Chapter 14 Investments
Investments: Classification an Valuation
There are three categories of investments:
1. Trading Securities – investments in debt and equity securities that are purchased
and held principally for the purpose of selling them in the near term are classified
as trading securities.
2. Available-for-Sale Securities – Investments in available-for-sale securities are
debt securities that are not classified as being held to maturity and debt and equity
securities that are not classified as trading securities.
3. Held-to-Maturity Debt Securities – investments in held-to-maturity debt securities
are debt securities for which the company has positive intent and ability to hold
those securities to maturity.
A company initially records each category of securities at cost, but subsequent valuations
of the securities on its balance sheet and the reporting of unrealized holding gains and
losses vary as follows:
1. Trading Securities- Investments in trading securities are reported at their fair
values on the balance sheet date, and unrealized holding gains and losses are
included in net income of the current period.
2. Available-for-Sale Securities- Investments in available-for-sale securities are
reported at their fair values on the balance sheet date, the net unrealized holding
gains or losses for the year are included in comprehensive income for that year
and the cumulative net unrealized holding gains or losses are reported in the
accumulated other comprehensive income section of the stockholder’s equity and
not in net income.
3. Held to Maturity Debt Securities- Investments in held-to-maturity debt securities
are reported at their amortized cost on the balance sheet date, and are not reported
at fair value.
Definitions important for investments discussions:
1. A debt security represents a creditor relationship with another entity
2. An equity security represents an ownership interest in another company
3. Fair Value is the amount at which a security could be exchanged in a current
transaction between willing parties.
Equity Method – is used for investments in equity securities when the investor has
significant influence over the investee. Significant influence generally occurs when
the investor owns between 20% -50% of the voting common stock of the investee.
Consolidation – occurs when the investor controls the investee through an investment
in equity securities. Control generally occurs when the investor owns over 50% of
the voting common stock in the investee.
Investments in Debt and Equity Trading Securities
GAAP for investments in debt and equity securities classifies trading securities as:
1) The investment is initially recorded at cost,
2) It is subsequently reported at fair value
3) Unrealized holdings and gains are included in net income of the current
period
4) Interest and dividend revenue as well as realized gains and losses on sales
are included in the net income of the current period
Investments in Available-for-Sale
GAAP for investments in debt and equity securities classifies available-for-sale securities
as:
1) The investment is initially recorded at cost
2) It is subsequently reported at fair value
3) Unrealized holding gains and losses are reported as a component of other
comprehensive income
4) Interest and dividend revenue, as well as realized gains and losses on
sales, are included in net income for the current period.
Recording initial cost – a company records all investments in securities initially at the
acquisition price of the securities plus any other costs necessary for the transaction.
Recording interest revenue – a company records interest revenue as it is earned during the
period
Recording dividend revenue – dividend revenue is recorded when the dividends are
declared by the investee company because that is the date on which the investor has the
right to receive them.
Investments in Held-to-Maturity Debt Securities
1)
2)
3)
4)
The investment is initially recorded at cost
It is subsequently reported at amortized cost
Unrealized holding gains and losses are not recorded
Interest revenue and realized gains and losses on sales (if any) are included in net
income.
Recognition and Amortization of Bond Premiums and Discounts – the amount of interest
revenue recognized each accounting period is based on the effective interest rate (yield)
at the time of acquisition. Therefore any premium or discount is amortized over the
remaining life of the bonds in order to assign the proper amount of interest revenue to
each accounting period.
Amortization of Bonds acquired between interest dates – bonds may be acquired between
interest dates, and if they are and any discount or premium exist, it must be amortized
over the remaining life of the bonds.
Sale of Investment in Bonds before Maturity – selling an investment in bonds being held
to maturity should be rare because this may violate the original intent of behind
acquisition and the valuation procedures underlying the intent. If such a sale occurs a
company must record any gain or loss form the transaction. Also the company eliminates
its Investment account and collects any interest earned since the last interest date from the
purchaser.
Equity Method
1) Acknowledges the existence of a material economic relationship between the
investor and the investee
2) Is based upon the requirements of accrual accounting
3) Reflects the change in stockholder’s equity of the investee company.
Equity Method Adjustments to investment income
1) Eliminate intercompany transactions in the determination of investor income.
2) Depreciate the proportionate share of any difference between the fair values and
book values of investee depreciable assets implied by the acquisition price of the
investee shares.
3) Treat the proportionate share of investee extraordinary items as investor
extraordinary items. The proportionate share of investee results of discontinued
operations and cumulative effects of changes in accounting principles are treated
similarly.
Investor Accounts for the investment and income under the equity method
Investment = Acquisition Cost + Investor’s Share of - Dividends Received
Investee Income
Where
Investor’s Share of = (Investee’s Net Income x Ownership %) – Adjustments
Investee Income
And
Dividends Received = Total Dividends Paid by Investee x Ownership %