Download CHAPTER 12

INVESTMENTS IN MARKETABLE
EQUITY AND DEBT SECURITIES
(SFAS #115, for fiscal years beginning after 12/5/1993)
REPORTING
CATEGORY
CLASSIFICATION CRITERIA
Held to Maturity
Debt securities the investor has the
positive intent and ability to hold to
maturity
Trading Securities
Debt or equity securities
held for immediate resale
Securities Available
for Sale
Debt or equity securities not classified
as either securities held to maturity or
trading securities
(“catch all”)
Debt Securities: (creditor relationship) US Gov. bonds and notes,
municipal securities, corp. bonds/notes/paper, convet. debt.
Equity Securities: (ownership interest) common, preferred, or
other capital stock, share rights, warrants, and call or put
options.
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Reporting Categories For Investments
Types of
Securities
Characteristics
Investor has the
positive intent and
ability to hold to
maturity
Debt
Debt or equity
Held in active trading
account for immediate
resale
Reporting
Category
Reported at:
Held To
Maturity
amortized cost
Trading
Securities
“catch all”
Debt or equity
Equity
Equity
Equity
Accounting 302
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Investments not
classified in another
category
Fair value not
determinable and the
equity method is not
appropriate
The investor can
“significantly
influence” the
operating and financial
policies of the investee
The investor controls
the investee
Chapter 17 – Investments
Securities
Available for
Sale
Cost
Method
Equity
Method
Consolidation
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fair value (with
unrealized gains and
losses included in
earnings)
fair value (with
unrealized gains and
losses excluded
from earnings and
reported in
shareholders' equity)
cost
cost, adjusted for
subsequent growth
of the investee
financial statements
are combined as if a
single company
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INVESTMENTS ACQUIRED TO BE HELD
TO MATURITY—DEBT SECURITIES
If an investor has the “positive intent and
ability” to hold the securities to maturity,
investments in debt securities are
classified as “held to maturity” and
reported at amortized cost in the balance
sheet.*
Holding gains or losses from market price
changes are ignored.
* To calculate the amortized cost, simply make an
amortization table for the investment (either bond or note
receivable).
If a par note/bond, then amortized cost = face.
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INVESTMENTS TO BE HELD FOR
AN UNSPECIFIED PERIOD OF TIME
(AFS or Trading)
/
When an investment is acquired to be held for an unspecified period of time,
/
it is reported at the fair value of the investment securities on the reporting date.
American Capital buys and sells both debt and equity securities of other
companies as investments. The following transactions during December 2000,
pertain to the investment portfolio. The company’s fiscal year-end is December 31.
INVESTMENT REVENUE
December 18
Received cash dividends of $2 million on an investment in
ABM Corporation common shares, the only securities in the
investment portfolio.
December 18
($ in millions)
Cash ........................................................................................
Investment revenue ............................................................
2
2
SALE OF INVESTMENTS
December 20
Sold the ABM Corporation common shares for $13 million.
These were purchased for $12 million.
December 20
($ in millions)
Cash ........................................................................................
Investment in ABM Corporation shares ...........................
Gain on sale of investments ...............................................
13
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PURCHASE OF INVESTMENTS
December 21
Acquired two new investments costing:
Millington-Frazier bonds
Bartlett Corporation common shares
$30 million
20 million
December 21
($ in millions)
Investment in Millington-Frazier bonds ................................
Investment in Bartlett Corporation shares ............................
Cash ....................................................................................
30
20
50
ADJUSTING INVESTMENTS TO FAIR VALUE
December 31
The market prices of the investments are:
Millington-Frazier bonds
Bartlett Corporation common shares
December 31
$33 million
19 million
($ in millions)
Investment in Millington-Frazier bonds ................................
Unrealized holding gain on investments ($33 – 30) ............
3
Unrealized holding loss on investments ($19 – 20) .................
Investment in Bartlett Corporation shares ........................
1
3
1
Portfolio Approach: In text, more complex for sales of investments
Securities Fair Value Adjustment (AFS or Trading) .............
Unrealized holding gain on investments ($52 – 50)* ........
☺
2
2
The way we report unrealized holding gains and losses in the financial
statements depends on whether the investments are classified as “securities
available for sale”—equity account or as “trading securities.”—directly to
IS as other gains/losses.
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AVAILABLE FOR SALE
☺
☺
☺
☺
☺
All investments in debt and equity securities that don’t fit
the definitions of the other reporting categories are classified
as “available for sale.”
Individual securities available for sale are reported as either
current or noncurrent assets, depending on how long they’re
likely to be held.
Investments in securities available for sale are reported at
fair value.
Holding gains and losses for securities available for sale are
reported as a component of shareholders’ equity, rather than
as part of earnings.
The journal entries to record the cash dividend, the sale of
the ABM Corporation common shares, the purchase of the
investment securities, and to adjust the investments to fair
value at year end would be precisely the same regardless of
whether the investments are available for sale or are trading
securities.
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REPORTING INVESTMENTS IN
SECURITIES AVAILABLE FOR SALE
Balance Sheet
($ in millions)
Assets:
Cash and cash equivalents ...................................................
Short-term* investments at fair value (cost $50) ................
Accounts receivable ............................................................
.
.
Shareholders’ Equity:
.
.
Net unrealized holding gain on investments
.
$xx
52
xx
.
.
.
.
..............
2
.
* assumes both securities are intended to be held less than one year; otherwise
long-term investments
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SELLING AFS SECURITIES PREVIOUSLY ADJUSTED TO FAIR VALUE
(1) Assume the Millington-Frazier bonds (AFS) are sold on January 29, 2001, for
$34 million. (individual security approach)
January 29, 2001
($ in millions)
Cash ........................................................................................
Unrealized Holding Gain on Investments-Millington...........
Gain on sale of investments (plug) .....................................
Investment in Millington-Frazier bonds ($30 + 3) ..............
34
3
4
33
(2) Assume the market price of Bartlett Corp. common shares has risen by $1
million to the original price American Capital paid for the investment, and the
shares are sold on Feb. 13.
February 13, 2001
($ in millions)
Cash ........................................................................................
Unrealized Holding Loss on Investments-Bartlett ............
Investment in Bartlett shares ($20 - 1) ................................
20
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TRADING SECURITIES
☺ Investments in debt or equity securities acquired principally
for the purpose of selling them in the near term.
☺ Unrealized holding gains or losses on trading securities are
reported on the income statement as if they actually had
been realized.
☺ Relatively
few investments are classified this way because
only banks and other financial operations invest in securities
in the manner and for the purpose necessary to be
categorized as trading securities.
☺ When securities are actively managed, as trading securities
are, with the expressed intent of profiting from short-term
market price changes, the gains and losses that result from
holding securities during market price changes are
appropriate measures of success or lack of success in that
endeavor.
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SELLING TRADING SECURITIES PREVIOUSLY ADJUSTED TO FAIR VALUE
(1) Assume the Millington-Frazier bonds are trading securities and are sold on
January 29, 2001, for $34 million.
January 29
($ in millions)
Cash ....................................................................................
Investment in Millington-Frazier bonds ($30 + 3) .........
Gain on sale of investments ..........................................
34
33
1
(2) Assume the market price of the Bartlett Corporation common shares rises by
$1 to the original price American Capital paid for the investment, and the
shares are sold on February 13. Assume that investment in Bartlett common
shares have always been classified as trading securities.
February 13
($ in millions)
Cash ........................................................................................
Investment in Bartlett Corporation shares ($20 – 1) ...........
Gain on sale of investments ...............................................
20
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TRANSFERS BETWEEN REPORTING CATEGORIES
When a security is reclassified between two reporting
categories, the security is transferred at its fair value at the date
of transfer. Any unrealized holding gain or loss should be
accounted for in a manner consistent with the classification into
which the security is being transferred.
1. When a security is transferred into the trading category,
any unrealized holding gain or loss should be recognized in
earnings of the reclassification period.
2. When a security is transferred into the available-for-sale
category, any unrealized holding gain or loss should be
recorded as a separate component of shareholders’ equity.
3. When a security is transferred into the held-to-maturity
category, any unrealized holding gain or loss should be
amortized over the remaining time to maturity.
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PRESENTATION AND DISCLOSURE
Trading securities are current assets by definition.
Individual held-to-maturity and available-for-sale securities
are either current or noncurrent depending on when they are
expected to be sold.
It’s not necessary that a company report individual amounts
for the three categories of investments – held to maturity,
available for sale, or trading – on the face of the balance sheet
as long as that information is presented in the disclosure notes.
Investors should disclose the following in the disclosure
notes:
* aggregate fair value
* gross realized and unrealized holding gains
* gross realized and unrealized holding losses
* the change in net unrealized holding gains and losses,
and amortized cost basis by major security type
Information about maturities should be reported for debt
securities, by disclosing the fair value and cost for at least 4
maturity groupings: (a) within 1 year, (b) after 1 year through
5 years, (c) after 5 years through 10 years, and (d) after 10
years.
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REPORTING CLASSIFICATIONS FOR
INVESTMENT RELATIONSHIPS
Classification
Reporting Method
The investor cannot significantly
influence the investee
Varies by Reporting
Category
The investor can significantly
influence the operating and
financial policies of the investee
The investor controls the
investee
Accounting 302
(see above)
Equity Method
Consolidation
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THE EQUITY METHOD



We use the equity method when the investor owns less than
51% of the voting shares, and therefore can’t control the
investee, but can exercise “significant influence” over the
operating and financial policies of an investee.
It should be presumed, in the absence of evidence to the
contrary, that the investor exercises significant influence over
the investee when it owns between 20% and 50% of the
investee's voting shares. The 20-50% rule is not hard-and-fast.
There are exceptions. Parent could hold 40% and someone else
holds 55%--not significant influence for the 40%. Parent could
hold 8% and no one else hold more than 1%--significant
influence for the 8%.
Initially, the investment is recorded at cost. The carrying
amount of this investment subsequently is:
 Increased by the investor's percentage share of the
investee’s net income (or decreased by its share of a loss).
 Decreased by dividends declared.
I.e., cost is adjusted for subsequent growth of investment.
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► The equity method is a partial consolidation. The investor
and investee are viewed as a single entity. Unlike
consolidation, under the equity method the equity
investment is reported in a single investment account (not
line by line).
► It is assumed that the fortune of the investee is intertwined
with the investor and therefore as the investee’s fortunes
change so do the investor’s. The investor owns a portion of
the investee’s net assets.
► Cannot do the equity method if you are unable to get enough
information about the investee.
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EQUITY METHOD
On January 2, 2000, American Capital Corporation purchased 25% of the
outstanding common shares of Embassy Message Corporation for $200 million.
The following information is available regarding Embassy Message Corporation:
($ in millions)
Net assets at acquisition:
Fair value
Book value
2000 net income
2000 dividends declared and paid
$600
480
100
24
The asset initially is recorded at cost.
($ in millions)
Investment in equity securities (cost of shares) ........................
Cash ....................................................................................
200
200
As the investee earns additional net assets, the investment in those net assets
increases.
($ in millions)
Investment in equity securities ..............................................
Investment revenue (25% share of $100 million earned) ..........
25
25
As the investee distributes net assets as dividends, the investment in those net assets
declines.
($ in millions)
Cash (25% share of $24 million dividends paid) ............................
Investment in equity securities ..........................................
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FURTHER ADJUSTMENTS

When the investor’s expenditure to acquire an investment exceeds the book
value of the underlying net assets acquired, additional adjustments to both
the investment account and investment revenue may be needed.
Our illustration provides the following information regarding Embassy
Message Corporation’s net assets at the time American Capital Corporation pays
$200 million for a 25% interest in the company:
($ in millions)
Net assets at acquisition:
Fair value
Book value
$600
480
Assume the difference between the book value of the net assets and their fair
market value is attributable to depreciable assets having a fair market value in
excess of their undepreciated cost.
($ in millions)
Investee
Net Assets

Cost
Net Assets
Purchased

Difference
Attributed To:

$200

Fair value:
$600 x 25% =
Accounting 302
$480 x 25% =
$50
Undervaluation
of assets:
$30
$150

Book value:
Goodwill:
$120
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AMORTIZATION OF ADDITIONAL DEPRECIATION
Assume that the depreciable assets have an average remaining
useful life of 10 years. Investment revenue and the investment
both would be reduced by the negative income effect of the
“extra depreciation” the higher fair value would cause:
($ in millions)
Investment Revenue ($30 million ÷ 10 years) .........
Investment in Equity Securities ..................
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3
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REPORTING THE INVESTMENT
The investment account represents the investor’s share of the
investee's net assets initially acquired, adjusted for the investor’s
share of the subsequent increase in the investee's net assets (net
assets earned and not yet distributed as dividends).
Investment in Equity Securities
______________________________________________
($ in millions)
Cost
Share of income
200
25
6
Balance
Accounting 302
Dividends
3 Depreciation
_________________
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A CHANGE FROM THE EQUITY METHOD TO ANOTHER METHOD

If conditions change and make the equity method no longer
appropriate, no adjustments are needed, simply discontinue
the equity method and use the new method from then on.
The cost basis at time of change is simply the balance in the
investment account (mark-to-market from here).
A CHANGE FROM ANOTHER METHOD TO THE EQUITY METHOD

When a change to the equity method is appropriate,
Retroactive treatment required—the balance in the investment
has to be what it would have been if the equity method has
been used the entire time. Go back and calculate net income
of investee reduced by dividends, then make entry to reflect
this balance in investment account.
Investment in equity securities $350,000
Retained earnings (investment revenue) $350,000
Disclosure note and restate the net income for each year
reported in the financial statements. Show an adjustment to
the beginning of period RE for the earliest period reported on
statement.
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Equity Method Accounting—Another example
Investment is recorded at cost—then,
The investment is increased (decreased) by a % share of investee’s
net income (loss).
The investment is decreased by dividends received from the
investee.
Assume that XXX buys 30% of PUD’s voting common shares for
$107 million on 1/1/2001. For 2001 PUD reports net income of
$10 million ($2 million of which was an extraordinary gain).
PUD also declares and pays dividends of $1 million in 2001.
Investment in PUD
Cash
$107,000,000
$107,000,000
Investment in PUD
Investment Revenue
Investment Gain (EO)
Cash ($1M * 0.30)
Investment in PUD
$3,000,000
$2,400,000
600,000
$300,000
$300,000
(receipt of dividends reduces XXX’s interest in PUD’s net assets).
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Further Complications:
More complicated adjustments have to be made if the investor’s
cost to acquire the investment exceeds the book value of the net
assets acquired.
Compare fair value of net assets acquired to their book value. If
any of the difference is due to “undervaluation” of depreciable
assets or inventory, then take additional depreciation over the life
of the depreciable assets or additional CoGS the next year.
Ignore portion of difference due to “undervaluation” of land. No
adjustment for goodwill.
Assume that XXX paid $107M for 30% of PUD. At time of
purchase, PUD’s net asset fair market value was $333.3M and
book value of identifiable net assets was $300 M. Depreciable
assets are “undervalued” by $18M, land by $12M, and inventory
by $3.3M. Depreciation is straight-line, with 6 yrs remaining.
Investee
Net Assets
Cost
Fair Value
Book Value
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$333.333 M
$300 M
Chapter 17 – Investments
Net Assets
Purchased
$107 M
$100 M
$ 90 M
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Difference
$7 M Goodwill
$5.4M dep.A.
$3.6 M land
$1.0 M inven.
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Each year for the next 6 years, recognize $0.9 M in “additional
depreciation.”
Investment revenue
Investment in PUD
$900,000
$900,000
In first year: (to recognize additional CoGS)
Investment revenue
Investment in PUD
$1,000,000
$1,000,000
************************************************
Reporting the equity investment—at adjusted cost.
The carrying amount in the investment account is the initial
cost plus the investor’s portion of undistributed earnings of
the investee.
Investee’s net losses result in a reduction of the investor’s
investment account. Never reduce the investment account
below zero.* If losses would cause this, wait until the
subsequent earnings equal losses not recognized during the
time equity method was discontinued.
* Reduce below zero if investor is liable for more than the initial investment.
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Variation in Earnings by Method
Used to Account for Investments
Situation: Investor Company owns 20% of Investee Company. Investee’s net
income is $1 million. Investee distributes one-half its earnings as
dividends. (Thus, Investor receives 20% x $1 million x 1/2 =
$100,000.) The fair value of Investor’s investment in Investee’s
common stock increased by $250,000 during the year.
Which accounting method causes reported income to be highest?
Share of Investee income*
Increase in Investee’s fair value**
Investor’s investment income
Accounting Method Used:
Trading
Security held
Equity
security
for sale
method
$100,000
$100,000
$200,000
250,000
0
0
$350,000
$100,000
$200,000
*
recognized whether received as dividends or not by the equity method; only if
received as dividends otherwise
** reported in income for trading securities, component of shareholders’ equity for
securities available for sale, and not recognized at all for equity-method
investments
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CONSOLIDATED FINANCIAL STATEMENTS
If a company has controlling interest (more than 50% of voting
stock) in another company, for reporting they are considered as
one entity and must prepare consolidated financial statements.
There is now a parent – subsidiary relationship. Both continue
to prepare separate financial reports, but the parent must report
consolidated financial statements. In short, the process of
consolidation removes all of the transactions between parents
and subs. (e.g., A/R and A/P). The parent records the acquired
company’s net assets at fair market value. If the acquisition
price exceeds the fair value, then the difference is called
goodwill (an intangible asset).
The investment in a subsidiary is usually accounted for on the
parent’s books using the equity method.
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DERIVATIVES
Financial instruments that derive their value (cash flows) from
some other security or index. The last 10 years has seen an
“explosion” in the types of derivatives available in our financial
markets. Financial futures, forward contracts, options, and
interest swaps are frequently used derivatives.
Derivatives are designed to lessen financial risk and are part of a
prudent hedge operation (provide insurance against risk).
Derivatives have long been used to mitigate interest rate, price,
and foreign exchange risks. Unfortunately, the improper use of
derivatives can cause a huge gamble. Using derivatives to
speculate has caused $ billions of losses in recent years.
Futures
Futures are contracts between buyer and seller to “deliver”
something of value in the future at a predetermined price. Many
of these are traded on the Chicago Board (oil, wheat, corn, pork
bellies…). If you are a bacon producer, using futures for pork
bellies can hedge your price risk, but if you are simply an
investor, pork-belly futures are a way for you to gamble (can
increase risk). Investors in futures do not take delivery of the
commodity—the agreement is settled at the future date and cash
exchanges hands.
When the item is a financial instrument (T-bills, CDs, NYSE
index…), then we have a financial futures contract. Suppose that
you take out an ARM loan on your house that has a balloon due
in 5 years. You might sell Treasury Notes futures. If interest
rates increase, then future pays off. This will offset the increased
cost to refinance in 5 years.
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Forward contracts
Forwards are like futures with a few differences:
(1) specific date versus any day in a specific month.
(2) private versus publicly traded.
(3) no daily settlements.
Options
Work like a future for hedging, except option gives the owner a
right to buy (or sell) something. The owner does not have to
exercise the option if doing so would make the owner worse off
(e.g., Puts and calls on stock, stock options).
Foreign Currency Futures
Financial futures in which the “commodity” is a specific foreign
currency. These are used to hedge changes in foreign exchange
rates (e.g., hedge risk when an American firm borrows from a
foreign bank).
Interest Rate Swaps
Majority of derivatives. For numerous reasons debtors think
that they prefer a different type of loan (fixed versus floating
rate) then they currently have. They would like to swap their
loan for someone else’s. There are financial intermediaries that
offer one-sided swaps for a fee. The actual loan is not swapped,
rather, the net difference in payments is exchanged.
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Accounting for Derivatives
The accounting depends on the purpose for holding derivatives.
► risk management (hedging activity)
► investment (speculative position), small investment outlay with
very large potential gain or loss. Any gain /loss from changes
in fair value is recognized immediately in earnings.
Basic rule: All derivatives are carried on the B.S. as either assets or
liabilities at fair (i.e., market) value.
Hedges are divided into three types: (accounting depends on the
“type” of hedge). The earnings effect of a hedge derivative cancels
out earnings effect of the item being hedged. All ineffectiveness of
hedge is recognized immediately in earnings. The effectiveness of a
hedge needs to be periodically assessed (3 months and when
financial statements are issued). If not highly effective, then hedge
accounting must be discontinued. We mark a hedged item to fair
value only to the extent that its fair value changed due to the risk
being hedged.
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For interest-rate swaps, effectiveness is assumed if the swap’s:
notional amount matches the note’s face,
expiration date is the same as note’s maturity date,
fair-value is zero at inception, and
reset dates are frequent enough so that floating rate is market.
(1) Fair-value hedges (e.g., swap fixed rate debt for floating
rate): gain/loss for derivative is recognized immediately in
income AND gain/loss to item being hedged also currently
recognized in income. These offset each other in an
effective hedge.
(2) Cash-flow hedges (e.g., swap floating rate for fixed rate
debt or purchase a futures contract): gain/loss for derivative
is deferred as a component of comprehensive income.
(3) Foreign-currency hedges: can be treated as either fair-value
or cash-flow hedges—depends on hedge.
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Interest-rate swap example—ignore this unless you want to
do more with the accounting than I expect.
Wintel Company issues $1 million of 10% bank notes, due on 1/1/2002 (18
months). They pay interest every 6 mo.s, 6/30 & 12/31. Wintel wants to hedge
the effect of changing market interest rates on Wintel’s borrowing costs
relative to the market. So, Wintel buys a swap—receives 10% interest on
$1million ($50,000) and pays a floating rate (based on some index) on $1
million. Settlement is every 6 mo.s for 18 months based on floating rate at start
of period. Over the 18 months, the floating rate decreased. This means that
Wintel was entitled to receive cash payments from the swap. This offsets the
increase in the fair-value of Wintel’s debt. (perfect hedge)
1/1/2000 (issuance)
Cash
$1,000,000
Notes Payable
$1,000,000
------------------------------------------------------------------------6/30/2000 (floating rate was 10% at start, 9% at end)
Interest Expense $50,000
Cash
50,000
Interest-rate Swap 9,363
Holding Gain—IR Swap
(mark-up value of derivative)
9,363 (current earnings)
Holding Loss—hedged note9,363
Premium on Note Payable
9,363
(create a premium/discount on note when its value is increased/decreased)
------------------------------------------------------------------------
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12/31/2000 (floating rate changes from 9% to 8%)
Interest expense
45,421 (9% * ½ * $1,009,363)
Premium—NP
4,579
(plug)
Cash
50,000
Cash
5,000
Interest-rate Swap
252
Interest Revenue
Holding Gain—IR swap
Holding Loss—hedged NP 4,831
Premium—NP
(1% * ½ * $1M)
(change in value of derivative)
421
4,831
(4.5% * $9,363)
(plug)
4,831
(according to calculations in example: premium account balance should be $9,615; $4,831 is the
amount it takes to get this balance)
------------------------------------------------------------------------6/30/2001 (last payment)
Interest Expense
40,385 (8% * ½ * $1,009,615)
Premium—NP
9,615
Cash
50,000
Cash
10,000
Holding loss (plug)
0
Interest-rate Swap
Interest Revenue
Note Payable
Cash
Accounting 302
(floating interest rate was 8%, BOP)
9,615
385
(8% * ½ * $9,615)
1,000,000
1,000,000
Chapter 17 —Investments
l.DuCharme
31
DISCLOSURE OF DERIVATIVES
Fair value of financial instruments must be disclosed either in the
body or in footnotes. For all long-term debt, disclose total
amount maturing and any sinking fund requirements for each of
the next 5 years. (see SFAS # 107 & 133). Extensive
requirements that include:
Objectives and strategies for holding/issuing derivatives
Hedged items
Forecasted transactions
Beginning, ending, and changes in balance of derivative
components of other comprehensive income.
Net gain/loss reported in earnings (ineffectiveness of hedge)
Information about failed hedges
Accounting 302
Fall 2005
Chapter 17 – Investments
L.DuCharme
32