Chapter 12
INVESTMENTS
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Nature of Investments
Bonds and
notes
(Debt
securities)
Common and
preferred stock
(Equity
securities)
Investments can be accounted for in a
variety of ways, depending on the nature
of the investment relationship.
McGraw-Hill /Irwin
Slide 3
Reporting Categories for Investments
Reporting Categories for Investments
Control Characteristics of the Investment
Reporting Method Used by the Investor
The investor lacks significant influence over the
operating and financial policies of the investee:
Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at
has the "positive intent and ability" to hold to
amortized cost.*
maturity.
Investment held in an active trading account.
Trading securities (TS) - investment reported at fair
value with unrealized holding gains and losses included
in net income.
Other.
Securities available-for-sale (AFS) - investment
reported at fair value with unrealized holding gains
and losses excluded from net income and reported in
Other Comprehensive income.*
The investor has significant influence over the
operating and financial policies of the investee:
Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for
of the voting stock of the investee.
subsequent earnings and dividends of the investee.*
The investor controls the investee:
The investor owns more than 50% of the voting
stock of the investee.
Consolidation - the financial statements of the
investor and investee are combined as if they are a
single company.
* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for
trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
McGraw-Hill /Irwin
Slide 4
Securities to Be Held to Maturity
On January 1, 2009, Matrix, Inc. purchased as an
investment $1,000,000, of 10%, 10-year bonds, interest
paid semi-annually. The market rate for similar bonds is
12%. Let’s look at calculation of the present value of the
bond issue.
Present
Amount
PV Factor
Value
Interest $ 50,000 × 11.46992 = $573,496
Principal 1,000,000 × 0.31180 = 311,805
Present value of bonds
$885,301
PV of ordinary annuity of $1, n = 20, i = 6%
PV of $1, n = 20, i = 6%
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.
Slide 5
Securities to Be Held to Maturity
Partial Bond Amortization Table
Period
1
2
3
4
Date
1/1/09
6/30/09
McGraw-Hill /Irwin
Interest
Payment
50,000
50,000
50,000
50,000
Interest
Revenue
53,118
53,305
53,503
53,714
Discount
Amortization
(3,118)
(3,305)
(3,503)
(3,714)
Description
Investment in bonds
Discount on bond investment
Cash
Cash
Discount on bond investment
Investment revenue
Unamortized
Discount
114,699
111,581
108,276
104,773
101,059
Debit
1,000,000
Carrying
Value
885,301
888,419
891,724
895,227
898,941
Credit
114,699
885,301
50,000
3,118
53,118
© 2008 The McGraw-Hill Companies, Inc.
Slide 6
Securities to Be Held to Maturity
How would this investment appear on
the balance sheet after one period of
discount amortization?
Investment in bonds
Less: Discount on bond investment
Book value (amortized cost)
$ 1,000,000
111,581
$ 888,419
$114,699 - $3,118 = $111,581 unamortized discount
McGraw-Hill /Irwin
Slide 7
Securities to Be Held to Maturity
On December 31, 2009 after interest is received by
Matrix, all the bonds are sold for $900,000 cash.
Period
1
2
3
4
Interest
Payment
50,000
50,000
50,000
50,000
Interest
Revenue
53,118
53,305
53,503
53,714
Discount
Amortization
(3,118)
(3,305)
(3,503)
(3,714)
Date
Description
12/31/09 Cash
Discount on bond invetment
Investment revenue
12/31/09 Cash
Discount on bonds investment
Investment in bonds
Gain on sale of investment
McGraw-Hill /Irwin
Unamortized
Discount
114,699
111,581
108,276
104,773
101,059
Debit
50,000
3,305
Carrying
Value
885,301
888,419
891,724
895,227
898,941
Credit
53,305
900,000
108,276
1,000,000
8,276
Slide 8
Trading Securities
Adjustments to fair value are recorded:
1. in a valuation account called Fair Value
Adjustment, or as a direct adjustment to the
investment account.
2. as a net unrealized holding gain/loss on the
Income Statement.
Unrealized Gain
Unrealized Loss
Income
Statement
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Slide 9
Trading Securities
Matrix, Inc. purchased additional securities classified as
Trading Securities (TS) at the end of 2009. The fair value
amounts for these securities on December 31, 2009, are
shown below. Prepare the journal entries for Matrix, Inc. to
adjust the securities to fair value at 12/31/09.
Type
TS
TS
Name
Mining, Inc
Ford Motor
No. of
Unit
Total
Fair
Gain or
Shares
Cost
Cost
Value
(Loss)
1,000 $ 42.00 $ 42,000 $ 41,000 $ (1,000)
1,500
15.00
22,500
20,000
(2,500)
Net Unrealized Holding Loss for TS
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$ (3,500)
Slide 10
Trading Securities
Date
12/31
Description
Net unrealized holding gains and losses-IS
Fair value adjustment
Debit
3,500
Credit
The Net Unrealized Holding Loss is
reported on the Income Statement.
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3,500
Slide 11
Trading Securities
Unrealized
holding
gains and
losses from
trading
securities
are reported
on the
income
statement.
McGraw-Hill /Irwin
Matrix, Inc.
Partial Income Statement
For the Year Ended 12/31/09
Income from
operations
$ 267,500
Unrealized
holding loss
Net income
(3,500)
$ 264,000
Slide 12
Trading Securities
On January 3, 2010, Matrix sold all trading
securities for $65,000 cash.
Date
1/3/10
12/31/10
McGraw-Hill /Irwin
Description
Cash
Investment in Ford Motor – TS
Investment in Mining, Inc. – TS
Gain on sale of investment
Fair value adjustment
Net unrealized holding gain or loss – I/S
Debit
65,000
Credit
22,500
42,000
500
3,500
3,500
© 2008 The McGraw-Hill Companies, Inc.
Slide 13
Securities Available-for-Sale
Adjustments to fair value are recorded:
1. in a valuation account called Fair Value Adjustment,
or as a direct adjustment to the investment account.
2. as a net unrealized holding gain/loss in Other
Comprehensive Income (OCI), which accumulates in
Accumulated Other Comprehensive Income (ACOI).
Unrealized Gain
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Unrealized Loss
Other
Comprehensive
Income
Slide 14
Other Comprehensive Income (OCI)
Other comprehensive income:
Foreign currency translation gains (losses)
Net unrealized holding gains (losses) on investments
Minimum pension liability adjustment
Deferred gains (losses) from derivatives
Less: aggregate income tax expense (benefit)
Other comprehensive income
$ XX,XXX
-3,500
XXX
XXX
$ XX,XXX
X,XXX
$XX,XXX
When we add other comprehensive income to net income
we refer to the result as “comprehensive income.”
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Slide 15
Accumulated Other Comprehensive Income
Unrealized holding gains and losses on
available-for-sale securities are accumulated in
the shareholders’ equity section of the balance
sheet. Specifically, the account is included in
Accumulated Other Comprehensive Income.
Net unrealized
holding gains
and losses.
McGraw-Hill /Irwin
Shareholders’ Equity
Common Stock
Paid-in Capital in Excess of par
Accumulated other comprehensive income
Retained earnings
Total Shareholders’ Equity
© 2008 The McGraw-Hill Companies, Inc.
Slide 16
Securities Available for Sale Example
Now assume the same facts for our Matrix, Inc.
example, except that the investment is for
available-for-sale securities rather than trading
securities.
Type
Name
AFS Mining, Inc
AFS Ford Motor
No. of
Unit
Total
Fair
Gain or
Shares
Cost
Cost
Value
(Loss)
1,000 $ 42.00 $ 42,000 $ 41,000 $
(1,000)
1,500
15.00
22,500
20,000
(2,500)
Net Unrealized Holding Loss for AFS
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$
(3,500)
Slide 17
Securities Available for Sale Example
Date
12/31
Description
Net unrealized holding gains and losses-OCI
Fair value adjustment
Debit
3,500
This net unrealized holding
gain is reported in
other comprehensive income.
McGraw-Hill /Irwin
Credit
3,500
Slide 18
Reclassification Adjustment When AFS
Investments are Sold
Event
Period 1: hold AFS investment and
experience net unrealized loss.
Period 2: sell AFS investment and
realize loss on sale
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Effect on Comprehensive
Income
OCI for unrealized holding
loss.
 OCI to back out previously
recognized unrealized
holding loss (so effect on
OCI over time is zero)
 Net income for realized
loss
Effect on Shareholders'
Equity
 AOCI
 AOCI (so net effect on
AOCI over time is zero)
 Retained earnings
© 2008 The McGraw-Hill Companies, Inc.
Slide 19
Securities Available for Sale Example
On January 3, 2010, Matrix sold all available-forsale for $65,000 cash.
Date
1/3/10
12/31/10
McGraw-Hill /Irwin
Description
Cash
Investment in Ford Motor – TS
Investment in Mining, Inc. TS
Gain on sale of investment
Fair value adjustment
Net unrealized holding gain or loss – OCI
Debit
65,000
Credit
22,500
42,000
500
3,500
3,500
© 2008 The McGraw-Hill Companies, Inc.
Slide 20
Other Than Temporary Impairments
This is called an. . .
Occasionally, an
investment’s value will
decline for reasons
that are “other than
temporary.”
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Impairment
in Value
Slide 21
Transfers Between Reporting Categories
Transfers are
accounted for
at fair value
on the
transfer date.
McGraw-Hill /Irwin
Unrealized holding
gains or losses at
reclassification
should be accounted
for in a manner
consistent with the
classification into
which the security is
being transferred.
Slide 22
Transfers Between Reporting Categories
Transfer from:
To:
Either of the other
Trading
Trading
Either of the other
Held-to-maturity Available-for-sale
Available-for-sale Held-to-maturity
Unrealized Gain or Loss from Transfer at FMV
Include in current net income
There is none (already recognized in net income)
Report as a separate component of shareholders' in OCI.
Don't write-off existing unrealized holding gain or loss.
Amortize it to net income over the remaining life of
the security.
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.
Slide 23
Disclosures
Aggregate
Fair Value
Gross realized &
unrealized holding
gains & losses
Maturities of
debt securities
Amortized cost
basis by major
security type
Change in net
unrealized holding
gains and losses
Inputs to fair
value estimates
McGraw-Hill /Irwin
Slide 24
Investor Has Significant Influence
Reporting Categories for Investments
Control Characteristics of the Investment
Reporting Method Used by the Investor
The investor lacks significant influence over the
operating and financial policies of the investee:
Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at
has the "positive intent and ability" to hold to
amortized cost.*
maturity.
Investment held in an active trading account.
Trading securities (TS) - investment reported at fair
value with unrealized holding gains and losses included
in net income.
Other.
Securities available-for-sale (AFS) - investment
reported at fair value with unrealized holding gains
and losses excluded from net income and reported in
Other Comprehensive income.*
The investor has significant influence over the
operating and financial policies of the investee:
Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for
of the voting stock of the investee.
subsequent earnings and dividends of the investee.*
The investor controls the investee:
The investor owns more than 50% of the voting
stock of the investee.
Consolidation - the financial statements of the
investor and investee are combined as if they are a
single company.
* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for
trading securities,
with the investment reported at fair value and unrealized holding gains and losses included in earnings.
McGraw-Hill
/Irwin
Slide 25
Investor Has Significant Influence
Extent of Investor Influence
Lack of significant influence
(usually < 20% equity ownership)
Significant influence
(usually 20% - 50% equity ownership)
Has control
(usually > 50% equity ownership)
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Reporting Method
Varies depending on classification
previously discussed
Equity method
Consolidation
Slide 26
What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it
is presumed that the investor has significant influence over
the financial and operating policies of the investee. The
presumption can be overcome if :
1. the investee challenges the investor’s ability to
exercise significant influence through litigation or
other methods.
2. the investor surrenders significant shareholder rights
in a signed agreement.
3. the investor is unable to acquire sufficient information
about the investee to apply the equity method.
4. the investor tries and fails to obtain representation on
the board of directors of the investee.
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.
Slide 27
Equity Method and Consolidation
If a company acquires more than 50% of the voting stock
of another company:
1. it controls the company acquired (cannot be
outvoted). The “parent” controls the “subsidiary.”
2.
3.
for accounting purposes, the parent and subsidiary
are considered a single reporting entity.
Consolidated financial statements combine the
separate financial statements of the parent and
subsidiary each period into a single aggregate set
of financial statements.
the equity method is sometimes referred to as a
“one line consolidation,” because it shows the
investor’s income and investment as increasing by
their portion of the investee’s income. © 2008 The McGraw-Hill Companies, Inc.
McGraw-Hill /Irwin
Slide 28
Equity Method
1.
The investment account is increased
by:


2.
Original investment cost.
Proportionate share of investee's
earnings.
The investment account is
decreased by:

McGraw-Hill /Irwin
Dividends received.
Slide 29
Equity Method
On January 1, 2009, Matrix, Inc. acquired 45% of
the equity securities of Apex, Inc. for $1,350,000.
On the acquisition date, Apex’s net assets had a
fair value of $3,000,000. During 2009, Apex paid
cash dividends of $150,000 and reported net
income of $1,750,000.
What amount will Matrix, Inc. report on the balance sheet
as Investment in Apex, Inc.?
McGraw-Hill /Irwin
Slide 30
Equity Method
Date
1/1/09
Description
Investment in Apex, Inc.
Cash
Debit
1,350,000
Credit
1,350,000
$ 3,000,000 Fair value of assets
×
45% Percentage ownership
$ 1,350,000 Fair value of assets purchased
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Slide 31
Equity Method
Date
1/1/09
12/31/09
Description
Investment in Apex, Inc.
Cash
Debit
1,350,000
1,350,000
Cash
Investment in Apex, Inc.
Investment in Apex, Inc.
Investment revenue
$
×
$
67,500
67,500
787,500
787,500
150,000 Dividends paid
45% Percentage ownership
67,500 Share of dividends
$
×
$
McGraw-Hill /Irwin
Credit
1,750,000 Reported earnings
45% Percentage ownership
787,500 Share of earnings
Slide 32
Equity Method
Investment in Apex, Inc.
Investment
1,350,000
45% Earnings
787,500
67,500 45% Dividends
Reported amount 2,070,000
If the investee had a loss,
the investment account
would have been
reduced.
McGraw-Hill /Irwin
Slide 33
Equity Method
On January 1, 2009, Matrix, Inc. purchase 25% of the
common stock of Apex, Inc. for $180,000. At the date of
acquisition, the book value of the net assets of Apex was
$400,000, and the net fair value of these assets is $600,000.
During 2009, Apex paid cash dividends of $40,000, and
reported earnings of $100,000.
Fair value of assets
Percentage ownership
Share of fair value of assets
Cost of investment in Apex
Excess of cost over fair value
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$ 600,000
25%
150,000
180,000
$ 30,000
Slide 34
Equity Method
Assume that of the $50,000 excess of the fair value of net
assets acquired ($600,000 × 25% = $150,000) over the book
value of those net assets on Apex’s balance sheet ($400,000
× 25% = $100,000), 75% is attributable to depreciable assets
with a remaining life of 20 years and the remainder is
attributable to land. Matrix uses the straight-line method of
depreciation on similar owned assets.
Excess of cost over fair value
Amount applicable to depreciable assets
Share subject to excess depreciation
Remaining useful life of assets in years
Additional depreciation expense
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$ 50,000
75%
37,500
20
$ 1,875
Slide 35
Equity Method
Date
1/1/09
12/31/09
Description
Investment in Apex, Inc.
Cash
Debit
200,000
200,000
Cash
Investment in Apex, Inc.
10,000
Investment in Apex, Inc.
Investment revenue
25,000
10,000
25,000
Investment revenue
Investment in Apex, Inc.
$ 40,000 Dividends paid
×
25% Percentage ownership
$ 10,000 Share of dividends
Credit
1,875
1,875
$ 100,000 Reported earnings
×
25% Percentage ownership
$ 25,000 Share of earnings
Remember, goodwill is not amortized.
McGraw-Hill /Irwin
Slide 36
Changing From the Equity Method to
Another Method
When the investor’s level of influence changes, it
may be necessary to change from the equity
method to another method.
At the transfer date,
the carrying value
of the investment
under the equity
method is regarded
as cost.
McGraw-Hill /Irwin
Slide 37
Changing From the Equity Method to
Another Method
Any difference between carrying value and fair
value is recorded in a valuation account and is
recognized as an unrealized holding gain or loss.
After the transfer, the investment is treated as a
trading security or a security available for sale,
depending on management’s intent.
McGraw-Hill /Irwin
Slide 38
Changing From Another Method to the
Equity Method
When the investor’s ownership level increases to the
point where they can exert significant influence, the
investor should change to the equity method.
At the transfer date, the recorded value is the initial
cost of the investment adjusted for the investor’s
equity in the undistributed earnings of the investee
since the original investment.
Reported earnings
– Dividends paid
= Undistributed Earnings
McGraw-Hill /Irwin
Slide 39
Changing From Another Method to the
Equity Method
The original cost, the unrealized holding
gain or loss, and the valuation account
are closed.
A retroactive change is recorded to
recognize the investor’s share of the
investee’s earnings since the original
investment.
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Slide 40
Fair Value Option
SFAS No. 159 allows companies to use a “fair value option”
for HTM, AFS and equity method investments.
The investment is carried at fair value.
Unrealized gains and losses are included in income.
For HTM and AFS investments, this just amounts to
classifying the investments as trading.
For equity-method investments, the investment is still
classified on the balance sheet with equity method
investments, but the portion at fair value must be clearly
indicated.
The fair value option is determined for each individual
investment, and is irrevocable.
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.
Slide 41
Financial Instruments & Derivatives
Financial
Instruments:
Derivatives:
1. Cash.
other securities.
2. Derivatives are often
used to “hedge”
(offset) risks created
by other investments
or transactions
2. Evidence of an
ownership interest
in an entity.
3. Contracts meeting
certain conditions.
McGraw-Hill /Irwin
1. Value is derived from
Slide 42
Other Investments – Appendix A
It is often convenient for companies to set aside money to
be used for specific purposes. In the short-term, funds
may be set aside for
1. Petty cash funds.
2. Payroll accounts.
In the long-run, funds are often set aside to:
1. Pay long-term debt when it comes due.
2. Acquire treasury stock.
Special purpose funds set aside for the long-term are
classified as investments.
McGraw-Hill /Irwin
Slide 43
Appendix 12A – Other Investments
It is a common practice for companies to purchase
life insurance policies on key officers. The
company pays the premium and is the beneficiary
of the policy. If the officer dies, the company
receives the proceeds from the policy. Some types
of policies build a portion of each premium as cash
surrender value. The cash surrender value of such
a policy is classified as an investment on the
balance sheet of the company.
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Slide 44
Appendix 12B – Impairment of a Receivable Due
to a Troubled Debt Restructuring
When the original terms of a debt agreement are
changed as a result of financial difficulties
experienced by the debtor, the new arrangement is
referred to as a troubled debt restructuring.
Sometimes a troubled debt is settled in full when the
debtor transfers assets or equities to the creditor. The
creditor usually recognizes a loss on the settlement.
Such a settlement is not considered unusual or
infrequent and is not an extraordinary item.
McGraw-Hill /Irwin
End of Chapter 12
McGraw-Hill /Irwin
© 2008 The McGraw-Hill Companies, Inc.