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Investments

ACCTG 5120David Plumlee

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Financial Instruments

Any contract that Imposes on a 1st entity on potentially unfavorable terms with 2nd entity an obligation to

deliver cash or other financial instrument to the 2nd entity or to exchange financial instrument

Conveys to 2nd entity at potentially favorable termsa contractual right to

receive cash or other financial instrument from 1st entity or to exchange financial instruments

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Equity Investments

0% 20% 50% 100%

What are the important “ownership” percentages when accounting for an investment in another entity?

Significant

influence

No significan

t influence

CONTROL

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Guidelines for Equity Investments

0% 20% 50% 100%

cost orfair value(i.e. FASB115)

equitymethod

consolidate

How does “ownership percentage” affect accounting for an investment in another entity?

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Background - Pre-FASB 115

Inconsistencies – accounting for debt was

either amortized cost or LCM, while

equity as LCM

Income manipulation (cherry picking)

BV irrelevant

Prior to FASB 115, what were the concerns about accounting treatment of investments?

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Scope of FASB 115

FASB 115 assumes that market value is readily available, what if its is not?

Record at cost (equity) or amortized cost (debt)

To what Investments does FASB 115 apply?

equity securities with no significant influence debt securities

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Classifications Under FASB 115

Trading securities -- debt or equity securities intended to be actively traded Held-to-maturity-- debt securities where the entity has both the intent and ability to hold to maturity Available-for-sale all other debt or equity securities

FASB 115 looks to the intent of management to classify investments, what are the 3 classifications?

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Held-to-Maturity Securities

Interest including discount/premium amortization; no adjustment for FV

How are held-to-maturity investments valued on the balance sheet?

amortized cost using effective interest method to amortize premium/discount

What is considered as income for held-to-maturity investments?

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Example - Held to Maturity

Jan. 1, 2004: Acme Co. purchases $100,000 face amount, 7% bonds of Olsen Co. for $96,634, and it intends to hold to maturity, Dec. 31, 2007

Yielding 8% per year when purchased Interest paid June 30 and December 31 Acme uses effective interest rate method to amortize discount FV at December 31, 2004 is $98,000

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Journal Entries

held to maturity 96,634cash 96,634

JE to record purchase at January 1, 2004:

cash (100,000 x 3.5%) 3,500held to maturity (plug) 365

interest income (96,634 x 4%) 3,865

JE to record income at June 30, 2004:

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Journal Entries

Unrealized gain at 12/31/04 not recorded!fair value 98,000cost basis 97,379unrealized gain 621

cash (100,000 x 3.5%) 3,500held to maturity (plug) 380

interest income* 3,880*(96,634 + 365) x 4%

JE to record income at Dec. 31, 2004:

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Available for Sale Securities

How are available for sale investments valued on the balance sheet?

Record purchase at cost adjust to fair value at period end Include unrealized gain/loss in equity

not in current year income

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Available for Sale Securities

Dividend income Interest received adjusted by premium/discount amortization Upon sale, realized gains and/or losses proceeds - cost basis

What is considered as income for available for sale investments?

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Example - Available for Sale

Jan. 1, 2004: Acme Co. purchases the following:

# Shares Price Total $Red Co. stock 5,000 $12 $60,000Blue Co. stock 1,000 $80 $80,000

March 1, 2004: $5,000 dividends received from Red.

December 31, 2004 FV:Red Co. ($14 x 5,000) $70,000Blue Co. ($75 x 1,000) $75,000

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Example - Available for Sale

June 15, 2005: 2,500 shares of Red Co. stock sold for $9/share

December 31, 2005 fair values:Red Co. ($9 x 2,500) $22,500Blue Co. ($78 x 1,000) $78,000

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Journal Entries

available for sale 140,000cash

140,000

JE to record purchase at January 1, 2004:

cash 5,000dividend income

5,000

JE to record income at March 1, 2004:

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Journal Entries

December 31, 2004: adjust to FMVfair value 145,000cost basis -140,000unrealized gain 5,000

valuation allowance (AFS) 5,000 unreal. gain/loss - B/S

5,000

What is the adj. JE?

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Calculation for each asset..

Red stockCost $12/share 60,000FMV $14/share 70,000

Valuation allowance $10,000 DR

Blue stockCost $80/share 80,000FMV $75/share 75,000

Valuation allowance $ 5,000 CR

Net valuation 5,000 DR

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Balance sheet presentation

Current assetsInvestments

AFS,at fair value (net) 145,000PPE etc. XXXX

Total Assets XXX,XXX

Total Liabilities XXXXStockholders’ Equity

Unrealized gain on AFS securities 5,000Total stockholders equity XXXXTotal Liabilities and S Equity XXX,XXX

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Journal Entries

JE to record sale of shares at June 15, 2005:

sale proceeds (2,500 x $9) 22,500cost basis (2,500 x $12) 30,000realized loss on sale (7,500)

cash 22,500loss on sale 7,500

available for sale30,000

What is the JE for the sale?

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Journal Entries

JE to adjust to FMV at December 31, 2005:fair value 100,500cost basis (2,500@$12; 1,000@$80) 110,000unrealized loss (9,500)

unreal. gain/loss - B/S 14,500valuation allowance (AFS)

14,500

change in valuation allowance: current balance $5,000 debitrequired balance $9,500 credit

What is the adj. JE?

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Calculation for each asset..

Red stockCost $12/share 30,000FMV@ 12/31/04 $14/share 70,000FMV@ 12/31/05 $9/share 22,500

Valuation allowance $ 7,500 CR

Blue stockCost $80/share 80,000FMV@12/31/04 $75/share 75,000FMV@ 12/31/05 $78/share 78,000

Valuation allowance $ 2,000 CR

Net valuation 9,500 CR

compare

compare

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Balance sheet presentation

Current assetsInvestments

AFS sec,at fair value (net) 100,500

PPE etc. XXXXTotal Assets XXX,XXX

Stockholders’ EquityUnrealized gain(loss) on AFS securities (9,500)Total stockholders equity XXXXTotal Liabilities and S Equity XXX,XXX

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Trading Securities

How are Trading Securities investments valued on the balance sheet?

Record purchase at cost adjust to fair value at period end

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Trading Securities

Dividend income (equity) or interest received (debt) NOT adjusted by premium/discount amortization Unrealized gains/losses Upon sale, realized gains and/or losses proceeds - cost basis

What is considered as income for Trading Securities investments?

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Journal Entries

The JE are identical to entries for available for sale securities except

Unrealized gains/losses are taken to the income statement No adjustment to amortize bond discount/premium

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Equity method

Situations where the investor has “significant influence,” but not control (>20% and < 50% ownership).

When do we account for investments using the equity method?

Dividends paid by investee is recorded as reduction of asset accountIncome earned by investee is recorded as income by investor

What are the important differences in the way we account for these investments?

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Journal Entries

Investment in Red Co. 60,000 cash

60,000

JE to record purchase at January 1, 2004:

cash 5,000Investment in Red Co.

5,000

JE to record income at March 1, 2004:

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Journal Entries

Investment in Red Co. 15,000Revenue from investment 15,000

Assume Acme has a 30% ownership and Red’s reported income is $50,000What is the JE to record Acme’s investment income in 2004?

No entry for FMV adjustment!!

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Current assetsLong term investments

Inv in Red Co 70,000PPE etc. XXXX

Total Assets XXX,XXX

Stockholders’ Equity

Total stockholders equity XXXXTotal Liabilities and S Equity

XXX,XXX

Balance sheet presentationOriginal investment $60,000

Dividends (5,000)

Pro Rata Income 15, 000

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Equity Method Stock Sale

Acme sold 1/2 of its investment in Red Company for $25,000.

What is the JE to record Acme’s investment sale?

Cash 25,000Loss on sale 10,000

Investment in Red 35,000

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Transfers from one category to another

FV at date of transfer--new cost basis Unrealized gains/losses are recognized

How to you account for transfers from Trading to AFS?

FV at date of transfer--new cost basisUnrealized gains/losses are recognized

How to you account for transfers from AFS to Trading?

Cannot avoid gains/losses by transferring!

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Transfers from one category to another

AFS to HTM FV at date of transfer Unrealized gain/loss is amortized over life of security

How to you account for transfers from Hold to Maturity to AFS?

FV at date of transferUnrealized gain/loss effective at date of transfer

How to you account for transfers from AFS to Hold to Maturity?