities.
6. Account for the sale of investment
securities.
7. Record the transfer of securities between
categories.
8. Properly report purchases, sales, and
changes in value of investment securities
in the statement of cash flows.
Continued
3
Learning Objectives
9. Explain the proper classification and
disclosure of investments in securities.
10. Compare the accounting for securities
under U.S. GAAP with the international
standard in IAS 39.
EXPANDED MATERIAL
11. Account for the impairment of a loan
receivable.
4
Investment in Debt and Equity
Securities—2001
Company
Berkshire Hathaway
Microsoft
Coca-Cola
Citigroup
AT&T
Verizon
Total Investment
(in billions)
$69.0
17.7
5.4
160.8
24.5
10.2
Percentage of
Total Assets
42.4%
34.7
24.2
15.3
14.8
6.0
5
Time Line of Business Issues
Involved with Investment Securities
?
DETERMINE
purpose of
investment
6
Time Line of Business Issues
Involved with Investment Securities
a, b,
c
CLASSIFY
investments
7
Time Line of Business Issues
Involved with Investment Securities
Cloud Corporation
Cloud Corporation
Good Buy Corporation
$100 par value
$100 par value
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$10 par value
PURCHASE
securities
8
Time Line of Business Issues
Involved with Investment Securities
Cloud Corporation
Cloud Corporation
Good Buy Corporation
$100 par value
$100 par value
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$10 par value
EARN AND
RECOGNIZE
a return
9
Time Line of Business Issues
Involved with Investment Securities
+
+
Cloud Corporation
Cloud Corporation
Good Buy Corporation
$100 par value
-
$100 par value
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$10 par value
-
MONITOR
changes in value
+
10
Time Line of Business Issues
Involved with Investment Securities
Cloud Corporation
Cloud Corporation
Good Buy Corporation
$100 par value
$100 par value
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$10 par value
SELL
securities
11
Time Line of Business Issues
Involved with Investment Securities
a
b
c
TRANSFER
securities between
categories
12
Time Line of Business Issues
Involved with Investment Securities
DISCLOSE
status of portfolio at the
end of the period
13
Why Companies Invest in
Other Companies
Safety Cushion
Cyclical Cash Needs
Investment for a Return
Continued
14
Why Companies Invest in
Other Companies
Investment for Influence
Purchase for Control
15
Classification of Investment
in Securities
Debt securities typically have the following
characteristics:
1. A maturity value, representing the amount
to be repaid to the debt holder at maturity.
2. An interest rate that specifies the periodic
interest payments.
3. A maturity date, indicating when the debt
obligation will be redeemed.
16
Classification of Investment
in Securities
Equity securities represent ownership in a
company.
 These shares of stock typically carry with
them the right to collect dividends and vote
on corporate matters.
 Equity securities have the potential for
significant increases in price.
17
Classification of Investment
in Securities
Debt/Equity
Securities
Held-toMaturity
Securities purchased with the
intent to hold until maturity.
Trading
Securities purchased for sale
in the near future.
Availablefor-sale
Securities not classified as
trading or held-to-maturity.
18
Classification of Investment
in Securities
Debt
Held-tomaturity
Availablefor-sale
Cost Method
Equity
Trading
Equity
Method
19
Equity Method 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.
20
Equity Method Securities
These are securities purchased
with the intent to control or
significantly influence the
operations of the investee.
21
Equity Method Securities
Even then, there may be
At least 20 percent of the
evidence to support the fact that
outstanding voting stock must
even a 20 percent investment
be owned to have this
does not have significant
significant influence or control.
influence.
22
Different Accounting
Treatments
Classification
of Securities
Held to maturity
Available for sale
Trading
Equity method
Types of
Securities
Disclosure
on the
Balance
Sheet
23
Treatment of
Temporary
Changes in
Value
Debt
Amortized cost
Not recognized
Debt/equity Fair market value Reported in
stockholders’
equity
Debt/equity Fair market value Reported on the
income statement
Equity
Historical cost
Not recognized
adjusted for
changes in the
assets of the investee
Purchases of Debt Securities
On May 1, Douglas Company purchases
$100,000 in U.S. Treasury notes at 104¼,
including brokerage fees. Interest is 9%
payable semiannually on January 1 and July
1. The debt securities are classified by the
purchaser as trading securities.
Accrued interest on May 1 is $3,000, calculated
as follows:
$100,000 x .09 x 4/12 = $3,000
24
Purchases of Debt Securities
Asset Approach
Purchase date:
May 1 Investment in
Trading Securities 104,250
Interest Receivable
3,000
Cash
107,250
Continued
25
Purchases of Debt Securities
Revenue Approach
Purchase date:
May 1 Investment in
Trading Securities 104,250
Interest Revenue
3,000
Cash
107,250
Continued
26
Purchases of Debt Securities
Receipt of semiannual payment:
Asset Approach
July 1 Cash
4,500
Interest Receivable
Interest Revenue
3,000
1,500
Revenue Approach
July 1 Cash
Interest Revenue
4,500
4,500
27
Purchase of Equity Securities
Purchased 10,000 shares of Dave’s Deli
common shares at $2 per share.
Treated as available-for-sale because
management has no intention of holding
these securities for a a long period of time
and will sell them as soon as it is
economically advantageous
28
Purchase of Equity Securities
Citty Co. purchased 1,000 shares of AB
Company common shares at $2 per share.
Available-for-Sale
Investment in Available-forSale Securities—AB Company 2,000
Cash
2,000
29
Purchase of Equity Securities
Citty Co. purchased 100,000 shares of AB
Company common shares at $2 per share.
Assume that the 100,000 shares
purchased represents 20 percent of the
outstanding voting stock of AB Company.
This investment gives the investor
significant influence over AB Company.
30
Purchase of Equity Securities
Purchased 100,000 shares of Dave’s Deli
common shares at $2 per share.
Trading Securities
Investment in Trading Securities—
AB Company Common Stock
2,000
Cash
2,000
31
PV of Debt Securities
On January 1, 2004, 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 bonds of similar quality and
maturity is 8%.
32
PV of Debt Securities
Present value of principal:
FV = $100,000; N = 10; I = 4%
Present value of interest payments:
$ 67,556
PMT = $5,000; N = 10; I = 4%
Total present value of the bonds
40,554
$108,110
Investment in Trading Securities
Cash
108,100
108,100
33
Interest Revenue for Debt
Securities (Trading)
When the first interest payment is
received from Silmaril, the following
entry would be made:
July 1 Cash
Interest Revenue
5,000
5,000
34
Interest Revenue for Debt
Securities (Held-to-Maturity)
When the first interest payment is
received from Silmaril, the following
entry would be made:
July 1 Cash
5,000
Interest Revenue
4,324
Investment in Held-toMaturity Securities
676
$108,110 x .04
35
Interest Revenue for Debt
Securities (Held-to-Maturity)
When the second interest payment is received,
the interest revenue is determined by the yield
times the bond carrying value.
Jan 1 Cash
5,000
Interest Revenue
4,297
Investment in Held-toMaturity Securities
703
$107,434 x .04
36
Determining the Appropriate
Accounting Method
Account for as
trading or
available-for-sale
Equity method
Ownership
No
significant
influence
0%
20%
Equity method
and consolidation
procedures
Percentage
Significant
influence
Control
50%
100%
37
Determining the Appropriate
Accounting Method
In the absence of persuasive
evidence to the contrary, equity
securities are classified as
trading or available for sale
when ownership is less than 20
percent.
Summary
38
Determining the Appropriate
Accounting Method
The equity method is used when
ownership is such that the
investor has the ability to
significantly influence or control
the investee’s operations.
Summary
39
Determining the Appropriate
Accounting Method
Ownership
Interest
More than 50%
20% to 50%
Less than 20%
Control or
Degree of
Influence
Control
Accounting
Method
Equity method
and consolidation
procedures
Significant Equity method
influence
No
Account for as
significant trading or
influence
available for sale
40
Applicable
Standard
APB Opinion #18
FASB Exposure
Draft
APB Opinion #18
FASB Statement
No. 115
Revenue for Equity Securities
Classified as Trading and AFS
AB Company announces dividends of
$0.25 per share. Assume that Citty Co.
owns 1,000 shares
Cash
Dividend Revenue
250
250
41
Revenue for Equity Securities
Classified as Trading and AFS
AB Company announces dividends of
$0.25 per share. Assume that Citty Co.
owns 100,000 which represents 50
percent of the outstanding voting stock.
Cash
25,000
Investment in AB Company
Stock
25,000
42
Revenue for Equity Securities
Classified as Trading and AFS
AB Company reports an income of
$250,000 for the year. Again, assume
that Citty Co. owns 50 percent of the
outstanding voting stock.
Investment in AB Company
Stock
125,000
Income from Investment
in AB Company Stock
125,000
43
Equity Method: Purchase For
More than Book Value
The net assets of Stewart Inc. was $500,000
at the time Phillips Manufacturing Co.
purchased 40% of the common shares for
$250,000 on January 1, 2005. The market
value of the net assets of Stewart Inc. would
be $625,000, which is $125,000 more than
the book value. Only $50,000 of this is
attributed to depreciable assets.
$250,000 ÷ .40
44
Equity Method: Purchase For
More than Book Value
The average remaining life of the
depreciable assets is 10 years and the
special operating license is to be
amortized over 20 years.
Additional depreciation ($50,000 x 0.40)/10
License amortization ($75,000 x 0.40)/20
$2,000
1,500
$3,500
45
Equity Method: Purchase For
More than Book Value
Stewart Inc. declared and paid
dividends of $70,000 to common
stockholders during 2005, and it
reported net income of $150,000 for the
year ended December 31, 2005.
46
Equity Method: Purchase For
More than Book Value
Investment in Stewart Inc. Common Stock
Acquisition cost 250,000 Dividends
Share of earnings 60,000 Additional
depreciation
Additional
amortization
310,000
Balance
278,500
28,000
2,000
1,500
31,500
47
Accounting for Temporary
Changes in Value of Securities
Classification
of Security
Disclosed
at
Report FMV
Change On
Trading
Fair market
value
Income
statement
Availablefor-sale
Fair market
value
Stockholder’s
equity
Held-tomaturity
Amortized
cost
Not
recognized
48
Accounting for Temporary
Changes in Value of Securities
Eastwood Inc. purchased the following securities on
March 23, 2005.
• Trading securities:
– Purchase price (Security #1)
$ 8,000
– Value end of year (#1)
$ 7,000
– Purchase price (#2)
$ 3,000
– Value end of year (#2)
$ 3,500
• Available-for-sale securities:
– Purchase price (#3)
$ 5,000
– Value end of year (#3)
$ 6,100
Continued
49
Accounting for Temporary
Changes in Value of Securities
• Available-for-sale securities:
– Purchase price (#4)
– Value end of year (#4)
• Held-to-maturity securities:
– Purchase price (#5)
– Value end of year (#5)
Continued
$12,000
$11,500
$20,000
$19,000
50
Accounting for Temporary
Changes in Value of Securities
Initial Purchase Entry
Investment in Trading Securities
Investment in Available-for-Sale
Securities
Investment in Held-to-Maturity
Securities
Cash
Continued
11,000
17,000
20,000
48,000
51
Accounting for Temporary
Changes in Value of Securities
52
By the end of the year, the value of
the trading securities decreased from
$11,000 to $10,500.
December 31, 2005:
Unrealized Loss on Trading Securities
Market Adjustment—Trading Securities
Continued
500
500
Accounting for Temporary
Changes in Value of Securities
53
By the end of the year, the value of
the available-for-sale securities
increased from $17,000 to $17,600.
December 31, 2005:
Market Adjustment—Available-for-Sale
Securities
Unrealized Increase/Decrease in Value
of Available-for-Sale Securities
600
600
Accounting for Temporary
Changes in Value of Securities
FASB No. 115 puts an end
to “cherry-picking.” This
is the practice of
selectively selling
securities whose prices
have increased, while
keeping those that have
experienced losses or
have maintained their
historical cost.
54
Accounting for Temporary
Changes in Value of Securities
Partial Balance Sheet for Eastwood Inc.
Assets
Invest. in trading securities
$11,000
Market adjustment—trading sec.
(500) $10,500
Invest. in available-for-sale sec. $17,000
Market adjustment
600 17,600
Invest. in held-to-maturity sec.
20,000
$48,100
Stockholders’ Equity
Add unrealized increase in
available-for-sale securities
$ 600
55
Accounting for Temporary
Changes in Value of Securities
Partial Income Statement for Eastwood Inc.
Other expenses and losses:
Unrealized loss on trading
securities
$500
56
Sale of Securities
On April 1, 2005, the investment in
Silmaril’s debt securities is sold for
$103,000, which includes accrued interest
of $2,500. Interest revenue of $2,105
($105,248 x .08 x 3/12) would be recorded.
On January 1, the debt securities had a
carrying value of $105,248. The required
amortization for the three-months’ premium
between January 1 and April 1 is $395.
57
Sale of Securities
Entry to record accrued revenue and to amortize
premium:
Apr. 1 Interest Receivable
2,500
Investment in Held-to
Maturity Securities
395
Interest Revenue
2,105
Entry to record sale:
Apr. 1 Cash
103,000
Realized Loss on Sale of
Securities
4,353
Interest Receivable
2,500
Investment in Held-to
Maturity Securities
104,853
58
Transferring Securities
Between Categories
Transferred
From trading
To trading
From held to maturity to
available for sale
Treatment of
Change in Value
Any unrealized change in value not
previously recognized will be
recognized in net income in the
current period.
Any unrealized change in value not
previously recognized will be
recognized in net income in the
current period.
Recognize any unrealized change in
value in a stockholders’ equity
account.
Continued
59
Transferring Securities
Between Categories
Transferred
From available for sale
to held to maturity
Treatment of
Change in Value
Any unrealized change in value
recorded in a stockholders’ equity
account is to be amortized over the
security’s remaining life using the
effective-interest method.
Statement of Financial Standards No. 115, par. 15d
60
Transferring Securities
Between Categories
Assume:
Cost of trading security
Fair market value, end of 2006
Fair market value at transfer
date
Continued
$3,000
3,600
3,800
61
Transferring Securities
Between Categories
Investment in Available-for-Sale
Securities
3,800
Market Adjustment--Trading
Securities
600
Unrealized Gain on Transfer
of Securities
200
Investment in Trading Securities
3,000
62
Transferring Securities
Between Categories
Assume:
Cost of available-for-sale security
Fair market value, end of 2006
$12,000
10,700
Transfer from the availablefor-sale category to the trading
security category.
Continued
63
Transferring Securities
Between Categories
Investment in Trading Securities 10,300
Market Adjustment--Trading
Securities
1,300
Unrealized Loss on Transfer
of Securities
1,700
Unrealized Increase/Decrease
in Value of Available-forSale Securities
1,300
Investment in Available-forSale Securities
12,000
64
Transferring Securities
Between Categories
Assume:
Cost of held-to-maturity
security
Fair market value, Dec. 31,
2006
20,000
20,700
Record a transfer from held-to-maturity to
the available-for-sale category.
Continued
65
Transferring Securities
Between Categories
Investment in Available-forSale Securities
Unrealized Increase/
Decrease in Value of
Available-for-Sale
Securities
Investment in Held-toMaturity Securities
66
20,400
400
20,000
Transferring Securities
Between Categories
Assume:
Cost of available-for-sale
securities
Fair market value, end of 2006
Fair market value at transfer date
$5,000
6,500
5,900
Record a transfer from availablefor-sale to held-to-maturity.
Continued
67
Transferring Securities
Between Categories
Investment in Held-to-Maturity
Securities
5,900
Unrealized Increase/Decrease
in Value of Available-for-Sale
Securities
600
Investment in Available-forSale Securities
Market Adjustment—
Available-for-Sale
Securities
68
5,000
1,500
Cash Flows from Gains and
Losses on Available-for-Sale
Caesh Company began with a $1,000
investment on January 1, 2005.
Cash sales
Cash expenses
Purchases of investment securities
Sale of investment securities
(costing $200)
Continued
$1,700
(1,400)
(600)
170
69
Cash Flows from Gains and
Losses on Available-for-Sale
The market value of the remaining securities
was $500 on December 31, 2005.
Sales
Expenses
Operating income
Realized loss on sale of securities
Net income
Continued
$1,700
(1,400)
$ 300
(30)
$ 270
70
Cash Flows from Gains and
Losses on Available-for-Sale
Caesh Company will report a $100
unrealized increase in the value of it
available-for-sale portfolio.
This $100 unrealized increase
is reported as an increase in
Accumulated Other
Comprehensive Income.
Continued
71
Cash Flows from Gains and
Losses on Available-for-Sale
72
The statement of cash flows for Caesh
Company for 2005 appear as follows:
Operating activities:
Net income
$ 270
Plus realized loss on sale of securities
30 $ 300
Investing activities:
Purchase of investment securities
$(600)
Sale of investment securities
170 (430)
Financing activities:
Initial investment by owner
1,000
Net increase in cash
$ 870
73
Classification and Disclosure
• Trading securities
– The change in net unrealized holding gain or
loss that is included in the income statement.
• Available-for-sale securities
– Aggregate fair value, gross unrealized holding
gains and gross unrealized holding losses, and
amortized cost basis by major security type.
– The proceeds from sales of available-for-sale
securities and the gross realized gains and
losses on those sales and the basis on which
Continued
cost was determined
in computing realized
gains and losses.
74
Classification and Disclosure
• Available-for-sale securities (continued):
– The change in net unrealized holding gain or
loss on available-for-sale securities that has
been included in stockholders’ equity during the
period.
• Held-to-maturity securities:
– Aggregate fair value, gross unrealized holding
gains and gross unrealized holding losses, and
amortized cost basis by major security type.
– The company should disclose information
about contractual Continued
maturities.
75
Classification and Disclosure
• Transfers of securities between categories:
– Gross gains and losses included in earnings
from transfers of securities from available-forsale into the trading category.
– For securities transferred from held-to-maturity,
the company should disclose the amortized cost
amount transferred, the related realized or
unrealized gain or loss, and the reason for
transferring the securities.
chapter 14
The End
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