12-1
Investments
Chapter 12
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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
12-11
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)
12-12
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
12-13
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
12-14
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.
12-15
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
12-16
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)
12-17
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
12-18
12-19
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
12-20
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.
12-21
U. S. GAAP vs. IFRS
Until recently, IFRS did not allow transfers out of their “Fair
Value through Profit and Loss” (FVTPL) classification.


U.S. GAAP also allows transfers
out of the trading security
category.
Reclassifications under U.S. GAAP
are rare.


IAS No. 39 now allows transfer of
debt investments out of the fair
value category into AFS or HTM in
“rare circumstances.”
The current financial crisis
qualified as one of those
circumstances.
12-22
U. S. GAAP vs. IFRS
IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new
classifications that are more restrictive. This has the general effect of pushing more
investments into being accounted for at “Fair Value Through Profit & Loss”
(FVTPL), and thus having unrealized gains and losses included in net income.



U.S. GAAP permits classification as
HTM, AFS, and TS.
No significant tests are required
to classify a debt investment.
There is no comparable FVTPL or
FVTOCI classification.

Investments in debt securities are
classified as either “Amortized Cost” or
FVTPL.

To be classified as a debt investment,
two important tests must be met. The
current financial crisis qualified as one
of those circumstances.

Investments in equity securities are
classified as either “FVTPL” or
“FVTOCI” (“Fair Value through Other
Comprehensive Income).
12-23
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).
12-24
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 OTT
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 OTT impairment is
recognized, the ordinary treatment of unrealized gains and losses
is resumed.
12-25
U. S. GAAP vs. IFRS
Until recently, IFRS did not allow transfers out of the “fair value
through P&L” (FVTPL) classification (which is roughly
equivalent to the trading securities classification in U.S. GAAP).

U.S. GAAP has no prohibition
against transfers between
categories as long as they can be
reasonably justified.


Under IAS No. 39 transfers of debt
investments out of the FVTPL
category into AFS or HTM in “rare
circumstances.”
The 2008 financial crisis qualifies
as one of those “rare
circumstances.”
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
12-26
12-27
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.
12-28
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
12-29
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.
12-30
A Single Entity Concept
Under the equity method . . .
1. The investor recognizes investment income equal to its
percentage share (based on stock ownership) of the net
income earned by the investee rather than the portion of
that net income received as cash dividends.
2. Initially, the investment is recorded at cost. The carrying
amount of this investment subsequently is:
a) Increased by the investor’s percentage share of the
investee’s net income (or decreased by its share of a
loss).
b) Decreased by dividends paid.
12-31
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?
12-32
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
12-33
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.
12-34
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
12-35
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
12-36
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
Changing From the Equity Method to
Another Method
When the investor’s level of influence changes, it
may be necessary to change from the equity
method to another method.
At the transfer date,
the carrying value of
the investment under
the equity method is
regarded as cost.
12-37
Changing from Another Method to the
Equity Method
When the investor’s ownership level increases to the point
where they can exert significant influence, the investor
should change to the equity method.
At the transfer date, the recorded value is the initial cost
of the investment adjusted for the investor’s equity in
the undistributed earnings of the investee since the
original investment.
Reported earnings
– Dividends paid
= Undistributed Earnings
12-38
Changing from Another Method to the
Equity Method
12-39
The original cost, the unrealized holding gain or
loss, and the valuation account are closed.
A retroactive change is recorded to recognize the
investor’s share of the investee’s earnings since
the original investment.
12-40
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
12-41
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
12-42
Appendix 12A – Other Investments
It is often convenient for companies to set aside money to
be used for specific purposes. In the short-term, funds may
be set aside for
1. Petty cash funds.
2. Payroll accounts.
In the long-run, funds are often set aside to:
1. Pay long-term debt when it comes due.
2. Acquire treasury stock.
Special purpose funds set aside for the long-term are
classified as investments.
12-43
Appendix 12A – Other Investments
It is a common practice for companies to purchase
life insurance policies on key officers. The
company pays the premium and is the beneficiary
of the policy. If the officer dies, the company
receives the proceeds from the policy. Some types
of policies build a portion of each premium as cash
surrender value. The cash surrender value of such
a policy is classified as an investment on the
balance sheet of the company.
Appendix 12B – Impairment of
Investments
If the fair value of an investment declines to a level below
cost, and that decline is not viewed as temporary, companies
typically have to recognize an other-than-temporary (“OTT”)
impairment loss in earnings.
We use a three-step process to determine whether an OTT
impairment loss must be recognized: (1) determine if the
investment is impaired, (2) determine whether any
impairment is OTT, and (3) determine where to report the
OTT impairment.
12-44
Appendix 12B – Impairment of
Investments
Is the investment impaired?
Is any of the impairment
other-than-temporary (OTT)?
12-45
Equity
Investment
Yes, if the fair value is less
than the investment's cost
Debt
Investment
Same (yes, if the fair value is
less than the investment's
amortized costs)
Yes, if the investor cannot
assert that it has the intent
and ability to hold the
investment until fair value
recovers
Yes, if the investor (a) intends
to sell the investment, (b)
believes it is "more likely than
not" that the investor will be
required to sell the investment
prior to recovering the
amortized cost of the
investment, or ( c ) has
incurred credit losses.
Appendix 12B – Impairment of
Investments
Where is the OTT inpairment
reported?
Equity
Investment
In net income
Debt
Investment
In net income, if the investor
intends to sell the security or
is "more likely than not" to
be required to sell it before
recovery of its amortized
cost.
Otherwise:
lCredit loss portion in net
income. (Credit loss =
amortized cost - PV of
expected cash flows);
l Noncredit loss portion in
OCI (Noncredit loss portion =
total impairment - credit
loss)
12-46
Appendix 12B – Impairment of
Investments
12-47
United Intergroup, Inc., buys and sells both debt and equity securities of other companies
as investments. United’s fiscal year-end is December 31. The following events during 2013
and 2014 pertain to the investment portfolio.
Purchase Investment: July 1, 2013, $1,000,000 of Bendac common stock. Adjust
Investment to Fair Value:
• December 31, 2013: Valued the Bendac stock at $990,000 and determined that the
decline in FV should not be treated as an OTT impairment.
• December 31, 2014 : Valued the Bendac stock at $985,000 and determined that
the decline in FV should be treated as an OTT impairment
The journal entries to record the adjustments of the Bendac stock investment to fair
value are:
December 31, 2013
Net unrealized holding gains and losses – OCI
Fair value adjustment
10,000
10,000
Appendix 12B – Impairment of
Investments
December 31, 2014
Other-than-temporary impairment loss – I/S
Investment in Bendac
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15,000
15,000
Fair value adjustment
10,000
Net unrealized holding gains and losses – OCI 10,000
Appendix 12B – Impairment of
Investments
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United Intergroup, Inc., buys and sells both debt and equity securities of other
companies as investments, and classifies these investments as AFS. United’s fiscal
year-end is December 31. The following events occurred during 2014:
Purchase Investment: July 1, 2014, $1,000,000 of Bendac bonds, maturing on
December 31, 2019.
Adjust Investment to Fair Value: December 31, 2014, valued the Bendac
bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and
$20,000 is noncredit loss.
Case 1: United either plans to sell the investment or believes it is more likely
than not that it will have to sell the investment before fair value recovers.
Case 2: United does not intend to sell the investment and does not believe it is
more likely than not that it will have to sell the Bendac investment before fair
value recovers, but estimates that $30,000 of credit losses have occurred.
Let’s look at the necessary journal entries in these two cases.
Appendix 12B – Impairment of
Investments
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Case 1
December 31, 2014
OTT impairment loss – I/S
Discount on bond investment
50,000
50,000
Case 2
December 31, 2014
OTT impairment loss – I/S
Discount on bond investment
OTT impairment loss - OCI
Fair value adjustment – Noncredit loss
30,000
30,000
20,000
20,000
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U. S. GAAP vs. IFRS
Under IAS No. 39, companies recognize OTT impairments if there exists
objective evidence of impairment. Objective evidence must relate to one or
more events occurring after initial recognition of the asset that affect the
future cash flows that are going to be generated by the asset.

U.S. GAAP recognizes in OCI any
non-credit losses on debt
investments.


Calculation of the amount of
impairment differs depending on the
classification of an investment.
Under IFRS, an OTT impairment for a
debt investment is likely to be larger
if it is classified as AFS than if it is
classified as HTM, because it includes
the entire decline in fair value if
classified as AFS but only the credit
loss if classified as HTM.
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Investments:
A Chapter Supplement
Supplement to Chapter 12
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
GAAP vs. Proposed
Accounting Standard Update
Reporting Category Used in
Current GAAP
Proposed ASU
Accounting Approach
Held-to-maturity ("HTM)*
Amortized Cost**
Investment recorded at amortized
cost.
Trading securities ("TS")
Fair Value through Net
Income ("FV-NI")
Investment reported at fair value.
Unrealized holding gains and losses
included in net income.
Securities available-for-sale
("AFS")
Fair Value through Other
Comprehensive Income
("FV-OCI")**
Investment reported at fair value.
Unrealized holding gains and losses
excluded from net income and
reported in OCI. Gains and losses
reclassified from OCI and reported
in net income whenrealized through
the sale of the investment.
Equity method*
Equity method**
Investment reported at cost
adjusted for subsequent earnings
and dividends of the investee.
Consolidation
Consolidation
The financial statements of the
investor and investee are combined
as if they are a single company.
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Accounting for Equity Investments
Determining how to account for equity investments in stock under the
proposed ASU is easy. If the investor does not have “significant influence”
over the investee, the equity investment is accounted for as FV-NI. If the
investor has significant influence over the investee, but lacks control, the
equity method is used. If the investor has control, the investment is
consolidated.
Under current GAAP, the
investor accounts for the
equity investment as a
trading or as an AFS
security.
Under the ASU an equity
investment always is treated as
FV-NI (equivalent to being
accounted for as a trading
security).
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Accounting for Debt Investments
Determining how to account for debt investments under the proposed ASU
is more complicated than accounting for equity investments. Under the
proposed ASU we base classification of debt investments on two criteria:
1. The characteristics of the debt instrument.
2. The business activity in which the instrument is used.
We discuss each of the criteria in turn.
Characteristics of a Simple Debt Instrument
1. An amount is transferred to the borrower (debtor) when the debt instrument is
issued that will be returned to the lender (creditor) when the debt matures or is
settled. The amount is the principal or face amount of the debt adjusted for any
discount or premium.
2. The debt cannot be prepaid or settled in such a way that the lender does not
recover substantially all of its original investment, unless the lender chooses to
allow it.
3. The debt instrument is not a derivative.
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Accounting for Debt Investments
Characteristics of a Complex Debt Instrument
Debt that lacks one or more of the characteristics of
simple debt is considered complex. Under the
proposed ASU, debt that is complex always is
classified as fair value in net income.
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Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity
that motivates the investor to hold the debt. The proposed ASU
identifies three primary business activities as
1. lending,
2. long-term investing, or
3. held for sale.
The debt holder’s purpose is lending or
customer financing with a focus on
collecting cash flows (interest and
principal). The debt holder must have the
ability to renegotiate, sell, or settle the
debt to minimize losses due to a borrower's
deteriorating credit. The appropriate
accounting approach is amortized cost.
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Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity
that motivates the investor to hold the debt. The ASU identifies
three primary business activities as
1. lending,
2. long-term investing, or
3. held for sale.
The debt holder may choose to hold on to
the debt investment or sell it as a way of
either (a) maximizing its return on
investment or (b) managing risk. The
appropriate accounting approach is Fair
Value – Other Comprehensive Income (FVOCI)
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Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity
that motivates the investor to hold the debt. The ASU identifies
three primary business activities as
1. lending,
2. long-term investing, or
3. held for sale.
For the business purpose to be classified as
held for sale, the debt instrument is either
(a) held for the purpose of being sold or (b)
actively managed internally on a fair value
basis. The appropriate accounting approach
is Fair Value – Net Income.
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Summary of Classification Criteria
Classification Criteria
Debt investment
Characteristics: Simple Debt
Business Purpose:
1. Lending or Customer Financing
2. Investment Returns or Risk Management
3. Trading Gains from Sale
Characteristics: Complex Debt
Equity investment
Accounting Approach
Amortized Cost
FV-OCI
FV-NI
FV-NI
FV-NI
The proposed ASU does not allow transfers of debt from one
category to another. After the debt is initially classified,
reclassifications are not permitted.
Impairments When the Investor Does
Not Exercise Significant Influence
Because equity investments are reported at FV-NI, no impairment
guidance is necessary. The same is true for debt investments
recorded at FV-NI. Declines in fair value always are reported in
net income. However, for debt investments reported at amortized
cost or at FV-OCI, impairment losses are possible. Let’s look at the
“three-bucket” approach currently under consideration.
1
Investments not affected
by observed events.
2
Investments affected by
observed events (but
individual defaults have
not been identified).
3
Individual debt
investments suffering
credit losses.
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Debt Impairment (continued)
Objective: Use expected value (probability-weighted
average) of losses of principal and interest on a discounted
basis.
Time horizon of estimated losses:
Bucket 1: over near term (say, 1-2 years).
Buckets 2 and 3: over remaining life of investment.
No impairment upon acquisition of distressed debt (interest
based on expected cash flows rather than contractual cash
flows).
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Equity Method
The criteria for applying the equity method are the same in the
ASU as in current GAAP. If a company is holding an investment
for sale that normally would qualify for the equity method, the
investment is accounted for as FV-NI.
If facts indicate an impairment in value of an equity
method investment, the investor recognizes an
amount equal to the difference between the
investment’s carrying value and its fair value. If fair
value increases in the future, the impairment
cannot be reversed.
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End of Chapter 12