C hapter
15
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under license.

Objectives
1.
2.
3.
4.
Explain the classification and valuation of investments.
Account for investments in debt and equity trading securities.
Account for investments in availablefor-sale debt and equity securities.
Account for investments in held-tomaturity debt securities, including amortization of bond premiums and discounts.
2

Objectives
5.
Understand transfers and impairments.
6.
Understand disclosures of investments.
7.
Explain the conceptual issues regarding investments in marketable securities.
8.
Account for investments using the equity method.
9.
Describe additional issues for investments.
10.
Account for derivatives of financial instruments. (Appendix)
3

Why Companies Invest in
Other Companies
1.
2.
3.
Additional revenues from idle cash.
Control over another company.
Beneficial relationship with another company.
4

Classification of
Investments
1.
2.
3.
5

Classification of
Investments
Trading securities are investments in debt and equity securities that are purchased and held principally for the purpose of selling them in the near term.
6

Trading Securities
Trading securities are investments in debt
7

Available-for-Sale Securities
Investments in available-forsale securities are (a) debt securities that are not classified as being held to maturity, and...
8

Available-for-Sale Securities
9
…(b) debt and equity securities that are not classified as trading securities.

Available-for-Sale Securities
Investments in available-for-sale securities are reported at their fair value on the balance sheet date. The unrealized holding gains or losses are included in other comprehensive income.
10

Available-for-Sale Securities
Therefore, the unrealized holding gains and losses for available-forsale securities are not included in net income.
11

Held-to-Maturity Securities
Investments in held-to-maturity debt securities are debt securities for which the company has the positive intent and ability to hold until they mature.
12

Held to Maturity Securities
Investments in held-to-maturity debt securities are reported at their amortized cost on the balance sheet…not their fair value.
13

Accounting for Investments
Reporting of
Unrealized Holding
Method Gains and Losses
Investment in Equity Securities
1. No significant influence a. Trading b. Available for sale
Fair value
Fair value
Net Income
Other comprehensive income
2. Significant influence Equity method Not recognized
3. Control Consolidation Not recognized
14

Accounting for Investments
Reporting of
Unrealized Holding
Method Gains and Losses
Investment in Debt Securities
1. Trading
2. Available for sale
3. Held to maturity
Fair value
Fair value
Net Income
Other comprehensive income
Amortized cost Not recognized
15

Investments in
Available-for-Sale
Debt and Equity Securities
1.
2.
3.
4.
The investment is initially recorded at cost.
It is subsequently reported at fair value.
Unrealized holding gains and losses are reported as a component of other comprehensive income.
Interest and dividend revenue, as well as realized gains and losses on sales, are included in net income for the current period.
16

Investments in
Available-for-Sale
Debt and Equity Securities
Kent Company purchases the following securities on May 1, 2006, as an investment in available-for-sale securities:
• 100 shares of A Company common stock at $50 per share
•
300 shares of B Company common stock at $80 per share
•
200 shares of Company C preferred stock at $120 per share.
•
$15,000 Company D 10% bonds
$ 5,000
24,000
24,000
15,000
Total $68,000
17

Investments in
Available-for-Sale
Debt and Equity Securities
See Page 709
18
Investment in Available-for-Sale
Securities
Interest Revenue
Cash
68,000
625
68,625

Investments in
Available-for-Sale
Debt and Equity Securities
Accrued interest on the D Company bond from
November 30, 2005, to May 31, 2006
$15,000 x 0.10 x 6/12
May 31, 2006
Cash
Interest Revenue
750
750
19

December 31, 2006
Interest Receivable
Interest Revenue
125
125
20
$15,000 x 0.10 x 1/12
During 2006 Kent Company receives dividends of $3,000 from its investment in the stocks of A, B, and C Companies.
Cash
Dividend Revenue
3,000
3,000

Investments in
Available-for-Sale
Debt and Equity Securities
The cost and fair value of the available-for-sale securities held by the Kent Company is as follows:
Security
12/31/06
Cumulative
Change
Fair in Fair
Cost Value Value
21
100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000
300 shares of B Co. common stock 24,000 23,500 (500)
200 shares of C Co. preferred stock 24,000 26,000
D Company 10% bonds 15,000 15,500
2,000
500
Totals $68,000 $71,000 $3,000

Investments in
Available-for-Sale
Debt and Equity Securities
The cost and fair value of the available-for-sale securities held by the Kent Company is as follows:
Allowance for Change in Value of Investment
12/31/06
Cumulative
Change
Cost Value Value
22 in Value of Available-for-
$ 6,000 $1,000
Sale Securities 24,000 23,500
200 shares of C Co. preferred stock 24,000 26,000 2,000
D Company 10% bonds 15,000 15,500 500
Totals $68,000 $71,000 $3,000

Investments in
Available-for-Sale
Debt and Equity Securities
The same securities are held on December 31, 2007.
Security
12/31/07
Cumulative
Change
Fair in Fair
Cost Value Value
100 shares of A Co. common stock $ 5,000 $ 6,100 $1,100
300 shares of B Co. common stock 24,000 22,700 (1,300)
200 shares of C Co. preferred stock 24,000 23,200
D Company 10% bonds 15,000 14,000
(800)
(1,000)
Totals $68,000 $66,000 $(2,000)
23

Allowance for Change in
Value of Investment
24
12/31/06 3,000 5,000 adjusting entry
2,000 12/31/07
Unrealized Increase/Decrease in
Value of Available-for-Sale Securities 5,000
Allowance for Change in Value of
Investment 5,000

Sale of Available-for-Sale
Securities
On March 1, 2008, the Kent Company sold 100 shares of A Company stock for $6,000. The stock had a fair value on Dec. 31, 2007, of $6,100.
Cash
Investment in Available-for-
Sale Securities
Gain on Sale of Available-for-
Sale Securities
6,000
5,000
1,000
The Unrealized Increase/Decrease in Value (DR) and the allowance (CR) account are reduced by $1,100.
25

Available-for-Sale Securities
Security
December 2008
Cumulative
12/31/08 Change
Fair in Fair
Cost Value Value
26
300 shares of B Co. common stock $24,000 $23,500 $(500)
200 shares of C Co. preferred stock 24,000 24,100 100
D Company 10 bonds
Totals
15,000
$63,000
14,700
$62,300
(300)
$(700)

Allowance for Change in
Value of Investments
2,400 adjusting entry
2,000 12/31/07
1,100 3/1/08
700 12/31/08
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Allowance for Change in Value of Investment 2,400
Unrealized Increase/Decrease in
Value of Available-for-Sale Securities 2,400

Accounting for Investments
Classify Recognize Recognize Compute
According to Interest and Realized Realized
Management Dividend Gain or Gain or
Intent as: Revenue in: Loss in: Loss as:
Trading
Availablefor-Sale
Held-to-
Maturity
Net Income Net Income Selling Price minus
Fair Value at Most
Recent Balance
Sheet Date
Net Income Net Income Selling price minus
(Amortized) Cost
Net Income Net Income Selling Price minus
(Amortized) Cost
28

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 all included in net income.
29

Investments in Held-to-
Maturity Debt Securities
A company purchases 9% bonds with a face value of $100,000 on August 1, 2006, at 99 plus accrued interest, which is payable semiannually.
$100,000 x 0.99
Investment in Held-to-Maturity
Debt Securities
Interest Revenue
Cash
99,000
1,500
100,500
$100,000 x 0.09 x 2/12
30

Accounting for Bond
Premiums
On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $102,458.71. The stated rate is
13% and the effective interest rate is 12%.
31
Investment in Held-to-
Maturity Debt Securities 102,458.71
Cash 102,458.71

Accounting for Bond
Premiums
Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method.
$100,000 x 0.13 x 1/2
32
Cash
Investment in Held-to-
Maturity Debt Securities
Interest Revenue
6,500.00
352.48
6,147.52
$102,458.71 x .12 x 1/2

Accounting for Bond
Discounts
On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $97,616.71. The stated rate is 13% and the effective interest rate is 14%.
Investment in Held-to-
Maturity Debt Securities 97,616.71
Cash 97,616.71
33

Accounting for Bond
Discounts
Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method.
Cash
Investment in Held-to-
Maturity Debt Securities
Interest Revenue
6,500.00
333.17
6,833.17
$97,616.71 x .14 x 1/2
34

Investment in Securities
Classify Subsequently
According to Report on the
Management Initially Balance
Intent as: Record as: Sheet at:
Trading Cost Fair Value
Recognize
Unrealized
Holding Gains and Losses in:
Net Income
AvailableCost for-Sale
Held-to-
Maturity
Cost
Fair Value
Amortized
Cost
Other Comprehensive Income
---
35

Tallen Company purchased 13% bonds with a face value of $200,000 for $204,575.07 on April 3, 2006.
Interest on these bonds is payable June 30 and
December 31, and the bonds mature on December 31,
2008.
36
Investment in Held-to-Maturity
Debt Securities
Interest Revenue
Cash
204,575.07
6,500.00
Continued
$200,000 x
0.13 x 3/12
211,075.07

($204,575.07 x 0.12 x ¼)
+ $6,500
June 30, 2006
Cash
Interest Revenue
13,000.00
Investment in Held-to-Maturity
Debt Securities
12,637.25
362.75
37
Continued
$13,000 –
$12,637.25

38
($204,575.07
- $362.75) X
0.12 X 1/2 December 31, 2006
Cash 13,000.00
Interest Revenue
Investment in Held-to-Maturity
Debt Securities
12,252.74
747.26
$13,000 –
$12,252.74

Sale of Investment in Bonds
Before Maturity
The $100,000 of 13% bonds purchased by the
Colburn Company for $97,616.71 were sold on
March 31, 2007, for $102,000 plus accrued interest.
($2,383.29 ÷
6) x ½
Investment in Held-to-Maturity
Debt Securities
Interest Revenue
198.61
198.61
39
Continued

40

Sale of Investment in Bonds
Before Maturity
$102,000
+ $3,250 $100,000 x 0.13 x ¼
Cash 105,250.00
Interest Revenue
Gain on Sale of Debt Securities
Investment in Held-to-Maturity
Debt Securities
3,250.00
3,390.24
98,609.76
41
$98,411.15 +
$198.61

1.
A transfer from the trading category.
2.
A transfer into the trading category.
3.
A transfer into the available for sale category.
4.
A transfer of a debt security into the
held to maturity category from the
available for sale category.
42

43
In 2007, Kent transfers the Company A securities into the trading category when the fair value is $6,300.
Investment in Trading Securities
Investment in Available-for-
Sale Securities
Gain on Transfer of Securities
6,300
Unrealized Increase/Decrease in
Value of Available-for-Sale Securities 1,100
Allowance for Change in Value of
Investment
5,000
1,300
1,100

Devon Company has $10,000 in bonds that were purchased at par. When the fair value is $9,500,
Devon transfers them to the available-for-sale category.
Investment in Available-for-Sale
Securities
Investment in Held-to-
Maturity Debt Securities
10,000
10,000
Unrealized Increase/Decrease in
Value of Available-for-Sale Securities 500
Allowance for Change in Value of
Investment 500
44

Disclosures
1.
Trading Securities-A company must disclose the change in the net unrealized holding gain or loss that is included in each income statement.
2.
Available-for-Sale Securities-For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses and
(amortized cost) by major types.
3.
Held-to-Maturity Debt Securities-For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost by major security types.
45

Devon Company classifies its bond investment as available for sale with a previous fair vale of $9,700, and transfers them into the held-to-maturity category when the current market value of the debt securities is $9,500.
46
Investment in Held-to-Maturity Debt
Securities
Unrealized Increase/Decrease from
9,500
Transfer of Securities
Investment in Available-for-
Sale Securities
500
Continued
10,000

An entry is needed to eliminate the previous $300
($9,700 – $10,000) amount in the allowance and unrealized increase/decrease accounts.
47
Allowance for Change in Value of
Investment
Unrealized Increase/Decrease in
Value of Available-for-Sale
Securities
300
300

Impairments
Impairments may be an “other than temporary” decline below the amortized cost of an investment in a debt security classified as available for sale or held to maturity.
48

Impairments
Tracy Company has a bond investment categorized as held to maturity, which has an unamortized carrying amount of $21,500 and a fair value of
$6,500. The investment is considered to be
“impaired.”
Realized Loss on Decline in Value 15,000
Investment in Held-to-Maturity
Debt Securities 15,000
49

Current Assets
Temporary investment in available-for-sale securities (at cost)
Plus: Allowance for change in value of investment
Temporary investment in available-for-sale securities (at fair value)
$29,000
500
$29,500
50
Noncurrent Assets
Investment in available-for-sale securities (at cost) $39,000
Plus: Allowance for change in value of investment 2,500
Investment in available-for-sale securities
(at fair value) $41,500

1.
Fair value is required in the balance sheet for trading securities and available-for-sale securities, whereas amortized cost is required for held-to-maturity securities.
2.
Fair value is not required for certain liabilities.
3.
Unrealized holding gains and losses are reported in net income for trading securities, but in other comprehensive income for available-for-sale securities.
4.
The classification of securities is based on management intent.
51

Equity Method
When an investor corporation owns a significantly large percentage of common stock, it is able to exert significant influence over the policies of the investee corporation. The equity method is used to account for this investment.
52

Equity Method

Acknowledges the existence of a material economic relationship between the investor and the investee.

Is based upon the requirements of accrual accounting.
 Reflects the change in stockholders’ equity of the investee company.
53

Equity Method
54

Equity Method Not Used

Opposition by the investee which challenges the investor’s ability to exercise significant influence.

The investor and investee sign an agreement under which the investor surrenders significant stockholder’s rights.

Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to views of the investor.

Inability to gather information not available to other shareholders.
 Failure to obtain representation on investee’s board of directors.
55

Equity Method
See Page 731
Cliborn Company purchases 4,200 shares of the S company’s outstanding stock (25%) on January 1,
2007, for $125,000 ( significant influence ).
Investment in Stock: S Company 125,000
Cash 125,000
S Company pays a $20,000 dividend.
Cash
Investment in Stock: S Company
5,000
5,000
56

Equity Method
S Company reported net income for 2007 of
$81,000, consisting of ordinary income of $73,000 and an extraordinary gain of $8,000.
25% of $81,000
25% of $73,000
Investment in Stock: S Company 20,250
Investment Income: Ordinary
Investment Income: Extraordinary
18,250
2,000
57
25% of 8,000

58
Equity Method
Investment Book
Value Difference
Balance Sheet
Book Value Fair Value
X
% of Investment
Depreciable assets $400,000 $450,000
(remaining life, 10 yrs)
Other nondepreciable assets 190,000 246,000
(e.g., land)
Total $590,000 $696,000
50,000 X 25% =
12,500
Liabilities
Common Stock
Retained earnings
Total
$200,000 $220,000
250,000
140,000
$590,000

Equity Method
When acquired by S Company, the investee’s depreciable assets had a fair market value that exceeded book value by $50,000 (10-year life).
Cliborn’s share of the depreciable asset value is $12,500 (25%). Additional depreciation is needed on December 31.
Investment Income: Ordinary
Investment in Stock: S Company
1,250
1,250
Note that this entry results in a deduction from ordinary income.
$12,500 /
10 years
59

Disclosure-Carrying Value
Investment 125,000
Ordinary income 18,250
Extraordinary income 2,000
Ending balance 139,000
5,000 Dividends received
1,250 Excess depreciation
60

Disclosure-Equity Income
Share of 2007 ordinary income
Less: excess depreciation
Ordinary investment income
Plus: investee extraordinary income
Net investment income
$18,250
1,250
$17,000
2,000
$19,000
61

Stock Dividends
Smith Corporation purchased 2,000 shares of Kell
Company common stock for $30 per share. Two months later, Kell issued a 50% stock dividend.
Memo: Received 1,000 shares of Kell Company common stock as a stock dividend. The cost of the shares is now $20 per share, computed as follows:
$60,000 ÷ 3,000 (2,000 + 1,000) shares.
62

Stock Dividends
Subsequently, Smith Corporation sold 500 of the shares for $25 per share, and the fair value at the most recent balance sheet date was $23 per share.
Cash
Investment in Available-for-Sale
Securities
Gain on Sale of Investment
12,500
10,000
2,500
Unrealized Increase/Decrease in Value of Available-for Sale Securities 1,500
Allowance for Change in Value of
Investment 1,500
63

Merle Corporation paid an annual insurance premium of $5,500 at the beginning of the year to cover the lives of its officers.
Prepaid Insurance
Cash
5,500
5,500
64
Continued

According to the terms of the insurance contract, the cash surrender value increases from $7,200 to $8,300 during the year.
Insurance Expense
Cash Surrender Value of Life
Insurance
Prepaid Insurance
4,400
1,100
5,500
$8,300 – $7,200
65

Appendix-Derivatives

Derivatives are financial instruments, such as forwards and options whose value depends upon the value of an underlying instrument such as a security, commodity, currency or interest rate. Hence, they are "derived" from these underlying instruments.

Derivatives are used to transfer risk, and companies often use them to reduce the risk of adverse changes in interest rates, commodity prices, and foreign currency exchange rates.

The fair value of a derivative fluctuates with movements in the underlying instrument (for example, if interest rates increase, the value of a swap to pay a fixed interest rate increases).
66

Derivatives

The two basic types of derivatives are:
–
Forward contracts
• Forwards
• Futures
• Swaps
–
Option contracts
• Puts
• Calls
67

Forward or Future Contracts

Contracts to purchase or sell a commodity or stock, such as grain, oil, or livestock, at a given price in the future. The purpose is to lock in a price. A seller wants to guarantee a current price for future delivery and a buyer wants to assure a steady supply of raw materials at a given price.
– A forward is a privately-negotiated contract to be satisfied in the future.
–
A future is a standardized forward contract, that can be traded on an exchange, like the Chicago Board of Trade.
–
A swap is a bundle of forward contracts, often used by companies to switch floating-rate debt to fixed-rate debt.
• Each interest payment would, in effect, be covered by an individual forward contract.
• A swap combines all these small forward contracts into one instrument.
68

Hedges
 Fair value hedge – protects against the risk from changes in value caused by fixed terms, rates or prices.
–
For example, a company with debt that has a fixed interest rate that enters into an interest rate swap to pay a variable rate of interest and receive a fixed rate.
–
This protects the company against paying more interest than necessary if interest rates decline.
–
Gains or losses on the market value of these hedges flow through net income.
69

Hedges
 Cash flow hedge – protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain
– For example, a company with variable rate debt that enters into a swap to pay a fixed rate of interest and receive a variable rate.
–
This guarantees that the company will pay a fixed rate, no matter what happens to interest rates in the market.
– Gains or losses of “effective” cash flow hedges flow through other comprehensive income.
– “Effectiveness” is determined by how well the terms of the hedge, such as time period and notional value, match the terms of the underlying debt.
70

Hedges
 Foreign currency hedge -to reduce the risk of currency fluctuation for transactions and investments in foreign currencies.
– Foreign currency hedges can be structured so that they behave like fair value hedges OR cash flow hedges.
71

Options

A call enables the owner to purchase a commodity, security, or currency at a set price in the future, but is under no obligation to do so. Any gain or loss is included in net income.

A put enables the owner to sell a commodity, security, or currency at a set price in the future, but again is under no obligation to do so. Any gain or loss is included in net income.
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C hapter
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