INTERMEDIATE
ACCOUNTING
Chapter 13
Investments and Long-Term Receivables
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Investing for the Future
A debt security is a financial instrument that represents a
creditor relationship with another company. Investments in debt
securities include such items as U.S. treasury securities,
municipal and corporate bonds, and convertible debt.
An equity security is a financial instrument that represents an
ownership interest in another company. Investments in equity
securities include common stock, preferred stock, warrants,
options, and rights.
A portfolio of investments in debt and/or equity securities that
have a readily determinable fair value is often referred to
marketable securities (investment securities).
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Are Investments Classified And Valued?
(Slide 1 of 4)
An investment in another company that does not allow the
investing company to control or exert significant influence over
the other company is considered a minority passive
investment.
Generally, an investment is considered a passive investment
when a company owns less than 20% of the voting common
stock of the investee.
At acquisition, a company classifies each passive investment in
debt and equity securities into one of three categories based
on the company’s intent to hold or sell the securities.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Are Investments Classified And Valued?
(Slide 2 of 4)
The three categories are:
Held-to-Maturity Securities. Investments in debt securities for
which the company has the positive intent and ability to hold until
maturity.
Trading Securities. Investments in debt and equity securities that
are purchased and held principally to sell in the near term.
Available-for-Sale Securities. Investments in debt and equity
securities that are not classified as held-to-maturity or trading.
The accounting for each of the three categories of securities
differs based on management intent.
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How Are Investments Classified And Valued?
(Slide 3 of 4)
A company reports its investments in trading securities at
fair value on the balance sheet with any changes in fair
value reported on the income statement as part of net
income.
A company may invest in the debt or equity securities of
other corporations to establish long-term relationships with
suppliers or to obtain significant influence over the
company.
Significant influence generally occurs when the investor
owns between 20% and 50% of the voting common stock
of the investee.
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How Are Investments Classified And Valued?
(Slide 4 of 4)
Minority active investments are investments in the debt or equity
securities of other corporations to establish a long-term relationships
with suppliers or to obtain significant influence over the companies’
activities. Significant influence generally occurs when the investor
owns between 20% and 50% of the voting common stock of the
investee.
Consolidation occurs when the investor controls the investee through
an investment in equity securities. The result of consolidation is the
issuance of the combined financial statements of both companies.
Legal control occurs when the investor owns more than 50% of the
voting common stock of the investee.
Majority active investment is where an investment in another company
allows the investor to control the investee.
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Accounting Methods for Investments
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How Are Investments in Held-To-Maturity
Securities Measured and Recorded?
When a company has the positive ability and intent to
hold a debt security to maturity, it can be reported as a
held-to-maturity security.
The investment is initially recorded at cost.
The investment is subsequently reported at amortized cost on
the ending balance sheet(s).
Unrealized holding gains and losses are not recorded but are
disclosed in the notes to the financial statements.
Interest income is recognized in net income as it is earned,
along with any realized gains and losses on sales.
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Recording Initial Cost
Debt securities, such as bonds, that carry a stated
interest rate above the prevailing market interest
rates are issued at a premium.
Debt securities carrying a stated interest rate below
the prevailing market are issued at a discount.
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Recognition of Interest Income and Amortization
of Bond Premiums and Discounts
The amount of interest income recognized each accounting
period is based on the effective interest rate determined
at the time of acquisition using the following formula:
Interest Income = Market Interest Rate × Book Value of the Investment at
the Beginning of Period
The effective interest method (interest method) of
amortizing bond discounts and premiums:
Amortization of = Interest Revenue ‒ Cash Interest Payment
Discount/Premium
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How Are Investments in Trading Securities
Measured and Recorded?
Recall that when investments in debt and equity securities are
actively bought and sold with the intention to profit on shortterm changes in price, they are classified as trading securities.
The accounting for trading securities applies the most complete
fair value measurement approach, as follows:
The investment is initially recorded at cost.
The investment is subsequently reported at fair value on the balance
sheet.
Unrealized holding gains and losses resulting from changes in the fair
value of the securities are included in the net income of the current
period.
Interest and dividend income, as well as realized gains and losses, are
included in net income of the current period.
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Recognition of Unrealized Holding
Gains and Losses
On its ending balance sheet, a company reports any
investments in trading securities at fair value.
An increase in the fair value of investment securities is an
unrealized holding gain.
A decrease in the fair value of investment securities is an
unrealized holding loss.
For investments in trading securities, the Unrealized holding
Gain/Loss account is a temporary account that is closed to
Retained Earnings.
A debit balance in the account represents a net unrealized loss.
A credit balance represents a net unrealized gain.
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How Are Investments in Available-for-Sale
Securities Measured and Recorded?
The investment is initially recorded at cost.
The investment is subsequently reported at fair value on the
balance sheet.
Unrealized holding gains and losses resulting from changes in the
fair value of the securities are reported as a component of other
comprehensive income of the current period.
Interest and dividend income are included in net income for the
current period.
When a security is sold, realized gains and losses are included in
net income for the current period, and any unrealized holding
gains or losses must be reclassified from accumulated other
comprehensive income into net income.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Recognition of Unrealized Holding
Gains and Losses
On its ending balance sheet, a company reports any investments in
available-for-sale securities at fair value.
The major difference in the accounting for investments in available-for-sale
and trading securities is that in available-for-sale securities, a company
reports its unrealized gains and losses in its other comprehensive income.
A credit balance in the Unrealized Holding Gain/Loss account represents the
cumulative net unrealized holding gains and is reported as a positive
element in the accumulated other comprehensive income section of
shareholders’ equity.
A debit balance in the account represents the cumulative net unrealized
holding losses and is reported as a negative element in the accumulated
other comprehensive income section of stockholders’ equity.
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Summary of Accounting for Investments
Investment in held-to-maturity securities are reported at
amortized cost while fair value is used to report investments in
trading and available-for-sale investments.
The major difference between the accounting for investments in
trading and available-for-sale is the treatment of unrealized
holding gains and losses.
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Transfer of Investments between Categories
(Slide 1 of 2)
The transfer of a security between investment categories is
accounted for at fair value at the time of the transfer.
The accounting for any unrealized gain or loss depends on
the type of transfer.
A transfer from the trading category into any other category.
No accounting for the unrealized holding gain or loss is needed because it
has already been recognized in net income.
A transfer into the trading category from any other category.
The previous unrealized holding gain or loss is recognized immediately in
net income and eliminated from accumulated other comprehensive income.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Transfer of Investments between Categories
(Slide 2 of 2)
A transfer into the available-for sale category from the held-tomaturity category.
A transfer of debt security into the held-to-maturity category.
An unrealized holding gain or loss is established and included in other
comprehensive income.
The unrealized holding gain or loss on the date of transfer will continue
to be reported as a separate component of accumulated other
comprehensive income and amortized over the remaining life of the
security.
Note that transfers into or out of the trading category
should be rare, as should transfers from the held-to-maturity
category.
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Impairments
At each reporting date, a company should evaluate
each investment to determine if an impairment exists.
This evaluation involves three steps:
Step 1. Determine whether the investment is impaired.
Step 2. Evaluate whether the impairment is other than
temporary.
Step 3. If the impairment is other than temporary, recognize a
loss equal to the difference between the cost of the
investment and its fair market value.
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Minority Active Investments: The Equity Method
When an investor company owns a sufficiently large
percentage of the common stock of another company, it is able
to exert significant influence over the financial and operating
policies of the investee company.
Significant influence is determined by factors such as
representation on the board and participation in policymaking processes.
In the absence of the contrary, an investment of 20% or more
in the outstanding common stock of the investee leads to the
presumption of significant influence.
The equity method of accounting is used to account for
investments in which significant influence exists.
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Impairment: Other Than Temporary
Evidence of a decline in the value of an equity investment:
Bankruptcy of the investee
Lengthy declines in the fair value of the stock
A number of years of operating losses
When the decline is determined to be other than temporary,
the investor debits a Loss account and credits the Investment
account for the difference between the carrying value of the
investment and the fair value.
If the fair value of the investment later increases, the investor
does not recognize the recovery in value.
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Change to Equity Method
When an investor currently using the fair value method
acquires enough additional common shares during a year to
obtain significant influence over the investee, the investor is
required to adopt the equity method of accounting.
When the equity method is adopted, the investor restates its
investments in the investee by debiting the Investment account and
crediting Retained Earnings for the previous percentage of investee
income (minus dividends) for the period from the original date of
acquisition to the date that significant influence was obtained.
Once the necessary adjustments have been made, the equity method
is applied in the usual manner based on the current percentage
ownership.
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How are Investments Disclosed
in the Financial Statements? (Slide 1 of 3)
Trading Securities: A company should disclose:
Aggregate fair value
Change in the net unrealized holding gain or loss that is
included in each income statement
Available-for-Sale Securities: For each balance
sheet date, a company should disclose:
Aggregate fair value
Gross unrealized holding gains and losses
Amortized cost
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How are Investments Disclosed
in the Financial Statements? (Slide 2 of 3)
For each income statement period, a company
should disclose:
Proceeds from sales and the gross realized gains and
losses on those sales
Basis on which cost was determined
Gross gains and gross losses included in net income
from transfers of securities from this category into the
trading category
Change in the net unrealized holding gain or loss
included as a separate component of other
comprehensive income
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How are Investments Disclosed
in the Financial Statements? (Slide 3 of 3)
Held-to-Maturity Debt Securities: For each balance
sheet date, a company should disclose
Aggregate fair value
Gross unrecognized holding gains and losses
Amortized cost
The related realized or unrealized gain or loss and the
circumstances leading to the decision to sell or transfer
the security
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Long-Term Notes Receivable
A note receivable is recorded at the fair value of the property,
goods, or services or the fair value of the note, whichever is
more clearly determinable.
If neither of these values can be determined, the note is
recorded at the present value by using the borrower’s
incremental interest rate.
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Loan Fees and Loan Origination Costs
The nonrefundable fees charged to borrowers for lending
activities that precede the payment of funds and generally
include efforts to identify and attract potential borrowers and
to obligate a loan or loan commitment are called loan
origination fees (or commitment fees).
Generally, any loan origination fees are deferred and
recognized over the life of the loan as an increase in interest
income.
A loan (note receivable) is impaired if it is probable that the
creditor will be unable to collect all amounts due according to
the contractual terms of the loan agreement.
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Cash Surrender Value of Life Insurance
Many insurance policies allow a portion of accumulated
premiums to build up as a savings plan.
The cash surrender value is the portion of life insurance
premiums that build up as a savings plan—it is returned to
the purchaser if the policy is cancelled.
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Investment in Funds
Companies may place assets in special funds for
specific purposes. Special funds may be current,
such as petty cash funds, or they may be long term.
The most common long-term funds are as follows:
Long-term funds used to accumulated cash to retire
long-term liabilities (sinking funds)
Long-term funds used to retire preferred stock (stock
redemption funds)
Long-term funds used to purchase long-term assets
(plant expansion funds)
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Derivatives of Financial Instruments
(Slide 1 of 3)
A financial instrument is cash, evidence of an
ownership interest in an entity or a contract that both:
Imposes on one entity a contractual obligation to deliver
cash or another financial instrument to a second entity or to
exchange other financial instruments on potentially
unfavorable terms with the second entity
Conveys to that second entity a contractual right to receive
cash or another financial instrument from the first entity or
to exchange other financial instruments on potentially
favorable terms with the first entity
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Derivatives of Financial Instruments
(Slide 2 of 3)
A derivative financial instrument (or simply derivative)
is a financial instrument, such as a future, a forward, a
swap, or an option contract, that derives it value from an
underlying asset, market price, interest rate, foreign
exchange rate, or index.
A hedge is a means of protecting against a financial loss
by mitigating exposure to changes in values of underlying
assets, liabilities, or future cash flows.
An interest-rate swap is an agreement in which two
companies agree to exchange the interest payments on
debt over a specific period.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Derivatives of Financial Instruments
(Slide 3 of 3)
A principal amount upon which interest payments of
an interest-rate swap are based is referred to as a
notional (i.e., imaginary) amount because the swap
does not involve an actual exchange of principal at
either the inception or maturity.
A cash flow hedge protects against the risk caused
by variable prices, costs, rates, or terms that cause
future cash flows to be uncertain.
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