Agenda
Items to be covered:
• Equity investments
• Debt investments
© 1999 by Robert F. Halsey
Introduction
 The Area of Controversy - before the current accounting standard
was enacted investments in equity and debt securities were recorded
at historical cost with no adjustment for changes in their market
value.
 This reflected the feeling that historical cost was free form bias and,
therefore, would not inject subjectivity into the financial statements.
 Now, some debt and equity investments are reported at market value
on the balance sheet. Since these securities have known market
values (we can look up the price of a stock in the Wall Street
Journal), we can use market values without risk of creating bias in
the balance sheet.
 This standard met the needs of the investment community which
desired current market values as well as the accounting community
which desired to protect the integrity of financial statements.
© 1999 by Robert F. Halsey
The following is a general roadmap of the accounting for
marketable securities:
Securities available for
sale (Unrealized gains
and losses to
stockholder's equity)
Passive - market method
Trading securities
(Unrealized gains and
losses to Income
Statement)
Minority
Significant Influence Equity method
Degree of Ownership
Purchase method
Majority
Consolidate
Pooling-of-interests method
© 1999 by Robert F. Halsey
Equity Investments (no significant influence)
At acquisition, the securities are recorded at their cost (including
taxes, brokerage fees), which is equal to their market price on the
day they are purchased.
Subsequent to acquisition
– Record dividends received as dividend income
– At each statement date, report the securities at their
market value through the use of a security fair value
adjustment account
– Changes in market value are reflected in net income if the
securities are classified as “trading” and bypass the
income statement if they are classified as “available-forsale”
Upon disposition, the difference between the proceeds received and
the cost of the securities is recorded as a gain or loss on sale.
© 1999 by Robert F. Halsey
The accounting for changes in market value depends on
how the securities are classified by the company:
If the securities are classified as “Trading”, changes in their
market value are reflected in the net income of the company.
Stockholder’s equity changes by the change in retained
earnings. The company’s profitability, therefore, fluctuates with
changes in the market value of its investments.
If the securities are classified as “Available-For-Sale”,
Changes in their market value are reflected as a direct debit or
credit to stockholder’s equity and are not run through the
income statement. A separate stockholder’s equity account is
reflected on the balance sheet to recognize changes in the
market value of the firm’s investment portfolio.
© 1999 by Robert F. Halsey
Here is an example from Aetna’s annual report:
Notice the reduction of stockholder’s equity relating to
“Accumulated other comprehensive income”.
© 1999 by Robert F. Halsey
The statement of Stockholder’s Equity provides additional
information relating to this other comprehensive loss. The after-tax
amount is 833.4M and most of this relates to unrealized losses in the
company’s investment portfolio:
© 1999 by Robert F. Halsey
The schedule provided in the notes reveals that total unrealized losses
exceed unrealized gains:
© 1999 by Robert F. Halsey
Why do we account for changes in market value differently
depending on the classification of the securities?
The original standard contemplated that all changes in
market value would be reflected in earnings, but the banking
industry was concerned that increased volatility in earnings
would undermine confidence in the banking system.
So, the current standard reflected a compromise by FASB
which would allow current market values to be reflected on
the balance sheet, but not increase the volatility of the
earnings for those firms not actively trading in the securities.
© 1999 by Robert F. Halsey
Debt Investments
Recall accounting for bonds...
 At acquisition: Record the bond at its market price as of the date of
sale (recall how to price bonds )
 During the bond’s life: Amortize the premium or discount using the
effective interest method and reflect the amortization as interest
expense together with the cash interest paid.
 Upon retirement: Compare selling price with carrying value and
record a gain or loss on retirement as the difference.
The accounting for debt investments is just the same.
© 1999 by Robert F. Halsey
What about changes in market values?
Recall that the value of marketable bonds will vary with market
interest rates. That is when interest rates rise then the value of
your investment will fall.
Should these value changes be reflected in financial statements?
The FASB has answered this question -- IT DEPENDS…
On management’ intent.
The current accounting standards provide for three classifications of
debt investments, each with its own set of accounting rules.
© 1999 by Robert F. Halsey
1. Held to maturity -- companies can elect to account for their debt
investments as “held to maturity” if they have both the positive
intent and the ability to hold these investments to maturity.
2. Trading -- debt securities accounted for using this classification are
purchased and held primarily for resale in the near term to generate
income from short term price changes.
3. Available for sale -- these are debt securities not classified as Held
To Maturity or Trading. They are securities that the firm intends to
hold and possibly sell if the “price is right”, but does not intend to
“trade” in their short-term price movements.
© 1999 by Robert F. Halsey
Here are the accounting rules related to these classifications…
For the Held To Maturity classification, use historical cost
(amortize any discount or premium and record the difference
between the proceeds and the carrying value of the securities as a
gain or loss on sale). The rationale for this accounting treatment is
a follows: if a security is held to maturity, changes in its value due
to market fluctuations are not relevant, because at maturity, the
firm will receive the face amount regardless of intervening price
changes.
For both the Trading and Available-For-Sale classifications, the
securities are reported at their market value on the statement date.
The difference in the accounting for these securities relates to the
treatment of changes in market value.
© 1999 by Robert F. Halsey
The remainder of the accounting classifications is identical to that
for equity securities:
If the securities are classified as “Trading”, changes in their
market value are reflected in the net income of the company.
Stockholder’s equity changes by the change in retained
earnings. The company’s profitability, therefore, fluctuates with
changes in the market value of its investments.
If the securities are classified as “Available-For-Sale”, changes
in their market value are reflected as a direct debit or credit to
stockholder’s equity and are not run through the income
statement. A separate stockholder’s equity account is reflected
on the balance sheet to recognize changes in the market value
of the firm’s investment portfolio.
© 1999 by Robert F. Halsey
The End
© 1999 by Robert F. Halsey