Download Available-for-Sale Securities

CHAPTER
13
Investments and Fair
Value Accounting
Warren
Reeve
Duchac
human/iStock/360/Getty Images
Financial and
Managerial
Accounting
13e
Investing Cash in Current Operations
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Cash may be used to replace worn-out equipment or
to purchase new, more efficient and productive
equipment.
In addition, cash may be reinvested in the company to
expand its current operations.
Cash may be used to pay:
o
o
o
o
Expenses.
Suppliers of merchandise and other assets.
Interest to creditors.
Dividends to stockholders.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Investing Cash in Temporary Investments
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Instead of letting excess cash remain idle in a checking account,
most companies invest their excess cash in securities such as:
o
o
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Debt securities, which are notes and bonds that pay interest and have
a fixed maturity date.
Equity securities, which are preferred and common stock that
represent ownership in a company and do not have a fixed maturity
date.
Investments in debt securities and equity securities, termed
investments or temporary investments, are reported in the
Current Assets section of the balance sheet.
The primary objective of investing in temporary investments is to
earn interest revenue, receive dividends, or realize gains from
increases in the market price of the securities.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Investing Cash in Long-Term Investments
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Long-term investments often involve the purchase of a
significant portion of the stock of another company.
o
Such investments usually have a strategic purpose:
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Reduction of costs.
Replacement of management.
Expansion.
Integration.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accounting for Debt Investments
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Debt securities include notes and bonds issued by
corporations and governmental organizations.
Most companies invest excess cash in bonds as
investments to earn interest revenue.
The accounting for bond investments includes
recording the following:
o
o
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Purchase of bonds
Interest revenue
Sale of bonds
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Purchase of Bonds
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The purchase of bonds is recorded by debiting an
investments account for the purchase price of the
bonds, including any brokerage commissions.
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A brokerage commission is the fee charged by the agent
who arranges the transaction between the buyer and seller.
If the bonds are purchased between interest dates,
the purchase price includes accrued interest since the
last interest payment.
o
This is because the seller has earned the accrued interest,
but the buyer will receive the accrued interest when it is
paid.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Sale of Bonds
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The sale of a bond investment normally results in a
gain or loss.
o
o
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If the proceeds from the sale exceed the book value (cost)
of the bonds, then a gain is recorded.
If the proceeds are less than the book value (cost) of the
bonds, a loss is recorded.
The gain or loss on the sale of bond investments is
reported as part of Other Income (Loss) on the income
statement.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accounting for Equity Investments
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A company may invest in the preferred or common stock of
another company.
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o
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The company investing in another company’s stock is the investor.
The company whose stock is purchased is the investee.
The percent of the investee’s outstanding stock purchased by
the investor determines the degree of control that the investor
has over the investee. This, in turn, determines the accounting
method used to record the stock investment.
The percent of the investee’s outstanding stock purchased by
the investor determines the degree of control that the investor
has over the investee. This, in turn, determines the accounting
method used to record the stock investment.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Cost Method: Less Than 20% Ownership
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Investments of less than 20% of the investee’s
outstanding stock are accounted for by using the cost
method.
Under the cost method, entries are recorded for the
following transactions:
o
o
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Purchase of stock
Receipt of dividends
Sale of stock
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Equity Method: Between 20%–50% Ownership
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Investment of between 20% and 50% are accounted for using
the equity method.
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Under the equity method, the stock is recorded initially at its cost,
including any brokerage commissions.
Under the equity method, the investment account is adjusted for
the investor’s share of the net income and dividends of the
investee. These adjustments are as follows:
o
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Net income: The investor records its share of the net income of the
investee as an increase in the investment account. Its share of any net
loss is recorded as a decrease in the investment account.
Dividends: The investor’s share of cash dividends received from the
investee decreases the investment account.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Consolidation: More Than 50% Ownership
(slide 1 of 2)
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If the investor purchases more than 50% of the
outstanding stock of the investee, the investor is
considered to have control over the investee. The
purchase is termed a business combination.
o
In this case, it is assumed that the investor purchased the
stock of the investee primarily for strategic reasons, such as
to produce more efficiently, diversify product lines, expand
geographically, or acquire know-how.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Consolidation: More Than 50% Ownership
(slide 2 of 2)
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A corporation owning all or a majority of the voting
stock of another corporation is called a parent
company.
The corporation that is controlled is called the
subsidiary company.
At the end of the year, the financial statements of the
parent and subsidiary are combined and reported as
a single company. These combined financial
statements are called consolidated financial
statements.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Valuing and Reporting Investments
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Debt and equity securities are financial assets that are often
traded on public exchanges such as the New York Stock
Exchange. As a result, their market value can be observed and,
thus, objectively determined.
o
For this reason, generally accepted accounting principles (GAAP) allows
some debt securities, and requires equity securities where there is less
than a 20% ownership interest to be valued in the accounting records
and financial statements at their fair market values.
 These securities are classified as follows:
– Trading securities
– Available-for-sale securities
– Held-to-maturity securities
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Trading Securities
(slide 1 of 3)
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Trading securities are debt and equity securities that
are purchased and sold to earn short-term profits
from changes in their market prices.
Trading securities are often held by banks, mutual
funds, insurance companies, and other financial
institutions.
Because trading securities are held as a short-term
investment, they are reported as a current asset on
the balance sheet.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Trading Securities
(slide 2 of 3)
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Trading securities are valued as a portfolio (group) of
securities using the securities’ fair values.
o
Fair value is the market price that the company would receive for a
security if it were sold.
 A change in the fair value of the portfolio (group) of trading securities is
recognized as an unrealized gain or loss for the period.
• If the fair value of the portfolio of trading securities was less
than the cost:
o
o
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The adjustment would debit Unrealized Loss on Trading Investments and
credit Valuation Allowance for Trading Investments for the difference.
Unrealized Loss on Trading Investments would be reported on the
income statement as Other Expenses.
Valuation Allowance for Trading Investments would be shown on the
balance sheet as a deduction from Trading Investments (at cost).
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Trading Securities
(slide 3 of 3)
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Over time, the valuation allowance account is
adjusted to reflect the difference between the cost
and fair value of the portfolio.
o
o
Thus, increases in the valuation allowance account from the
beginning of the period will result in an adjustment to
record an unrealized gain.
Likewise, decreases in the valuation allowance account from
the beginning of the period will result in an adjustment to
record an unrealized loss.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Available-for-Sale Securities
(slide 1 of 4)
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Available-for-sale securities are debt and equity
securities that are neither held for trading, held to
maturity, nor held for strategic reasons.
Changes in the fair values of available-for-sale
securities are reported as part of stockholders’ equity
and, thus, excluded from the income statement.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Available-for-Sale Securities
(slide 2 of 4)
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The valuation allowance and unrealized gain are
reported on the balance sheet as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Available-for-Sale Securities
(slide 3 of 4)
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If the fair value of the portfolio of available-for-sale
securities was less than the cost:
o
o
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The adjustment would debit Unrealized Gain (Loss) on
Available-for-Sale Investments and credit Valuation
Allowance for Available-for-Sale Investments for the
difference.
Unrealized Gain (Loss) on Available-for-Sale Investments
would be reported in the Stockholders’ Equity section as a
negative item.
Valuation Allowance for Available-for-Sale Investments
would be shown on the balance sheet as a deduction from
Available-for-Sale Investments (at cost).
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Available-for-Sale Securities
(slide 4 of 4)
•
Over time, the valuation allowance account is
adjusted to reflect the difference between the cost
and fair value of the portfolio.
o
o
Thus, increases in the valuation allowance from the
beginning of the period will result in an adjustment to
record an increase in the valuation and unrealized gain
(loss) accounts.
Likewise, decreases in the valuation allowance from the
beginning of the period will result in an adjustment to
record decreases in the valuation and unrealized gain (loss)
accounts.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Held-To-Maturity Securities
(slide 1 of 2)
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Held-to-maturity securities are debt investments, such
as notes or bonds, that a company intends to hold until
their maturity date.
Held-to-maturity securities are primarily purchased to
earn interest revenue.
If a held-to-maturity security will mature within a
year, it is reported as a current asset on the balance
sheet. Held-to-maturity securities maturing beyond a
year are reported as noncurrent assets.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Held-To-Maturity Securities
(slide 2 of 2)
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Only securities with maturity dates, such as corporate notes and
bonds, are classified as held-to-maturity securities.
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Equity securities are not held-to-maturity securities because they have no
maturity date.
Held-to-maturity bond investments are recorded at their cost,
including any brokerage commissions.
If the interest rate on the bonds differs from the market rate of
interest, the bonds may be purchased at a premium or discount.
o
In such cases, the premium or discount is amortized over the life of the
bonds.
• Held-to-maturity bond investments are reported on the balance
sheet at their amortized cost.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Fair Value Accounting
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Fair value is the price that would be received for
selling an asset.
Fair value assumes that the asset is sold under normal
business conditions.
Generally accepted accounting principles require
trading and available-for-sale investments to be
recorded at their fair value.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Effect of Fair Value Accounting on the
Financial Statements: Balance Sheet
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When an asset is reported at its fair value, any
difference between the asset’s original cost or prior
period’s fair value must be reported in a valuation
allowance.
Changes in the fair value of available-for-sale
securities are included as part of stockholders’ equity
through the comprehensive income and accumulated
other comprehensive income accounts.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Effect of Fair Value Accounting on the
Financial Statements: Income Statement
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Although trading securities are reported at fair value
in the balance sheet, changes in their fair values are
not reported as part of stockholders’ equity; rather,
the unrealized gains or losses are reported on the
income statement.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Analysis and Interpretation:
Dividend Yield
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The dividend yield measures the rate of return to
stockholders, based on cash dividends.
Dividend yield is most often computed for common
stock because preferred stock has a stated dividend
rate.
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In contrast, the cash dividends paid on common stock
normally vary with the profitability of the corporation.
The dividend yield is computed as follows:
Dividends per Share of Common Stock
Dividend Yield =
Market Price per Share of Common Stock
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Appendix: Comprehensive Income
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Comprehensive income is defined as all changes in
stockholders’ equity during a period, except those resulting
from dividends and stockholders’ investments.
Comprehensive income is computed by adding or subtracting
other comprehensive income to (from) net income, as follows:
o
Other comprehensive income items include unrealized gains and losses
on available-for-sale securities as well as other items such as foreign
currency and pension liability adjustments.
 The cumulative effect of other comprehensive income is reported on the balance
sheet, as accumulated other comprehensive income.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.