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 12-48 15,000 15,000 Fair value adjustment 10,000 Net unrealized holding gains and losses – OCI 10,000 Appendix 12B – Impairment of Investments 12-49 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 12-50 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 12-51 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. 12-52 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. 12-53 12-54 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). 12-55 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. 12-56 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. 12-57 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. 12-58 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) 12-59 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. 12-60 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. 12-61 12-62 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). 12-63 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. 12-64 End of Chapter 12