Chapter 11 -- Marketable
Securities, Derivatives, and
Investments
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil
Learning Objectives
1. Understand why firms acquire securities of
other firms and how the purpose of the
investment governs the method of
accounting for that investment.
2. Develop skills to apply the market value
method to minority, passive investments,
including financial derivatives.
3. Develop skills to apply the equity method to
minority, active investments, contrasting its
financial statement effects with those of the
market value method.
Learning Objectives
4. Understand the concepts underlying
consolidated financial statements for
majority, active investments, contrasting
the financial statement effects of
consolidation with those of the equity
method.
5. Understand when a firm must consolidate
a variable interest entity, for which it does
not have conventional control, but does
have parent-like characteristics.
Chapter Outline
1. Overview of the accounting and
reporting of investment securities
2. Minority, passive investments
3. Derivative investments
4. Dealing with uncertainty by using
measurement, not recognition
5. Minority, active investments
Chapter Outline
6. Majority, active investments
7. An International Perspective
Chapter Summary
8. Appendix 11:1: Effects on the statement
of cash flows of investments in securities
Types of Investments

The accounting for investments depends on the
purpose of the investment and the percentage of
voting stock held.
Types of Investments (Cont.)

Minority, passive investments
– Less than 20% of voting stock.
– Assumed to be held for short term returns including dividends
and growth.

Minority, active investments
– Between 20% and 50% of voting stock.
– Assumed to be held to exert influence over the other
company.

Majority, active investments
– Greater than 50% of voting stock.
– Assumed to be held so for full control over the other
company.
Discuss Marketable Securities
 Marketable
securities are bonds or stocks
for which there is an active market and
hence a reliable market value.
are liquid assets in that they can
easily and quickly be converted into cash.
 They
 Marketable
securities held as a temporary
investment are classified as current
assets.
Market Securities Classification

Securities are properly classified as marketable
securities when
1. The firm can readily convert them into cash,
and
2. Intends to do so when it needs cash.


If either of the two tests for marketable
securities do not apply, then the securities are
properly classified as investment in securities.
Investment in securities are securities held for
long-term goals and are classified as long-term
assets.
Valuation at Acquisition
 Marketable
securities are initially
recorded at acquisition cost.
 Which
includes purchase price plus
any commissions, taxes or other
costs related to the acquisition.
 This
is the same rule as the general
rule for valuing assets at
acquisition.
Valuation after Acquisition



Because there exists a market value, marketable
securities can be reliably written up or down to
the market value giving a more current estimate
of economic worth.
This also results in a holding gain or loss which is
not due to the normal operations of a firm.
For the purposes of valuation after acquisition,
there are three classes of marketable securities:
1. Debt held to maturity
2. Trading securities
3. Securities available for sale
Debt Held to Maturity



Debt securities for which a firm has both the
positive intent & ability to hold to maturity.
Shown on the balance sheet at the amortized
acquisition cost.
Amortized acquisition cost means that the
securities are amortized like a mortgage or bond.
– The acquisition cost is assumed to be the present
value.
– The maturity value and maturity date are known
from the bond certificate.
– An internal rate of return can be calculated using PV
techniques.
What are trading securities?

Trading securities are assumed to be held for
short-term profit.
– Characterized by frequent & active buying &
selling with the object of generating profit.
– Typically only financial institutions hold trading
securities.

Since trading securities are acquired for shortterm profit, unrealized gains or losses that
result from adjustments to market value pass
through the income statement and increase or
reduce net income before there is a sale of
the securities.
Recording Trading Securities

Record acquisition of trading securities
Dec 28 Marketable securities
Year 3
Cash

400,000
To revalue the securities to market value and
recognize an unrealized holding gain
Dec 31 Marketable securities
Year 3
Unrealized holding gain

400,000
35,000
35,000
The unrealized holding gain is closed to income,
appears on the income statement and increases
retained earnings.
Complete this trading securities
problem.


Record the sale for $480,000 in the next year after the
unrealized gain has been closed to income.
Recall at the new value of the securities is $435,000.
Jan 3
Year 4

cash
marketable securities
realized gain on sale
480,000
435,000
45,000
This realized gain (because it is supported by a sale) is
closed to income also.
Securities Available for Sale

Securities available for sale are neither
trading securities or securities held to
maturity.
– They are an intermediate class and are typically
tied to a specific cash need.
– They are held by non-financial companies.

For example, a manufacturing firm may build
a large fund of securities to pay for a
renovation to its plant or to retire bonds that
will come due.
Securities Available for Sale
 Since
they are acquired for longer-term
return, unrealized gains or losses that
result from adjustments to market value
do not pass through the income statement
but stay on the balance sheet as an equity
account.
Solve Securities Available for Sale
Problem


Reconsider the example, but assume that the securities
are properly classified as securities available for sale.
Record acquisition of trading securities at acquisition
cost just as before to revalue the securities to market
value and recognize an unrealized holding gain (also
like before).
Dec 31
Year 3

Marketable securities
Unrealized holding gain
35,000
35,000
This unrealized holding gain is not closed to income, but
appears in the equity section of the balance sheet having
bypassed the income statement.
Solve Securities Available for Sale
Problem


Record the sale for $480,000 in the next year after
the unrealized gain has been closed to income.
Recall at the new value of the securities is $435,000.
Jan 3
Year 4

Cash
Unrealized holding gain
Marketable securities
Realized gain on sale
480,000
35,000
435,000
80,000
This realized gain (because it is supported by a sale)
is closed to income also.
Trading Securities & Securities
Available for Sale



Both are recorded at acquisition cost. Both
are written up or down to market with
adjusting entries.
Both give rise to an unrealized holding gain or
loss account upon adjustment.
However, the unrealized holding gain or loss
for trading securities is considered income; it
is close to income and increases or decreases
net income.
Compare Trading Securities &
Securities Available for Sale
 While
the unrealized holding gain or loss
for available for sale securities is not
closed but remains on the balance sheet.
When these securities are sold, this
account must then be closed and the
realized gain or loss is the same as
historical cost accounting.
Disclosure Requirements for
Securities
FASB 115 requires the following disclosures
for each period for marketable securities:
1. The aggregate market value, gross unrealized
holding gains, gross unrealized holding losses,
and amortized costs for debt securities held to
maturity and equity securities available for sale.
2. The proceeds from sales of securities available
for sale and the gross realized gains and losses
on those sales.
Disclosure Requirements for
Securities
3. The change during the period in the net
unrealized holding gains or loss on trading
securities included in a separate
shareholders’ equity account.
4. The change during the period in the net
unrealized holding gain or loss on trading
securities included in earnings.
Marketable Securities Controversy
The accounting for marketable securities has been
controversial. The accounting issues are:
– Whether to report these instruments at historical cost
(or some method based on historical cost) or at
market value, and
– If at market value, whether to report the changes
from period to period as part of that period’s income
or to wait until the firm sells or otherwise disposes of
the instrument to record the gain or loss in income.
Derivative Instruments
Firms face risks in carrying out business operations:
1. That customers will stop buying its products and
services
2. That raw material used in production will increase in
cost after the firm has committed to a selling price
3. That currency exchange rates will change after the
firm has made commitments fixed in terms of a
foreign currency
4. That interest rates will change
5. That employees will quit or retire
Derivative Instruments



Many firms seek to avoid risk even if it
is costly.
Some financial firms specialize in
helping firms avoid risk through
financial instruments which are sold to
the firm.
In general, such a financial instrument
substitutes a fixed known cost for an
unknown cost.
Derivative Instruments
 These
instruments are analogous to
insurance.
 These
instruments act as hedging when
money is involved and as derivative
instruments when the payoff is based on
economic outcomes.
 GAAP
requires firms to show the market
value of derivatives on their balance
sheets.
Minority, Passive Investments




Minority means > 50% ownership.
< 50% of the voting stock means absolute control over
the corporation.
When the investing firm cannot or does not influence the
decisions of the owned firm, the investment is passive.
Owner of a passive minority investment must account for
the investment using the
– Initial investment recorded at acquisition cost
– Dividends recorded as revenue
– At the end of accounting periods, asset is adjusted to the
market value
– Sale of asset results in a realized gain or loss
Minority, Active Investments
 Between
20% and 50% gives rise to the
presumption of active because an investor can
often exert influence over the decisions of the
firm with less than 50% of the voting stock
provided the remainder of the votes are split.
 It
requires the equity method of accounting.
– Initial purchase is recorded as an asset at the
acquisition cost.
– Each period, the investing firm recognized revenue
equal to its proportionate share of the firm.
– Dividends reduce the asset and are not revenue but
rather a return of capital.
What’s the rationale for the equity
method?
Since the purchaser is assumed to be able to
influence the decision of the purchased firm
including its dividend policy,


There is a risk that the purchaser might use
this influence to manipulate its own
income…by having the purchased firm declare
or fail to declare a dividend.
Recognizing a proportionate share of the
purchased firm’s income removes this risk.
Majority, Active Investments
A
parent firm holds more than 50% of
the voting stock of another firm, called
the subsidiary firm.
 This
gives the parent complete control
over the subsidiary.
 The
portion of the subsidiary not owned
by the parent is called the minority
interest.
Majority, Active Investments



A corporation is a legal entity and not
necessarily an economic entity. Laws might
require or allow separate legal entities that are
controlled by one entity, thus being one
economic entity.
Certain legal risks can be reduced by having
legally separate corporations.
Because one economic entity can control several
legal entities and because there is a risk that
income might be manipulated by economic
transactions between the legal entities,
Majority, Active Investments
 U.S.
GAAP requires that the financial
statements of legally separate entities be
combined under one controlling economic entity
and that one set of financial statements called
the consolidated financial statements be
produced.
 Consolidated
financial statements combine the
individual financial statements but reverse out
all transactions that occur between the related
firms (for example, sales from one to another).
An International Perspective




Most countries account for minority, passive
investments using the lower-of-cost-or-market
rule.
Accounting for minority and majority active
investments is similar to U.S. GAAP.
The IASC requires the equity method for
investments where the holder exerts
significant influence and has no plans to sell in
the near future.
The IASC expresses a preference for
consolidations of controlled entities.
Chapter Summary


Investments are held either for profit (resold
at a higher price) or for control purposes.
If held for profit, the current market value
provides useful information on that profit
potential. Because of this, GAAP provides for
certain securities to be valued at market
value.
Chapter Summary
 If
held for control, then the profit of the
subsidiary firm provides useful
information. Both the equity method and
consolidations require the parent firm to
recognize accrued income of the
subordinate.
Appendix 11.1: Effects on the
Statement of Cash Flows of
Investments in Securities

Market Value Method:
Calculating cash flow from operations normally
requires no adjustments to net income.
Unrealized gains or losses require an
adjustment for trading securities but do not
for available-for-sale securities.

Equity Method:
Does require an adjustment to net income.
Rapid Review - MC
1. If Pappa company owns between 20% and 50%
of voting stock of Sunshine Company, this is a
a. Minority passive investment
b. Minority active investment
c. Majority passive investment
d. Majority active investment
2. Which one below is a risk to a firm’s business
operations regarding derivative instruments?
• Interest rates will change
• People will stop buying their product
• Employees will quit or retire
• All of the above