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Investments

12

12-2

Accounting for Investment Securities

Bonds and notes

(Debt securities)

Bonds and notes

(Debt securities)

Common and preferred stock

(Equity (Equity securities)securities)

Common and preferred stock

(Equity (Equity securities)securities)

Investments can be accounted for in a variety of ways, depending on the nature

of the investment relationship.

12-3

Reporting Categories for Investments

12-4

Learning Objectives

Demonstrate how to identify and account for investments classified for reporting purposes

as held to maturity.

12-5

Trading securities Trading securities (TS) are bought and (TS) are bought and held primarily to be held primarily to be

sold in the near term.sold in the near term.

Trading securities Trading securities (TS) are bought and (TS) are bought and held primarily to be held primarily to be

sold in the near term.sold in the near term.

Securities available Securities available for sale (SAS) are for sale (SAS) are

expected to be held expected to be held for an unspecified for an unspecified

period of time.period of time.

Securities available Securities available for sale (SAS) are for sale (SAS) are

expected to be held expected to be held for an unspecified for an unspecified

period of time.period of time.

Reporting Categories for Investments

Held-to-maturity Held-to-maturity (HTM) securities (HTM) securities

are investments in are investments in debt the investor debt the investor intends and has intends and has

the ability to hold the ability to hold until they mature.until they mature.

Held-to-maturity Held-to-maturity (HTM) securities (HTM) securities

are investments in are investments in debt the investor debt the investor intends and has intends and has

the ability to hold the ability to hold until they mature.until they mature.

12-6

Securities to Be Held to Maturity

On January 1, 2006, 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%, so Matrix paid $885,301 for the bonds. Let’s look at the required

journal entries.

Date Description Debit Credit1/1/06 Investment in bonds 1,000,000

Discount on bond investment 114,699 Cash 885,301

6/30/06 Cash 50,000 Discount on bond investment 3,118 Investment revenue 53,118

$885,301 $885,301 × (12% ÷ 2) = $53,118× (12% ÷ 2) = $53,118$885,301 $885,301 × (12% ÷ 2) = $53,118× (12% ÷ 2) = $53,118

12-7

Securities to Be Held to Maturity

Investment in bonds 1,000,000$ Less: Discount on bond investment 111,581 Book value (amortized cost) 888,419$

$114,699 - $3,118 = $111,581 unamortized discount$114,699 - $3,118 = $111,581 unamortized discount

On January 1, 2006, 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%, so Matrix paid $885,301 for the bonds. Let’s look at the required

journal entries.

12-8

Investments Held for an Unspecified Period of Time

When an investment is held for an unspecified period of time, it is reported at the fair value of the

security on the reporting date.

When an investment is held for an unspecified period of time, it is reported at the fair value of the

security on the reporting date.

Must be “readily determinable”

Must be “readily determinable”

Otherwise, the investment is

reported at cost.

Otherwise, the investment is

reported at cost.

.

12-9

Learning Objectives

Demonstrate how to identify and account for investments classified for reporting purposes

as available-for-sale.

12-10

Securities Available-for-Sale

Adjustments to fair value Adjustments to fair value are recorded as:are recorded as:

1.1. a direct adjustment to the a direct adjustment to the investment account, andinvestment account, and

2.2. an allowance account in an allowance account in the equity section of the the equity section of the balance sheet called “balance sheet called “Net Net Unrealized Holding Unrealized Holding Gains/LossesGains/Losses”.”.

Adjustments to fair value Adjustments to fair value are recorded as:are recorded as:

1.1. a direct adjustment to the a direct adjustment to the investment account, andinvestment account, and

2.2. an allowance account in an allowance account in the equity section of the the equity section of the balance sheet called “balance sheet called “Net Net Unrealized Holding Unrealized Holding Gains/LossesGains/Losses”.”.

12-11

Securities Available for Sale Example

Matrix, Inc. purchased the securities listed below in Matrix, Inc. purchased the securities listed below in 2006. They are classified as Securities Available 2006. They are classified as Securities Available

for Sale (SAS). The fair value of the securities for Sale (SAS). The fair value of the securities were determined on December 31, 2006. Prepare were determined on December 31, 2006. Prepare

the journal entries for Matrix, Inc. to adjust the the journal entries for Matrix, Inc. to adjust the securities to fair value at December 31, 2006.securities to fair value at December 31, 2006.

Matrix, Inc. purchased the securities listed below in Matrix, Inc. purchased the securities listed below in 2006. They are classified as Securities Available 2006. They are classified as Securities Available

for Sale (SAS). The fair value of the securities for Sale (SAS). The fair value of the securities were determined on December 31, 2006. Prepare were determined on December 31, 2006. Prepare

the journal entries for Matrix, Inc. to adjust the the journal entries for Matrix, Inc. to adjust the securities to fair value at December 31, 2006.securities to fair value at December 31, 2006.

12-12

Securities Available for Sale Example

.

This net unrealized holding gain is reported as an allowance in the equity

section of the balance sheet.

This net unrealized holding gain is reported as an allowance in the equity

section of the balance sheet.

12-13

Other Comprehensive Income

Other comprehensive income:Foreign currency translation gains (losses) $ XX,XXXNet unrealized holding gains (losses) on investments 3,000Minimum pension liability adjustment X,XXXDeferred gains (losses) from derivatives XXX $ XX,XXXLess: aggregate income tax espense (benefit) X,XXX

Other comprehensive income $XX,XXX

When we add When we add other comprehensive incomeother comprehensive income to to net incomenet income we refer to the result as “comprehensive income.”we refer to the result as “comprehensive income.”

When we add When we add other comprehensive incomeother comprehensive income to to net incomenet income we refer to the result as “comprehensive income.”we refer to the result as “comprehensive income.”

12-14

Securities Available for Sale

Net unrealized holding gains and losses from securities available-for-sale are reported in the equity section of

the balance sheet.

12-15

Securities Available for Sale

This is called . . .Occasionally, an Occasionally, an

investment’s value investment’s value will decline for will decline for

reasons that are reasons that are “other than “other than temporary”.temporary”.

Occasionally, an Occasionally, an investment’s value investment’s value

will decline for will decline for reasons that are reasons that are

“other than “other than temporary”.temporary”.

12-16

Securities Available for Sale

The new cost The new cost basis (the basis (the

impaired fair impaired fair value) is not value) is not changed for changed for subsequent subsequent recoveries in recoveries in

fair value.fair value.

The new cost The new cost basis (the basis (the

impaired fair impaired fair value) is not value) is not changed for changed for subsequent subsequent recoveries in recoveries in

fair value.fair value.

If the value is impaired . . .

. . . the recorded cost of the security is reduced

to the impaired fair impaired fair valuevalue, and the

difference is included in the current period’s

income.

If the value is impaired . . .

. . . the recorded cost of the security is reduced

to the impaired fair impaired fair valuevalue, and the

difference is included in the current period’s

income.

12-17

Learning Objectives

Demonstrate how to identify and account for investments classified for reporting purposes

as trading securities.

12-18

Trading Securities

Adjustments to fair Adjustments to fair value are recorded value are recorded

as:as:1.1. a direct adjustment to a direct adjustment to

the investment the investment account, andaccount, and

2.2. a net unrealized a net unrealized holding gain/loss on holding gain/loss on the the Income Income StatementStatement..

Adjustments to fair Adjustments to fair value are recorded value are recorded

as:as:1.1. a direct adjustment to a direct adjustment to

the investment the investment account, andaccount, and

2.2. a net unrealized a net unrealized holding gain/loss on holding gain/loss on the the Income Income StatementStatement..

12-19

Trading Securities

Matrix, Inc. purchased the addition securities classified Matrix, Inc. purchased the addition securities classified as Trading Securities (TS) in 2006. The fair value as Trading Securities (TS) in 2006. The fair value amounts were determined on December 31, 2006. amounts were determined on December 31, 2006. Prepare the journal entries for Matrix, Inc. to adjust Prepare the journal entries for Matrix, Inc. to adjust

the securities to fair value at 12/31/06.the securities to fair value at 12/31/06.

Matrix, Inc. purchased the addition securities classified Matrix, Inc. purchased the addition securities classified as Trading Securities (TS) in 2006. The fair value as Trading Securities (TS) in 2006. The fair value amounts were determined on December 31, 2006. amounts were determined on December 31, 2006. Prepare the journal entries for Matrix, Inc. to adjust Prepare the journal entries for Matrix, Inc. to adjust

the securities to fair value at 12/31/06.the securities to fair value at 12/31/06.

12-20

Trading Securities

The Net Unrealized Holding Loss is reported on the Income Statement.

The Net Unrealized Holding Loss is reported on the Income Statement.

12-21

Trading Securities

Unrealized holding

gains and losses from

trading securities

are reported on the income

statement.

12-22

Transfers Between Reporting Categories

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.

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.

Transfers are accounted for at fair valuefair value

on the transfer date.

Transfers are accounted for at fair valuefair value

on the transfer date.

12-23

Disclosures

12-24

Learning Objectives

Explain what constitutes significant influence by the investor over the operating and financial

policies of the investee.

12-25

12-26

When an investment results When an investment results in thein the controlcontrol of the investee of the investee

(generally(generally > 50> 50%), the %), the subsidiary issubsidiary is consolidatedconsolidated with the parent company.with the parent company.

When an investment results When an investment results in thein the controlcontrol of the investee of the investee

(generally(generally > 50> 50%), the %), the subsidiary issubsidiary is consolidatedconsolidated with the parent company.with the parent company.

The cost method is used for investments in equity securities

when significant influence is not

present.

The cost method is used for investments in equity securities

when significant influence is not

present.

The equity method is used for investments in

equity securities resulting in significant influence (20%-50%).

The equity method is used for investments in

equity securities resulting in significant influence (20%-50%).

12-27

Learning Objectives

Understand the way investments are recorded and reported by the equity method.

12-28

Equity Method

1. The investment account is increased increased by: Original investment cost. Proportionate share of investee's

earnings.

2. The investment account is decreaseddecreased by: Dividends received.

1. The investment account is increased increased by: Original investment cost. Proportionate share of investee's

earnings.

2. The investment account is decreaseddecreased by: Dividends received.

12-29

Equity Method

The investment account is reported on the balance sheet as a single amount.

The investor’s share of the investee’s earnings from date of acquisition is reported as a single item on the investor’s income statement.

12-30

Equity Method

On January 1, 2006, 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 2006, Apex cash paid 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.?

On January 1, 2006, 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 2006, Apex cash paid 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.?

12-31

Equity Method

Date Description Debit Credit1/1/06 Investment in Apex, Inc. 1,350,000

Cash 1,350,000

3,000,000$ Fair value of assets× 45% Percentage ownership

1,350,000$ Fair value of assets purchased

12-32

Equity Method

Date Description Debit Credit1/1/06 Investment in Apex, Inc. 1,350,000

Cash 1,350,000

12/31/06 Cash 67,500 Investment in Apex, Inc. 67,500

Investment in Apex, Inc. 787,500 Investment revenue 787,500

150,000$ Dividends paid× 45% Percentage ownership

67,500$ Share of dividends

1,750,000$ Reported earnings× 45% Percentage ownership

787,500$ Share of earnings

12-33

Equity Method

Investment in Apex, Inc.

Investment 1,350,000 67,500 45% Dividends

45% Earnings 787,500

Reported amount 2,070,000

If the subsidiary had a loss, the investment account would have

been reduced.

12-34

Learning Objectives

Explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceeds their book

value at acquisition.

12-35

Equity Method

If the investor acquires the equity securities of an investee by paying more than the fair

value of net assets . . .

. . . the difference is allocated between GOODWILLGOODWILL and IDENTIFIABLE IDENTIFIABLE

ASSETSASSETS.

If the investor acquires the equity securities of an investee by paying more than the fair

value of net assets . . .

. . . the difference is allocated between GOODWILLGOODWILL and IDENTIFIABLE IDENTIFIABLE

ASSETSASSETS.

12-36

Equity Method

On January 1, 2006, Matrix, Inc. purchase 25% of the common stock of Apex, Inc. for $200,000. At the date of acquisition, the book value of the net assets of Apex was

$480,000, and the net fair value of these assets is $600,000. During 2006, Apex paid cash dividends of $40,000, and reported earnings of $100,000. Let’s prepare the journal

entries to reflect the acquisition and other events during 2006.

Fair value of assets acquired 600,000$ Percentage ownership 25%Share of fair value of assets 150,000 Cost of investment in Apex 200,000 Excess of cost over fair value 50,000$

12-37

Equity Method

Assume that of the $50,000 excess of purchase price over fair value of the net asset acquired, 75% is attributable to

depreciable assets with a remaining life of 20 years and the remainder is considered goodwill. Matrix uses the straight-line

method of depreciation on similar owned assets.

Excess of cost over fair value 50,000$ Amount applicable to depreciable assets 75%Share subject to excess depreciation 37,500 Remaining useful life of assets in years 20 Additional depreciation expense 1,875$

12-38

Equity MethodDate Description Debit Credit1/1/06 Investment in Apex, Inc. 200,000

Cash 200,000

12/31/06 Cash 10,000 Investment in Apex, Inc. 10,000

Investment in Apex, Inc. 25,000 Investment revenue 25,000

Investment revenue 1,875 Investment in Apex, Inc. 1,875

40,000$ Dividends paid× 25% Percentage ownership

10,000$ Share of dividends

100,000$ Reported earnings× 25% Percentage ownership

25,000$ Share of earnings

Remember, goodwill is not amortized.

12-39

Changing From Equity To Cost

At the transfer date, the carrying value of the investment under the equity

method is regarded as cost.

At the transfer date, the carrying value of the investment under the equity

method is regarded as cost.

When the investor’s level of influence changes, it may be necessary to change from the equity

method to another method.

12-40

Changing From Equity To Cost

Any difference between cost 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.

Any difference between cost 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.

12-41

Changing From Cost To Equity

When ownership level increases to a significant influence, the investor may

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.

When ownership level increases to a significant influence, the investor may

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

12-42

Changing From Cost To Equity

The original cost, the unrealized holding The original cost, the unrealized holding gain or loss, and the valuation account gain or loss, and the valuation account

are closed.are closed.

A A retroactiveretroactive change is recorded to change is recorded to recognize the investor’s share of the recognize the investor’s share of the investee’s earnings since the original investee’s earnings since the original

investment.investment.

The original cost, the unrealized holding The original cost, the unrealized holding gain or loss, and the valuation account gain or loss, and the valuation account

are closed.are closed.

A A retroactiveretroactive change is recorded to change is recorded to recognize the investor’s share of the recognize the investor’s share of the investee’s earnings since the original investee’s earnings since the original

investment.investment.

12-43

Financial Instruments & Derivatives

Financial Instruments:

1.1. Cash.Cash.

2.2. Evidence of an Evidence of an ownership interestownership interest in an entity.in an entity.

3.3. Contracts meeting Contracts meeting certain conditions.certain conditions.

Financial Instruments:

1.1. Cash.Cash.

2.2. Evidence of an Evidence of an ownership interestownership interest in an entity.in an entity.

3.3. Contracts meeting Contracts meeting certain conditions.certain conditions.

Derivatives:Derivatives:1.1. Hedges created to Hedges created to

offset risks created by offset risks created by other financial other financial investments or investments or transactions.transactions.

2.2. Value is derived from Value is derived from other securities.other securities.

Derivatives:Derivatives:1.1. Hedges created to Hedges created to

offset risks created by offset risks created by other financial other financial investments or investments or transactions.transactions.

2.2. Value is derived from Value is derived from other securities.other securities.

12-44

Appendix 12A

Other Investments

12-45

Special Purpose Funds

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.

12-46

Investment in Life Insurance Policies

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.

12-47

Appendix 12B

Impairment of a Receivable Due to a Troubled Debt

Restructuring

12-48

When the Receivable is Settled Outright

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 troubled debt restructuringdebt restructuring.

Sometimes a troubled debt is settled in full when the debtor transfers to the creditor assets

or equities. The creditor usually recognized a loss on

the settlement. Such a settlement is not considered unusual or infrequent and is not an extraordinary item.

12-49

When the Receivable is Settled Outright

Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable

to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to accept a parcel of land

with a fair market value of $615,000 in full settlement of the debt and the accrued interest.

Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable

to pay the $1,000,000 due or the accrued interest of $42,500. Creditor, Inc. agrees to accept a parcel of land

with a fair market value of $615,000 in full settlement of the debt and the accrued interest.

Description Debit CreditLand 615,000 Loss on trouble debt restructuring 427,500 Notes receivable 1,000,000 Accrued interest receivable 42,500

12-50

When the Receivable is Continued, But with Modified Terms

Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500.

Creditor, Inc. agrees to forgive the accrued interest of $42,500, and reduce the principal amount to $800,000.

Interest of $40,000 is due at the end of each year and the principal amount is due in full at the end of five years.

Creditor discounts future cash inflows at 6%.

Creditor, Inc. is owed $1,000,000 by Debtor Company. Because of financial difficulties, Debtor Company is unable to pay the $1,000,000 due or the accrued interest of $42,500.

Creditor, Inc. agrees to forgive the accrued interest of $42,500, and reduce the principal amount to $800,000.

Interest of $40,000 is due at the end of each year and the principal amount is due in full at the end of five years.

Creditor discounts future cash inflows at 6%.

Accrued interest 42,500$ Previous principal amount 1,000,000 Amount due to Creditor, Inc. 1,042,500 Present value of new interest 168,495$ Present value of principal 597,807 Present value of receivable 766,301 Loss on restructuring 276,199$

12-51

When the Receivable is Continued, But with Modified Terms

Description Debit CreditLoss on trouble debt restructuring 276,199 Notes receivable 233,699 Accrued interest receivable 42,500

The journal entry to record the forgiveness of principal and accrued interest and record the new note is:

12-52

End of Chapter 12