FAS 115: Accounting for Certain
Investments in Debt and Equity Securities
•
Debt securities that the enterprise has the positive
intent & ability to hold to maturity are classified as
held-to-maturity securities. Report at amortized cost.
•
Debt & equity securities that are bought & held
principally for the purpose of selling them in the near
term are classified as trading securities. Reported at
fair value, with unrealized gains & losses included in
earnings.
•
Debt & equity securities not classified as either
held-to-maturity securities or trading securities are
classified as available-for-sale securities. Report at
fair value, with unrealized gains & losses excluded
from earnings & reported in a separate component of
shareholders' equity.
Investments in Debt & Equity Securities
Category (based
on intent)
Held-to-maturity
Debt securities
Valuation
(intent & ability)
(amortize the
discount or
premium)
Unrealized Holding
Gains or Losses
Amortized Cost Do not recognize
Trading Securities Fair Value
Interest when
earned; gains
& losses from
sale
Recognize in net income
Interest when
earned; gains
& losses from
sale
Recognize as other
comprehensive
income & as
separate component
of stockholders’
equity
Interest when
earned; gains
and losses from
sale
(short-term holdings
Of debt or equity)
Available-for-Sale Fair Value
(intermediate to
longer term
holdings of debt
or equity)
Other Income
Effects
Account for held-to maturity debt
securities at amortized cost
Accounting for Held-to-Maturity Debt Securities
(1st) Journalize Acquisition:
Dr Held-to-Maturity Securities
AmntPd
Cr Cash
AmntPd
(2nd) Journalize Receipt of Interest Payment:
Dr Cash
AmntRecd
Dr Held-to-Maturity Securities
AmorDisc
Cr Held-to-Maturity Securities
AmorPrem
Cr Interest Revenue
Earned
(3rd) Adjusting Entry:
no “Mark to Market” adjustment …carry at amortized cost
Held-to-Maturity Securities...
may lose this classification under some circumstances:
a. Evidence of a significant deterioration in the issuer's
creditworthiness
b. A change in tax law that eliminates or reduces the tax-exempt
status of interest on the debt security (but not a change in tax law
that revises the marginal tax rates applicable to interest income)
c. A major business combination or major disposition (such as sale
of a segment) that necessitates the sale or transfer of held-tomaturity securities to maintain the enterprise's existing interest
rate risk position or credit risk policy
d. A change in statutory or regulatory requirements significantly
modifying either what constitutes a permissible investment or the
maximum level of investments in certain kinds of securities,
thereby causing an enterprise to dispose of a held-to-maturity
security
e. A significant increase by the regulator in the industry's capital
requirements that causes the enterprise to downsize by selling
held-to-maturity securities
f. A significant increase in the risk weights of debt securities used
for regulatory risk-based capital purposes.
May not classify as
Held-to-Maturity Securities … if ...
if the enterprise anticipates that the security would be available
to be sold in response to:
a. Changes in market interest rates and related changes in the
security's prepayment risk
b. Needs for liquidity (for example, due to the withdrawal of
deposits, increased demand for loans, surrender of insurance
policies, or payment of insurance claims)
c. Changes in the availability of and the yield on alternative
investments
d. Changes in funding sources and terms
e. Changes in foreign currency risk
The following conditions do not lose
Held-to-Maturity Classification… if ...
a.The sale of a security occurs near enough to its maturity date (or
call date if exercise of the call is probable) that interest rate risk is
substantially eliminated as a pricing factor. That is, the date of
sale is so near the maturity or call date (for example, within 3
months) that changes in market interest rates would not have a
significant effect on the security's fair value.
b. The sale of a security occurs after the enterprise has already
collected a substantial portion (at least 85 percent) of the principal
outstanding at acquisition due either to prepayments on the debt
security or to scheduled payments on a debt security payable in
equal installments (both principal and interest) over its term. For
variable-rate securities, the scheduled payments need not be
equal.
Account for available-for-sale
& trading securities portfolios
at fair value
Investments in Available-for-Sale Securities
(debt or equity)
(1st) Journalize Acquisition:
Dr Available-for-Sale Securities
AmntPd
Cr Cash
AmntPd
(2nd) Journalize Receipt of Interest/Dividend Payment:
Dr Cash
AmntRecd
Dr Available-for-Sale Securities
AmorDisc
Cr Available-for-Sale Securities
AmorPrem
Cr Interest/Dividend Revenue
Earned
(3rd) Adjusting Entry -- Mark-to-Market against Equity:
Securities Fair Value Adjustment—Available-for-Sale $$$GAIN
Unrealized Holding Gain or Loss—Equity
$$$GAIN
Unrealized Holding Gain or Loss—Equity
$$$LOSS
Securities Fair Value Adjustment—Available-for-Sale
$$$LOSS
Investments in Trading Securities
(debt or equity securities)
(1st) Journalize Acquisition:
Dr Trading Securities
AmntPd
Cr Cash
AmntPd
(2nd) Journalize Receipt of Interest/Dividend Payment:
Dr Cash
AmntRecd
Cr Interest/dividend Revenue
AmntRecd
(3rd) Adjusting Entry -- Mark-to-Market against Income:
Securities Fair Value Adjustment—Trading
Unrealized Holding Gain or Loss—Income
$$$GAIN
$$$GAIN
Unrealized Holding Gain or Loss—Income
Securities Fair Value Adjustment—Trading
$$$LOSS
$$$LOSS
The 4 reasons to buy the
stocks of another company:
• To make money -- fair value accounting
• For influence ----- equity method
• For control -------- consolidate results
(covered in advanced accounting)
Account for securities held for the
purpose of influence (20% - 50% interest)
using the equity method
The Investment Account
reflects the activity of the Equity Section on the
Investee Company
(adjusted for intercompany transactions)
(as if the net assets were revalued at fair value)
… based on the percentage ownership acquired
Accounting for Equity Investments
Classification:
Purpose:
Valuation:
Valuation Accounts:
Level of Influence
A
Trading
B
Available-for-Sale
C
20-50% holdings
Short-Term Gain
Moderate to LT Gain
For Influence
Fair Value
Fair Value
Equity
Security Fair Value Adjustement (TS or AFS)
Unrealized Gain or Loss - Income or Equity
None
Little, if any
Passive Interest
Significant
Dividends Received
Income
Income
Reduce Investment
Investee Net Income
No Direct Impact
No Direct Impact
Increase Investment
(net o f interco mpany gains &
lo sses & after amo rtizatio n o f the dif
the dif between the Co st o f the & the
pro po rtio nate share o f B V o f assets)
Investment in XYZ Account
• Cost
• Share of Income
• Share of Losses
• Dividends
• Amortizations (but no
amortization of any
implied goodwill!!!)
Accounting for Equity Securities
Using the Equity Method
Acquisition:
Dr Investment in ABC Co.
Cr Cash
Dividend Receipt:
Dr Cash
Cr Investment in ABC Co.
Income of Investee:
Dr Investment in ABC Co.
Dr Loss from ABC Co. (extraordinary)
Cr Revenue from ABC Co.
Cost
Cost
AmntRec’d
AmntRec’d
%NI
%Extr
%NIBX
Dr Revenue from ABC Co.
Amort
Cr Investment in ABC Co. (1/N (Cost-BV))
Amort
Adjusting Entry to Carry Investment at Fair Value:
none … hold at Adjusted Cost (adjusted for Income & Add’l Depr)
Fair Value Accounting Controversy
1. Measurement is based on intent. A subjective
evaluation which will result in arbitrary
classifications.
2. Gains recorded are based on trading. Selling
"winners" and holding on to "losers."
3. Liabilities are recorded at cost, not fair value.
Recognizing changes in asset values while ignoring
similar changes in liabilities will lead to a high
degree of volatility in income and stockholders'
equity.
4. There is a great deal of subjectivity in fair
values. Results in opportunity gains and losses
being recognized in the financial statements…
which may quickly reverse.
Transfers Between Categories
1. Transfers between categories are accounted for at
fair value.
2. The "fair value rule" assures that a company cannot
escape recognition of fair value by simply transferring
securities to held-to-maturity.
3. Appendix 18A illustrates the accounting entries to
record the transfer of securities between categories.
Impairment of Value. If the decline is judged
to be other than temporary, the cost basis of the
individual security is written down to a new cost basis.
The amount of the write-down is accounted for as a
realized loss.
1. For debt securities, the impairment test is to
determine whether it is probable that the investor will
be unable to collect all amounts due according to the
contractual terms.
2. For equity securities, guidelines are less precise. Any
time realizable value is lower than carrying amount, an
impairment must be considered.
Financial Statement Presentation:
Comprehensive Income
1. Changes in unrealized gains and losses related to
available-for-sale securities are reported as part of other
comprehensive income, and reflected as a separate
component of stockholders' equity. Comprehensive
income may be reported in:
(a) a combined statement of income & comprehensive
income or,
(b) a separate statement of comprehensive income
beginning with net income, or
(c) a statement of stockholders' equity.
A derivative … is any financial
instrument that derives its value from
an outside benchmark. For example, a
stock option is a derivative in that the value
of the option is derived from the underlying
price of the stock ... Specifically, the “option
premium” is the sum of its “intrinsic value”
(difference between its market price & its
strike price) & its “time value” (based on
the possibility that the option will be “in the
money” before it expires).
FASB’s definition of a “Derivative”
... “a derivative financial instrument is a futures,
forward, swap, or option contract, or other
financial instrument with similar characteristics.”
includes:
• interest rate caps or floors
• fixed rate loan commitments
• letters of credit
... they provide the holder with benefits
of favorable movements in the price of an underlying
asset or index with limited or no exposure to losses from
unfavorable price movements, generally in return for a
premium paid...
FABB exposure draft April 14, 1994
Example Derivatives:
Speculative Derivatives:
•
call options
Derivatives to Hedge Risk:
FAIR VALUE HEDGE
• interest rate swap from fixed to
variable rate
CASH FLOW HEDGE
• futures contracts - purchase side
• interest rate swap from variable to
fixed rate
FAS 133: Accounting for Derivatives
Use
Speculation:
Fair Value
Hedge
Cash Flow
Hedge
Accounting for the
Accounting for the
Derivative
Hedge
• Fair Value, unrealized • n/a
holding G/L hit
income
• Fair Value, unrealized • Fair Value, G/L hit
income
holding G/L hit
income
• Fair Value, unrealized • Use other GAAP for the
holding G/L hit equity
hedged item
& are reclassified in
income when the
hedged transaction’s
cash flow affects
earnings