12 Investments Chapter 12: Investments.
In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity of other companies. Depending on the nature of an investment, investors can use alternative accounting approaches that ignore most fair value changes (e.g., held-to-maturity investments) or that include fair value changes only in other comprehensive income (e.g., available-for-sale-investments).When an equity investor can significantly influence an investee but does not control it, the investor can use the equity method of accounting, which ignores fair valuechanges but includes the investees income when reporting the investors income. McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Common and preferred stock
Nature of Investments Bonds and notes (Debt securities) Common and preferred stock (Equity securities) To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities are purchased as investments by individual investors, mutual funds, and also by other corporations. Our focus in this chapter is on the corporations that invest in securities issued by other corporations as well as those issued by governmental units (bonds, Treasury bills, and Treasury bonds). Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship. Reporting Categories for Investments
To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities are purchased as investments by individual investors, mutual funds, and also by other corporations. In later chapters we discuss equity and debt securities from the perspective of the issuing company. Our focus in this chapter is on the corporations that invest in debt and equity securities issued by other corporations as well as debt securities issued by governmental units (bonds, Treasury bills, and Treasury bonds). Most companies invest in financial instruments issued by other companies. For some investors, these investments represent ongoing affiliations with the companies whose securities are acquired. Investor Lacks Significant Influence
When the investor lacks significant influence over the investee, the investment is classified in one of three categories: held-to-maturity securities (HTM), trading securities (TS), and available-for-sale securities (AFS). Each type of investment has its own reporting method. However, regardless of the investment type, investors can elect the fair value option that we discuss later in the chapter and classify HTM and AFS securities as TS. The key difference among the reporting approaches is how we account for unrealized holding gains and losses. Securities to Be Held to Maturity
Investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the positive intent and ability to hold the securities to maturity and classified as held-to-maturity (HTM). They are reported on the balance sheet at amortized cost. Amortized cost (Face amount less unamortized discount, or plus unamortized premium). Investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the positive intent and ability to hold the securities to maturity and classified as held-to-maturity (HTM). They are reported on the balance sheet at amortized cost.Amortized cost is equal to the face amount of the debt less any unamortized discount, or plus any unamortized premium. If management decides to sell the securities prior to maturity, they will be reclassified to trading securities. We will discuss trading securities later in the presentation. Balance Sheet Securities to Be Held to Maturity
On January 1, 2011, 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%. Lets look at calculation of the present value of the bond issue. Present Amount PV Factor Value Interest $ ,000 = $573,496 Principal 1,000,000 311,805 Present value of bonds $885,301 On January 1, 2011, 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%. Lets look at calculation of the present value of the bond issue. The interest annuity is $50,000 ($1,000,000 times 10% equals $100,000, divide $100,000 by 2 for $50,000 cash interest). Look at the present value of an ordinary annuity of $1 table. Find the 20 periods row and move across to the 6% column to find the factor of Go to the present value of $1 table and follow the same procedures to arrive at the present value factor of The present value of the bonds at 12% return is $885,301. PV of ordinary annuity of $1, n = 20, i = 6% PV of $1, n = 20, i = 6% Securities to Be Held to Maturity
Partial Bond Amortization Table January 1, 2011 Investment in bonds1,000,000 Discount on bond investment ,699 Cash ,301 Part I Here is a partial amortization table for the bonds purchased on January 1, 2011 with the intent of holding them to maturity.The bonds were priced as $885,301, to yield Matrix, a 12% return. Interest semi-annually on June 30th and December 31st. Lets look at the journal entry to record the initial purchase of the bonds and the subsequent receipt of the first interest amount. Part II On January 1, Matrix will debit investment in bonds for the face amount of $1 million, credit discount on bond investment for $114,699, and credit cash for $885,301.On June 30, the first at payment is due to Matrix.The journal entry is to debit cash for $50,000, debit discount on bonds payable for $3,118 and credit interest revenue for $53,118.The interest revenue is determined by taking 6% of the carrying value of the bonds, which is $885,301. The $50,000 cash received is determined by multiplying the face amount of the bonds, $1 million, by 5%, the stated rate. The difference between the calculated interest revenue and the cash interest received represents the amortization of the bond discount. June 30, 2011 Cash (stated rate face amount) ,000 Discount on bond investment ,118 Investmentrevenue ,118 Securities to Be Held to Maturity
This investment would appear on the June 30, 2011, as follows: $114,699 - $3,118 = $111,581 unamortized discount As of June 30, discount on the bond investment account has been reduced to $111,581.The amortized amount of the investment is $888,419.If a balance sheet were prepared as of June 30, the investment in bonds would be shown at $888,419. We do not recognize unrealized holding gains and losses for HTM investments. Unrealized holding gains and losses are not recognized for HTM investments. Securities to Be Held to Maturity
On December 31, 2011, after interest is received by Matrix, all the bonds are sold for $900,000 cash. December31, 2011 Cash50,000 Discount on bond investment3,305 Investment revenue 53,305 Part I On December 31, 2011, Matrix receives $50,000 cash interest. The journal entry to record the receipt is to debit cash for $50,000, debit discount on bonds payable of $3,305, and credit investment revenue for the total of $53,305. Part II Immediately after the receipt of interest, Matrix sells its investment in bonds for $900,000 cash. The entry to record the sale is to debit cash for the proceeds of $900,000, eliminate the unamortized discount with a debit to discount on bonds payable for $108,276, credit the investment in bonds for $1,000,000, and credit the realized gain on sale of investment for $8,276 (the difference between the cash received of $900,000 and the carrying value of the investment,$891,724). December 31, 2011 Cash ,000 Discount on bond investment108,276 Investmentin bonds 1,000,000 Gain on sale of investment ,276 Trading Securities Income Statement Unrealized Gain Unrealized Loss
Investments in debt or equity securities acquired principally for the purpose of selling them in the near term. Adjustments to fair value are recorded: in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. as a net unrealized holding gain/loss on the Income Statement. Trading securities are investments in debt or equity securities acquired principally for the purpose of selling them in the near term. Trading securities initially are recorded at cost including any brokerage fees. Adjustments to fair value for trading securities are made when the balance sheet is prepared. These adjustments are typically made to a fair value adjustment account, but could also be made directly to the investment account. Unrealized Gain Unrealized Loss Income Statement Trading Securities Matrix, Inc. purchased securities classified as Trading Securities (TS) on December 22, The fair value amounts for these securities on December 31, 2011, are shown below. Prepare the journal entries for Matrix, Inc. to showing the purchase of the securities, and adjust the securities to fair value at 12/31/11. On December 22, 2011, Matrix purchases 1,000 shares of Mining, inc. and 1,500 shares of Toys and Things to be held as trading securities.The cost of these securities are shown on the table at the bottom of your screen.On December 31, 2011, the fair value of the Mining, Inc. shares is $41,000, and the fair value of Toys and Things shares is $20,000.Lets see how we record the purchase of the shares and the unrealized holding loss on the securities. Trading Securities December22, 2011 Investment in Mining, Inc. stock ,000 Investment in Toys and Things stock 22,500 Cash ,500 Part I On December 22, 2011, Matrix purchases shares of stock and classified these shares as trading securities. The journal entry to record the investments is to debit investment in Mining, Inc. stock for $42,000 and debit investment in Toys and Things stock for $22,500, with a credit to cash for the total amount of $64,500. Part II At December 31, 2011, the journal entry required is to debit net unrealized holding gains and losses - IS for $3,500, and credit the fair value adjustment account for the same amount.The net unrealized holding loss will be reported in the current period income statement. The fair value adjustment account is an adjunct account included with the investment account on the balance sheet, so that the investment is carried at fair value.Also, any interest revenue is handled the same as with HTM investments, and any dividend revenue is handled similarly, with a debit to cash and a credit to investment revenue. Reported on the balance sheet as a adjunct account to the investment. December 31, 2011 Net unrealized holding gains and losses I/S3,500 Fair value adjustment ,500 The Net Unrealized Holding Loss is reported on the Income Statement. Trading Securities On January 3, 2012, Matrix sold all trading securities for $65,000 cash. Lets record the entry for the sale and the adjustment to the fair value adjustment account. January 3, 2012 Cash ,000 Investment in Mining, Inc. stock T/S42,000 Investment in Toys and Things stock T/S22,500 Gain on sale of investment December 31, 2012 Fair value adjustment ,500 Net unrealized holding gains or losses I/S3,500 Part I On January 3, 2012, Matrix sold all it trading securities for $65,000 cash. The entry to record the sale is to debit cash for $65,000,credit each trading security for its cost, and credit gain on sale of investments for $500. Part II In the period of sale, the fair value adjustment associated with the sold investment is eliminated, typically as part of the normal valuation process at the end of the period. This also has the effect of backing out of income any unrealized gains and losses that were recognized in prior periods, which avoids the double accounting that would result from including gains and losses both when unrealized (because fair value changes) and when realized (because the investment is sold).So, in our example, we eliminate the fair value adjustment with a debit of $3,500, and credit net unrealized gain or loss for the same amount. Financial Statement Presentation
Trading securities are presented on the financial statement as follows: Income Statement and Comprehensive Income Statement: Fair value changes are included on the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income. Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders equity. Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investor that hold trading securities consider them as part of their normal operations. Trading securities are presented on the financial statement as follows: Income Statement and Comprehensive Income Statement: Fair value changes are included on the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income. Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders equity. Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investor that hold trading securities consider them as part of their normal operations. Financial Statement Presentation
Presented below are the partial financial statements showing the accounting for TS owned by United: Presented below are the partial financial statements of the trading securities owned by United for the years ended December 31, 2011 and Notice the reporting of realized and unrealized gains and losses on investments that are reported on the income statement. The interest and dividends were received from Masterwear and Arjent. The purchase and sale of the securities are classified as operating activities in the Statement of Cash Flows because they will be traded in the near term. Securities Available-for-Sale
Investments in debt or equity securities that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS). Adjustments to fair value are recorded: in a valuation account called fair value adjustment, or asa direct adjustment to the investment account. as a net unrealized holding gain/loss in othercomprehensive income (OCI), which accumulates inaccumulated other comprehensive income (ACOI). When an investment is not classified as an HTM or trading security, it is classified asavailable-for-sale. Available-for-sale securities are recorded on the balance sheet atfair value subsequent to acquisition. Adjustments to fair value are recorded in avaluation account called Fair Value Adjustment, or as a direct adjustment tothe investment account. The net unrealized holding gains or losses is shown inthe account Other Comprehensive Income (OCI), which accumulates inAccumulated Other Comprehensive Income (ACOI). Unrealized Gain Unrealized Loss Other Comprehensive Income (OCI) Other Comprehensive Income (OCI)
When we add other comprehensive income to net income we refer to the result as comprehensive income. Other comprehensive income consists of the four elements shown and is reported net of aggregate income tax expense or benefit. Accumulated Other Comprehensive Income
Unrealized holding gains and losses on available-for-sale securities are accumulated in the shareholders equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income (AOCI). Shareholders Equity Common Stock Paid-in Capital in Excess of par Accumulated other comprehensive income Retained earnings Total Shareholders Equity Net unrealized holding gainsand losses. Unrealized holding gains and losses on available-for-sale securities are reported in the shareholders equity section of the balance sheet. Specifically, the account is included in Accumulated Other Comprehensive Income. The reason for this placement is that many in the business world believe that including unrealized holding gains and losses on available-for-sale securities would cause greater volatility in net income than was appropriate (or at least desired!). Securities Available for Sale Example
Assume the same information for our T/S example for Matrix, Inc., except that the investments are classified as available-for-sale securities rather than trading securities. Part I Assume the same information for our T/S example for Matrix, Inc., except that the investments are classified as available-for-sale securities rather than trading securities. Recall that on December 31, 2011, we calculated a net unrealized holding loss of $3,500. Lets see how we account for this net unrealized holding gain or loss on available-for-sale securities. Part II The adjusting entry on December 31, 2011, is to debit the net unrealized holding gains and losses for other comprehensive income for $3,500, and credit the fair value adjustment account for the same amount. December 31, 2011 Net unrealized holding gains and losses OCI3,500 Fair value adjustment ,500 Financial Statement Presentation
AFS securities are presented on the financial statement as follows: Income Statement and Comprehensive Income Statement: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders equity, and are reclassified out of AOCI in the periods in which securities are sold. Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities. AFS securities are presented on the financial statement as follows: Income Statement and Comprehensive Income Statement: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders equity, and are reclassified out of AOCI in the periods in which securities are sold. Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities. Financial Statement Presentation
Presented below are the partial income statement showing the accounting for AFS of United: The important items to note in the income statement of United is the reporting of the realized net loss on sale of investment in the other income or expense category and the development of the other comprehensive income or loss items. Notice that we income both the unrealized holding gains or losses in AFS investments and any adjustment resulting from the reclassification of securities in our investment portfolio. Financial Statement Presentation
Finally, we have the partial balance sheet and statement of cash flows for the company. Finally, we have the partial balance sheet and statement of cash flows for the company. Notice that we report accumulated other comprehensive income in the stockholders equity section of the companys balance sheet. U. S. GAAP vs. IFRS Until recently, IFRS did not allow transfers out of their fair value through profit and loss classification. U.S. GAAP also allows transfers out of the trading security category. Reclassifications under U.S. GAAP are rare. IAS No. 39 now allows transfer of debt investments out of the fair value category into AFS or HTM in rare circumstances. The current financial crisis qualified as one of those circumstances. Until recently, IFRS did not allow transfers out of their fair value through profit and loss classification. From the perspective of the IFRS, IAS No. 39, now allows transfer of debt investments out of the fair value category into AFS or HTM in rare circumstances. The current financial crisis qualified as one of those circumstances. However, IAS No. 39 increases convergence to U.S. GAAP, which also allows transfers out of the trading security category. Reclassifications under U.S. GAAP are even more rare. U. S. GAAP vs. IFRS IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at Fair Value Through Profit & Loss (FVTPL), and thus having unrealized gains and losses included in net income. U.S. GAAP permits classification as HTM, AFS, and TS. No significant tests are required to classify a debt investment. There is no comparable FVTPL or FVTOCI classification. Investments in debt securities are classified as either Amortized Cost or FVTPL. To be classified as a debt investment, two important tests must be met. The current financial crisis qualified as one of those circumstances. Investments in equity securities are classified as either FVTPL or FVTOCI (Fair Value through Other Comprehensive Income). IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at Fair Value Through Profit & Loss (FVTPL), and thus having unrealized gains and losses included in net income. Investments in debt securities are classified as either Amortized Cost or FVTPL. Like the previous HTM classification, debt in the amortized cost classification is accounted for at (you guessed it) amortized cost. However, to be included in the amortized cost category, a debt investment has to meet both (a) the cash flow characteristics test (which requires that the debt instrument consist of only principal and interest payments) and (b) the business model test (which requires that the objective of the companys business model is to hold the investment to collect the contractual cash flows rather than to sell the investment at a gain). If debt isnt classified in amortized cost, it is classified in FVTPLthere is no equivalent to AFS accounting for debt under IFRS No. 9. Investments in equity securities are classified as either FVTPL or FVTOCI (Fair Value through Other Comprehensive Income). If the equity is held for trading, it must be classified as FVTPL, but otherwise the company can irrevocably elect to classify it as FVTOCI. Like the previous AFS classification, equity in the FVTOCI category has unrealized gains and losses included in OCI. However, unlike AFS, realized gains and losses are not reclassified out of OCI and into net income when they are later sold. Rather, the accumulated gain or loss associated with a sold investment is just transferred from AOCI to retained earnings (both shareholders equity accounts), without passing through the income statement. Transfers Between Reporting Categories
Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Securities are transferred at fair market value on the date of transfer. At each reporting date, the appropriateness of the classification is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. Reclassifications are quite unusual, so when they occur, disclosure notes should describe the circumstances that resulted in the transfers. When a security is reclassified between two reporting categories, the security is transferred at its fair value on the date of transfer. This table illustrates reclassification of securities from one category to another. We will concentrate of the proper handling of any unrealized gain or loss from the transfer at fair market value. Impairment of Investments
Occasionally, aninvestments value willdecline for reasonsthat are other thantemporary (OTT). Impairment in Value For HTM and AFS investments, a companyrecognizes an OTT impairment loss in earnings. Determining an other than temporary decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed. Sometimes an investment will incur an other than temporary (permanent) decrease in value.We refer to this as an impairment in value. For HTM and AFS investments, a companyrecognizes an OTT impairment loss in earnings. Determining an other than temporary decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed. U. S. GAAP vs. IFRS Until recently, IFRS did not allow transfers out of the fair value through P&L (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP). U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified. In recent changes, IAS No. 39 allows transfers of debt investments out of the FVTPL category into AFS or HTM in rare circumstances, The 2008, financial crisis qualifies as one of those rarecircumstances. Part I Until recently, IFRS did not allow transfers out of the fair value through P&L (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP). From the perspective of the IFRS, In recent changes, IAS No. 39 to allow transfers of debt investments out of the FVTPL category into AFS or HTM in rare circumstances, The 2008, financial crisis qualifies as one of those rarecircumstances. However, U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified. Financial Statement Presentation and Disclosure
AggregateFair Value Gross realized & unrealized holding gains & losses Maturities ofdebt securities Amortized cost basis by major security type Listed on this slide are six disclosures required for investments in securities classified as held-to-maturity, available-for-sale, or trading.Additional disclosures are also required. Change in net unrealized holding gains and losses Inputs to fairvalue estimates Investor Has Significant Influence
Now we are going to change the accounting for investments dramatically.We are going to assume a company has acquired enough equity securities in another company to exert significant influence over the operating policies of that company. The presumption is that if the investor owns between 20 and 50 percent of the voting stock of the investee company, the investor is able to exert significant influence over the policies of the investee. Under these circumstances, the equity method of accounting for the investment is required. Investor Has Significant Influence
Extent of Investor Influence Reporting Method Lack of significant influence (usually < 20% equity ownership) Varies depending on classification previously discussed Significant influence(usually 20% - 50% equity ownership) Equity method Has control (usually > 50% equity ownership) Consolidation We use the equity method for investments in equity securities that are large enough to allow us to exert significant influence, typically assumed as occurring when we own between 20% and 50% of the voting common stock.If we own more than 50% of the voting common stock, we use consolidation. Consolidated financial statements combine the separate financial statements of the parent and the subsidiary each period into a single aggregate set of financial statements as if there were only one company. The investor is referred to as the parent; the investee is termed the subsidiary.In a consolidation, if the acquisition price is more than the sum of the separate fair values of the acquired net assets (assets less liabilities), that difference is recorded as an intangible asset goodwill. What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if : the investee challenges the investors ability toexercise significant influence through litigation or other methods. the investor surrenders significant shareholder rights in a signed agreement. the investor is unable to acquire sufficient information about the investee to apply the equity method. the investor tries and fails to obtain representation on the board of directors of the investee. If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if : The investee challenges the investors ability to exercise significant influence through litigation or other methods. The investor surrenders significant shareholder rights in a signed agreement. The investor is unable to acquire sufficient information about the investee to apply the equity method. The investor tries and fails to obtain representation on the board of directors of the investee. A Single Entity Concept
Under the equity method The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends. Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is: Increased by the investors percentage share of the investees net income (or decreased by its share of a loss). Decreased by dividends paid. Under the equity method The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends. Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is: Increased by the investors percentage share of the investees net income (or decreased by its share of a loss). Decreased by dividends paid. Equity Method On January 1, 2011, Wilmer, Inc. acquired 45% of the equity securities of Apex, Inc. for $1,350,000.On the acquisition date, Apexs net assets had a fair value of $3,000,000.During 2011, Apex paid cash dividends of $150,000 and reported net income of $1,750,000. What amount will Wilmer, Inc. report on the balance sheet as Investment in Apex, Inc. on December 31, 2011? Lets look at a rather straightforward example of the equity method.In this case, the investor acquires 45% of the voting common stock of the investee. The investor pays $1,350,000, for its proportionate share of net assets with a fair value of $3 million. During 2009, the investee reports earnings of $1,750,000 and pays cash dividends of $150,000. Lets look at the accounting for this investment under the equity method. Equity Method January 1, 2011 Investment in Apex, Inc. stock 1,350,000
Cash ,350,000 2011 Investment in Apex, Inc. stock ,500 Investment revenue ,500 Part I On January 1, 2011, we paid $1,350,000 cash for 45 percent of the stock of Apex, Inc.The fair value of the net assets of Apex was $3,000,000, and we acquired 45 percent of these net assets. The journal entry at date of acquisition will be to debit investment in Apex, Inc. for $1,350,000, and credit cash for the same amount. Part II During 2011, Apex reported net earning of $1,750,000. Our share of the reported earning is $787,500 ($1,750,000 45 percent). The journal entry to recognize our share of the earnings of the investee is to debit the investment in Apex, Inc. stock for $787,500, and credit investment revenue for the same amount. Part III During 2011, Apex declared and paid dividends of $150,000. Our share of the dividends is $67,500 ($150,000 45 percent). The journal entry to record the dividend received is to debit Cash for $67,500, and to credit investment in Apex, Inc. stock for the same amount. Note that dividends are not considered revenue under the equity method. 2011 Cash ,500 Investment in Apex, Inc. stock ,500 Equity Method Investment in Apex, Inc.
Investment ,350, , % Dividends 45% Earnings ,500 Reported amount 2,070,000 Part I The Investment in Apex, Inc. account will be shown in the balance sheet of the investor at $2,070,000.Notice that the dividends received reduces the investment account, and recognition of the proportionate share of earnings increases the investment account. Part II If the investee company had reported a loss, the investment account would have been reduced by the investors proportionate share of that loss. If the investee had a loss, the investment account would have been reduced. Equity Method On January 1, 2011, Wilmer, Inc. purchased 25% of the common stock of Apex, Inc. for $180,000. At the date of acquisition, the book value of the net assets of Apex was $400,000, and the fair value of these assets is $600,000. During 2011, Apex paid cash dividends of $40,000, and reported earnings of $100,000. Now lets complicate our discussion of the equity method. Please read this information carefully, noting that the price Wilmer paid for 25% of Apex ($180,000) is greater than 25% of the fair value of Apexs net assets ($150,000). That difference of price paid over fair value of net assets is viewed as a goodwill component of the purchase price. Notice also that the fair value of Apexs net assets is greater than 25% of the book value of those net assets on Apexs balance sheet (25% times $400,000 equals $100,000). Equity Method The excess of the fair value of net assets over book value of those net assets is 75% is attributable to depreciable assets with a remaining life of 20 years and 25% is attributable to land. Wilmer uses the straight-line depreciation. Of the $50,000 excess of the fair value over book value of those net assets on Apexs balance sheet, 75% is attributable to depreciable assets with the remaining useful life of 20 years.Wilmer, the investor, uses the straight-line method to depreciate similar owned assets. If Apex carried those net assets at their fair value on their financial statements, they would have to record additional depreciation expense, and Wilmers share of that additional depreciation expense would be $1,875 per year. To capture this income effect, Wilmer will impute that depreciation expense and include it as a deduction of investment revenue and the investment. Note that, because neither goodwill nor land is amortized, Wilmer makes no adjustment for those items in terms of imputing additional expense. Equity Method January 1, 2011 Investment in Apex stock 180,000
Cash ,000 2011 Cash ,000 Investment in Apex stock ,000 Investment in Apex stock ,000 Investment revenue ,000 December 31, 2011 Investment revenue ,875 Investment in Apex stock ,875 Wilmer will record the following journal entries on its books during We are familiar with the first three entries: purchase of the investment, recognition of dividends received, and recording of our proportionate share of earnings reported by Apex.The only new entry is the last one.This is the entry to recognize the additional depreciation that Wilmer must record.The journal entry is to debit investment revenue and credit investment in Apex stock for $1,875.The additional depreciation reduces the investment revenue Matrix recognized. Changing From the Equity Method to Another Method
When the investors level of influence changes, it may be necessary to change from the equity method to another method. At the transfer date,the carrying valueof the investmentunder the equitymethod is regardedas cost. When we change from the equity method to another method (TS or AFS), the accounting is quite easy.The carrying value of the investment at the date of transfer becomes the cost basis under the new method. Changing From Another Method to the Equity Method
When the investors ownership level increases to the point where they can exert significant influence, the investor should change to the equity method. At the transfer date, the recorded value is the initialcost of the investment adjusted for the investorsequity in the undistributed earnings of the investeesince the original investment. When we change from another method to the equity method, we adjust the investment to appear as if we had always used the equity method.Thus, we adjust the cost basis of the investment for the total undistributed earnings of the investee since the date of the original acquisition. Undistributed earnings is defined as reported earnings minus dividends paid. Changing From Another Method to the Equity Method
The original cost, the unrealized holding gain or loss, and the valuation account are closed. A retroactive change is recorded to recognize the investors share of the investees earnings since the original investment. Any unrealized holding gains or losses included in a valuation allowance account are closed at the date of transition from cost to equity.A retroactive adjustment is required to restate the investment for the total undistributed earnings since the date of original acquisition. Fair Value Option The investment is carried at fair value.
GAAP allows companies to use a fair value option for HTM, AFS and equity method investments. The investment is carried at fair value. Unrealized gains and losses are included in income. For HTM and AFS investments, this amounts to classifying the investments as trading. For equity-method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated. The fair value option is determined for each individual investment, and is irrevocable. GAAP allows companies to use a fair value option for HTM, AFS and equity method investments. The investment is carried at fair value. Unrealized gains and losses are included in income. For HTM and AFS investments, this amounts to classifying the investments as trading. For equity-method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated. The fair value option is determined for each individual investment, and is irrevocable. Financial Instruments and Investment Derivatives
Cash. Evidence of an ownership interest in an entity. Contracts meeting certain conditions. Investment Derivatives: Value is derived from other securities. Derivatives are often used to hedge (offset) risks created by other investments or transactions Financial instruments include cash, evidence of ownership interest in an entity, and contracts meeting certain conditions.Derivatives are often used to hedge (offset) risks created by other financial investments or transactions. Derivatives have values that are derived from the value of the underlying security. Other Investments Appendix 12A
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 Petty cash funds. Payroll accounts. In the long-run, funds are often set aside to: Pay long-term debt when it comes due. Acquire treasury stock. Special purpose funds set aside for the long-term are classified as investments. Appendix 12AOther Investments Petty cash is considered a special-purpose fund because it is monies that are set aside for the payment of small business expenditures that require cash. We might use the petty cash fund to pay for postage, cab fare for employees, or meals when employees work overtime. Most companies establish a payroll account as a special-purpose fund. The balance in the payroll account shortly after payday should be zero. The special-purpose funds serve as a control mechanism for the company. Some companies set up special-purpose funds for long-term purposes.These funds might include a sinking fund used to reacquire long-term debt or treasury stock. Appendix 12A Other Investments
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. It is a common business practice for companies to purchase life insurance policies for key officers and employees.The company pays the premium and is the beneficiary of the policy. If the policy is a whole life policy, it develops a cash surrender value. The cash surrender value of the life insurance policy is treated as an investment on the companys balance sheet. Appendix 12B Impairment of Investments
If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (OTT) impairment loss in earnings. We use a three-step process to determine whether an OTT impairment loss must be recognized: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements. Part I Appendix 12BImpairment of Investments If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (OTT) impairment loss in earnings. We use a three-step process to determine whether an OTT impairment loss must be recognized: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements. Appendix 12B Impairment of Investments
On this screen and the one following we will look at the proper treatment of impairment to an investment. If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (OTT) impairment loss in earnings. We dont need to worry about OTT impairments for trading securities or other investments for which a company has chosen the fair value option, because all changes in the fair values of those investments (whether temporary or OTT) always are recognized in earnings. However, that is not the case for HTM and AFS investments. Declines in fair value typically are ignored for HTM investments and recorded in OCI for AFS investments. Therefore, companies need to evaluate HTM and AFS investments to determine whether an OTT impairment loss has occurred. We use a three-step process to determine whether an OTT impairment loss must be recognized and how that loss is to be measured and recorded: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements. The graphic on your screen summarizes these steps. Appendix 12B Impairment of Investments
This is a continuation of the chart shown on the previous screen. Companies need to evaluate HTM and AFS investments to determine whether an OTT impairment loss has occurred. We use a three-step process to determine whether an OTT impairment loss must be recognized and how that loss is to be measured and recorded: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements. The graphic on your screen summarizes these steps. Appendix 12B Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. Uniteds fiscal year-end is December 31. The following events during 2011 and 2012 pertain to the investment portfolio. Purchase Investment: July 1, 2011, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value: December 31, 2011 Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment. December 31, 2012 Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment The journal entries to record the adjustments of the Bendac stock investment to fair value are: United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. Uniteds fiscal year-end is December 31. The following events during 2011 and 2012 pertain to the investment portfolio. Purchase Investment: July 1, 2011, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value: December 31, 2011 Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment. December 31, 2012 Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment The journal entries to record the adjustment at December 31, 2011, when the impairment in not to be treated as an OTT impairment is to debit net unrealized holding gains and losses in other comprehensive income for $10,000, and credit fair value adjustment for the same amount. December 31, 2011 Net unrealized holding gains and losses OCI10,000 Fair value adjustment ,000 Appendix 12B Impairment of Investments
December 31, 2012 Other-than-temporary impairment loss I/S15,000 Investment in Bendac15,000 Fair value adjustment10,000 Net unrealized holding gains and losses OCI10,000 The first 2012 journal entry reduces the Bendac investment to reflect the OTT impairment and recognizes the entire $15,000 in 2012 earnings. United adjusts the Bendac investment directly rather than using a fair value adjustment account because the OTT impairment cannot be recovered. The second 2012 journal entry reclassifies any previously recognized unrealized losses associated with the investment, the same as if the investment had been sold. In 2011 United debited OCI and credited the fair value adjustment for $10,000 to reflect the decline in Bendacs fair value to $990,000, so the second 2012 journal entry reverses the 2011 entry to remove those amounts. Appendix 12B Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. Uniteds fiscal year-end is December 31. The following events occurred during 2012, Purchase Investment: July 1, 2012, $1,000,000 of Bendac bonds, maturing on December 31, Adjust Investment to Fair Value: December 31, 2012, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss. Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers. Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred. United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. Uniteds fiscal year-end is December 31. The following events occurred during 2012, Purchase Investment: July 1, 2012, $1,000,000 of Bendac bonds, maturing on December 31, Adjust Investment to Fair Value: December 31, 2012, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss. Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers. Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred. Lets look at the necessary journal entries in these two cases. Lets look at the necessary journal entries in these two cases. Appendix 12B Impairment of Investments
Case 1 December 31, 2012 OTT impairment loss I/S50,000 Discount on bond investment50,000 Case 2 December 31, 2012 OTT impairment loss I/S30,000 Discount on bond investment30,000 OTT impairment loss -OCI 20,000 Fair value adjustment Noncredit loss20,000 In both Cases 1 and 2, the amortized cost of the investment is reduced by the amount of OTT impairment that is recognized in earnings. United achieves this by crediting a contra-asset, discount on bond investment, which United amortizes over the remaining life of the debt the same way it would if it had initially purchased the debt at that discounted amount. In Case 2, the noncredit-loss component of the impairment is recognized in OCI, the same way it would be if it were viewed as an unrealized loss under normal accounting for fair value declines of AFS investments. In both cases the carrying value of the debt becomes $950,000, reduced by the entire amount of the OTT impairment. In Case 1 this occurs via the $50,000 discount, and in Case 2 via the combination of the $30,000 discount and $20,000 fair value adjustment. GAAP requires that the entire OTT impairment be shown in the income statement, and then the portion attributed to noncredit losses backed out, such that only the credit loss portion reduces net income. U. S. GAAP vs. IFRS Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset. IFRS, unlike U.S. GAAP, there is no equivalent to recognizing OCI any non-credit losses on debt investments. Calculation of the amount of impairment differs depending on the classification of an investment. Under IFRS, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM. Part I Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset. From the perspective of the IFRS, Calculation of the amount of impairment differs depending on the classification of an investment. Under IFRS, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM. However, IFRS, unlike U.S. GAAP, there is no equivalent to recognizing OCI any non-credit losses on debt investments. End of Chapter 12 End of Chapter 12.