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Investment Investment in Debt and in Debt and

Equity Equity SecuritiesSecurities

chapterchapter 14

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1. Determine why companies invest in other companies.

2. Understand the varying classifications associated with securities.

3. Account for the purchase of debt and equity securities.

4. Account for the recognition of revenue from investments.

Learning Objectives

ContinuedContinuedContinuedContinued

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5. Account for the change in value of securities.

6. Account for the sale of investment securities.

7. Record the transfer of securities between categories.

8. Explain the proper classification and disclosure of investments in securities

Learning Objectives

ContinuedContinuedContinuedContinued

4Time Line of Business Issues Involved with Investment Securities

1. DETERMINE purpose of investment

2. CLASSIFY investments

3. PURCHASE securities

4. EARN AND RECOGNIZE a return

5. MONITOR changes in value

6. SELL securities

7. TRANSFER securities between categories

8. DISCLOSE status of portfolio at the end of the period

5Why Companies Invest in Other Companies

•Safety Cushion

•Cyclical Cash Needs

•Investment for a Return

•Investment for Influence

•Purchase for Control

6Investment in Debt and Equity Securities—2001

Total Investment Percentage ofTotal Investment Percentage ofCompany (in billions) Total AssetsCompany (in billions) Total Assets

Berkshire Hathaway $69.0 42.4%Microsoft 17.7 34.7Coca-Cola 5.4 24.2Citigroup 160.8 15.3AT&T 24.5 14.8Verizon 10.2 6.0

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1. A maturity value, representing the amount to be repaid to the debt holder at maturity.

2. An interest rate that specifies the periodic interest payments.

3. A maturity date, indicating when the debt obligation will be redeemed.

Classification of Investment in Securities

Debt securities typically have the following characteristics:

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These shares of stock typically carry with them the right to collect dividends and vote on corporate matters.

Equity securities represent ownership in a company.

Equity securities have the potential for significant increases in price.

Classification of Investment in Securities

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Debt/EquitySecurities

TradingTradingSecurities purchased for salein the near future.

Held-to-Maturity

Held-to-Maturity

Securities purchased with theintent to hold until maturity.

Available-for-sale

Available-for-sale

Securities not classified astrading or held-to-maturity.

Classification of Investment in Securities

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Available-for-sale

TradingHeld-to-maturity

DebtDebt

Equity Method

EquityEquity

Classification of Investment in Securities

Cost Method

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Equity Method Securities

These are securities purchased with the intent to control or significantly influence the operations of the investee.

These are securities purchased with the intent to control or significantly influence the operations of the investee.

At least 20 percent of the outstanding voting stock must be owned to have

this significant influence or control.

At least 20 percent of the outstanding voting stock must be owned to have

this significant influence or control.

Even then, there may be evidence to support the fact

that even a 20 percent investment does not have

significant influence.

Even then, there may be evidence to support the fact

that even a 20 percent investment does not have

significant influence.

12Different Accounting Different Accounting TreatmentsTreatments

Classification of Securities

Types of Securities

Disclosure on the

Balance Sheet

Treatment of Temporary Changes in

Value

Held to maturity Debt Amortized cost Not recognizedAvailable for sale Debt/equity Fair market value Reported in

stockholders’ equity

Trading Debt/equity Fair market value Reported on the income statement

Equity method Equity Historical cost Not recognized adjusted for changes in the assets of the investee

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Purchases of Debt Securities

On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9%

payable semiannually on January 1 and July 1. The debt securities are classified by the

purchaser as trading securities.

On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9%

payable semiannually on January 1 and July 1. The debt securities are classified by the

purchaser as trading securities.

Accrued interest on May 1 is $3,000, calculated as follows:

$100,000 x .09 x 4/12 = $3,000

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Purchases of Debt Securities

May 1 Investment in Trading Securities 104,250Interest Receivable 3,000

Cash 107,250

Purchase date:

Asset Approach

ContinuedContinuedContinuedContinued

Always includes

brokerage fees

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Purchases of Debt Securities

May 1 Investment in Trading Securities 104,250Interest Revenue 3,000

Cash 107,250

Purchase date:

Revenue Approach

ContinuedContinuedContinuedContinued

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Purchases of Debt Securities

Receipt of semiannual payment:

July 1 Cash 4,500Interest Receivable 3,000Interest Revenue 1,500

Asset Approach

July 1 Cash 4,500Interest Revenue 4,500

Revenue Approach

17Purchase of Equity Securities - Available for Sale (AFS)/Trading

Purchased 1,000 shares of AB Company’s Purchased 1,000 shares of AB Company’s common shares at $2 per share.common shares at $2 per share.

Purchased 1,000 shares of AB Company’s Purchased 1,000 shares of AB Company’s common shares at $2 per share.common shares at $2 per share.

Investment in Available-for-Sale*/Trading Securities - AB Company 2,000

Cash 2,000

* - would be so classified if management has no intention of holding them for a long period of time and will sell them as soon

as it is economically advantageous

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Citty Co. purchased 100,000 shares of AB Citty Co. purchased 100,000 shares of AB Company common shares at $2 per share.Company common shares at $2 per share.

Citty Co. purchased 100,000 shares of AB Citty Co. purchased 100,000 shares of AB Company common shares at $2 per share.Company common shares at $2 per share.

Purchase of Equity Securities – Equity Method

Assume that the 100,000 shares purchased represents 20 % of the outstanding voting stock of AB

Company. This investment gives the investor significant influence over AB

Company.

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Purchased 100,000 shares of Dave’s Deli Purchased 100,000 shares of Dave’s Deli common shares at $2 per share.common shares at $2 per share.

Purchased 100,000 shares of Dave’s Deli Purchased 100,000 shares of Dave’s Deli common shares at $2 per share.common shares at $2 per share.

Equity Method SecuritiesEquity Method Securities

Investment in AB Company Stock 200,000Cash 200,000

Purchase of Equity Securities - – Equity Method

20Recognizing Revenue from Debt Securities

On January 1, 2004, Silmaril Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable

semiannually on January 1 and July 1. The market rate on bonds of similar quality and

maturity is 8%.

On January 1, 2004, Silmaril Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable

semiannually on January 1 and July 1. The market rate on bonds of similar quality and

maturity is 8%.

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PV/Price of Debt SecuritiesPresent value of principal:

FV = $100,000; N = 10; I = 4%

$ 67,556Present value of interest payments:

PMT = $5,000; N = 10; I = 4%

40,554Total present value of the bonds

$108,110Investment in Trading Securities 108,100

Cash108,100

Investment in Held-to-Maturity Securities 108,100

Cash108,100

OR

22Interest Revenue for Debt Securities (Trading)

When the first interest payment is received from Silmaril, the following

entry would be made:

When the first interest payment is received from Silmaril, the following

entry would be made:

July 1 Cash 5,000Interest Revenue 5,000

23Interest Revenue for Debt Securities (Held-to-Maturity)

When the first interest payment is received from Silmaril, the following

entry would be made:

When the first interest payment is received from Silmaril, the following

entry would be made:

July 1 Cash 5,000Interest Revenue 4,324Investment in Held-to- Maturity Securities 676

$108,110 x .04

24Recognizing Revenue for Equity Recognizing Revenue for Equity Securities depends on the Securities depends on the

Appropriate Accounting MethodAppropriate Accounting Method

0% 20% 50% 100%

No significantinfluence

Significantinfluence

Control

Ownership Percentage

Account for as trading or

available-for-saleEquity method

Equity method and consolidation

procedures

25Determining the Appropriate Determining the Appropriate Accounting MethodAccounting Method

Ownership Interest

Control or Degree of Influence

Accounting Method

Applicable Standard

More than 50% Control Equity method APB Opinion #18and consolidation FASB Exposureprocedures Draft

20% to 50% Significant Equity method APB Opinion #18influence

Less than 20% No Account for as FASB Statementsignificant trading or No. 115influence available for sale

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AB Company announces dividends of AB Company announces dividends of $0.25 per share. Assume that Citty Co. $0.25 per share. Assume that Citty Co. owns 10,000 of AB’s 200,000 shares owns 10,000 of AB’s 200,000 shares

(which represents 5%)(which represents 5%)

AB Company announces dividends of AB Company announces dividends of $0.25 per share. Assume that Citty Co. $0.25 per share. Assume that Citty Co. owns 10,000 of AB’s 200,000 shares owns 10,000 of AB’s 200,000 shares

(which represents 5%)(which represents 5%)

Cash 2,500Dividend Revenue 2,500

Revenue for Equity Securities Classified as Trading and AFS

27Revenue for Equity Securities Classified as Equity Method

Securities

AB Company announces AB Company announces dividends dividends of of $0.25 per share. Assume that Citty Co. $0.25 per share. Assume that Citty Co.

owns 100,000 which represents 50 % of owns 100,000 which represents 50 % of the outstanding voting stock.the outstanding voting stock.

AB Company announces AB Company announces dividends dividends of of $0.25 per share. Assume that Citty Co. $0.25 per share. Assume that Citty Co.

owns 100,000 which represents 50 % of owns 100,000 which represents 50 % of the outstanding voting stock.the outstanding voting stock.

Cash 25,000Investment in AB Company Stock 25,000

28Revenue for Equity Securities Classified as Equity Method

Securities

AB Company reports an AB Company reports an incomeincome of of $250,000 for the year. Again, assume $250,000 for the year. Again, assume

that Citty Co. owns 50 % of the that Citty Co. owns 50 % of the outstanding voting stock.outstanding voting stock.

AB Company reports an AB Company reports an incomeincome of of $250,000 for the year. Again, assume $250,000 for the year. Again, assume

that Citty Co. owns 50 % of the that Citty Co. owns 50 % of the outstanding voting stock.outstanding voting stock.

Investment in AB Company Stock 125,000

Income from Investment in AB Company Stock 125,000

29Accounting for TemporaryChanges in Value of Securities (an

extract of slide 12)

Classificationof Security

Disclosedat

Report FMV

TradingFair marketvalue

Incomestatement

Held-to-maturity

Amortizedcost

Notrecognized

Available-for-sale

Fair marketvalue

Stockholder’sequity

Change On

30Accounting for TemporaryChanges in Value of Securities

Security Classification Cost($) FMV 31/12/05($)

1 Trading 8,000 7,000

2 Trading 3,000 3,500

3 Available for Sale 5,000 6,100

4 Available for Sale 12,000 11,500

5 Held to Maturity 20,000 19,000

Eastwood Inc. bought the following securities on March 23, 2005.

31Accounting for TemporaryChanges in Value of Securities

Investment in Trading Securities 11,000Investment in Available-for-Sale Securities 17,000Investment in Held-to-Maturity Securities 20,000

Cash 48,000

Initial Purchase EntryInitial Purchase Entry

ContinuedContinuedContinuedContinued

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December 31, 2005:

Unrealized Loss on Trading Securities 500 Market Adjustment—Trading Securities 500

By the end of the year, the value of By the end of the year, the value of the the trading securitiestrading securities decreased from decreased from

$11,000 to $10,500.$11,000 to $10,500.

By the end of the year, the value of By the end of the year, the value of the the trading securitiestrading securities decreased from decreased from

$11,000 to $10,500.$11,000 to $10,500.

Accounting for TemporaryChanges in Value of Securities

Included in net income

A contra account to the “investment account”

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December 31, 2005:

Market Adjustment—Available-for-Sale Securities 600

Unrealized Increase/Decrease in Value of Available-for-Sale Securities

600

By the end of the year, the value of By the end of the year, the value of the the available-for-saleavailable-for-sale securitiessecurities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.

By the end of the year, the value of By the end of the year, the value of the the available-for-saleavailable-for-sale securitiessecurities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.

Accounting for TemporaryChanges in Value of Securities

Included in stock holder’s equity =>

Comprehensive income

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Partial Balance Sheet for Eastwood Inc.Assets

Invest. in trading securities $11,000 Market adjustment—trading sec. (500) $10,500Invest. in available-for-sale sec. $17,000 Market adjustment 600 17,600Invest. in held-to-maturity sec. 20,000$48,100

Stockholders’ EquityAdd unrealized increase in available-for-sale securities $ 600

Accounting for TemporaryChanges in Value of Securities

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Partial Income Statement for Eastwood Inc.

Other expenses and losses:Unrealized loss on trading

securities $500

Accounting for TemporaryChanges in Value of Securities