14-1 intermediate accounting,17e stice | stice | skousen © 2010 cengage learning powerpoint...

14-1

Intermediate Accounting,17E

Stice | Stice | Skousen

© 2010 Cengage Learning

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Investments in Debt and Equity Securities

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Why Companies Invest in Other Companies

• Safety cushion• Cyclical cash needs• Investment for a return• Investment for

influence• Purchase for control

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Classifications of Investment Securities

• Debt securities are financial instruments issued by a company that (1) have a maturity value, (2) have a fixed or variable interest rate that specifies the periodic interest payments, and (3) a maturity date.

• Equity securities represent ownership in a company.

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Held-to-Maturity Securities• Held-to-maturity securities are

debt securities purchased by a company with the intent to hold those securities until they mature.

• This category includes only debt securities because equity securities typically do not mature.

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Available-for-Sale Securities• Available-for-sale securities are

equity securities that are not considered trading securities and are not accounted for using the equity method.

• Debt securities that are not being held until maturity and are not classified as trading securities are considered to be “available-for-sale” securities.

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Trading Securities

Trading securities are debt and equity securities purchased with the intent of selling them in the near future.

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Equity Method Securities• Equity method securities are

equity securities purchased with the intent of being able to control or significantly influence the operations of the investee.

• A large block of stock (presumably at least 20% of the outstanding stock) must be owned to be considered for classification as an equity method security.

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Classification of Investment Securities According to IFRS

• The classification of investment securities under IFRS, specifically IAS 39, is essentially the same as under U.S. GAAP.

• IAS 39 is broader in scope than SFAS No 115.

• IAS 39 includes guidance on accounting for derivatives and accounting for loans and receivables.

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Purchase of Debt SecuritiesOn 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 × .09 × 4/12 = $3,000

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Purchase of Debt SecuritiesAsset ApproachAsset Approach

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

Cash 107,250

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

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Purchase of Debt SecuritiesRevenue ApproachRevenue Approach

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

Cash 107,250

July 1 Cash 4,500Interest Revenue 4,500

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Purchase of Equity SecuritiesGondor Enterprises purchased 300 shares of Boromir Co. stock at $75 per share plus brokerage fees of $80 (as trading securities) and 500 shares of Faramir Inc. stock at $50 per share plus brokerage fees of $30 (as available-for-sale securities).Investment in Trading Securities— Boromir Co. 22,580Investment in Available-for-Sale Securities—Faramir Inc. 25,030

Cash 47,610

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Recognition of Revenue from Debt Securities

• Assume that on January 1, 2010, 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 similar bonds is 8%.

• The first step is to calculate the market price of the bonds.

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Present value of principal:FV = $100,000; N = 10; I = 4%

$ 67,556Present value of interest payments:

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

40,554

Recognition of Revenue from Debt Securities

When interest is received:Cash 5,000

Interest Revenue5,000

Total present value of the bonds

$108,110Investment in Trading Securities 108,110

Cash108,110

When trading securities are purchased:

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

The initial purchase:Investment in Held-to-Maturity Securities 108,110

Cash108,110

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

When the first interest payment is received:Cash 5,000

Interest Revenue4,324

Investment in Held-to-Maturity Securities676

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

When the second interest payment is received:Cash 5,000

Interest Revenue4,297

Investment in Held-to-Maturity Securities703

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Recognition of Revenue from Equity Securities

In those instances where the level of ownership in the investee is such that the investor is able to control or significantly influence decisions made by the investee, the use of the equity method is appropriate.

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Recognition of Revenue from Equity Securities

Significant influence may be indicated by decisions affecting— Dividend distribution Participation in the policy-making process Intercompany transactions Interchange of management personnel Technical dependency of investee on investor Percentage of outstanding voting stock owned

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Determining the Appropriate Accounting Method

0% 20% 50% 100%

No significantinfluence

Significantinfluence Control

Ownership PercentageOwnership Percentage

Account for as Account for as trading or trading or

available-for-available-for-salesale

Equity methodEquity method

Equity method Equity method and and

consolidation consolidation proceduresprocedures

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Revenue for Equity Securities Classified as Trading and Available for

Sale

The journal entry to record receipt of the dividends would be:Cash 2,475

Dividend Revenue2,475

[(300 × $2.00) + (500 × $3.75) = $2,475]

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Revenue for Securities Classified As Equity Method Securities

BioTech Inc. purchased 40% of the outstanding stock of Medco Enterprises on January 1 of the current year by paying $200,000. During the year, Medco reported net income of $50,000 and paid dividends of $10,000.

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Investment in Medco Enterprise Stock:Investment in Medco Enterprise Stock 200,000

Cash 200,000To record the purchase of 40% of Medco stock.

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Recognize a percentage of net income:Investment in Medco Enterprise Stock 20,000

Income from Investment in Medco Enterprises Stock ($50,000 × 0.40)

20,000To record the recognition of revenue from investment in Medco.Record receiving a dividend:

Cash ($10,000 × 0.40) 4,000Investment in Medco Enterprises Stock

4,000To record the receipt of dividend onMedco stock.

Revenue for Securities Classified As Equity Method Securities

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Equity Method: Purchase for More than Book Value

The net assets of Stewart Inc. was $500,000 at the time Phillips Manufacturing Co. purchased 40% of the common shares for $250,000. Based on the ownership interest, the market value of the net assets of Stewart Inc. would be $625,000, which is $125,000 more than the book value. Only $50,000 of this is attributed to depreciable assets. The remaining $75,000 is attributed to a special operating license.

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Equity Method: Purchase for More than Book Value

The average remaining life of the depreciable assets is 10 years and the license is to be amortized over 20 years. Phillips Manufacturing Co. would adjust its share of Stewart Inc.’s net income as follows:

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Additional depreciation ($50,000 × 0.40)/10 $2,000License amortization ($75,000 × 0.40)/20 1,500

$3,500

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Equity Method: Purchase for More than Book Value

Each year for the first 10 years, Phillips would make the following entry in addition to entries made to recognize its share of Stewart’s income and dividends.

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Income from Investments in Stewart Inc. Stock 3,500

Investment in Stewart Inc. Stock 3,500To adjust share of income on StewartInc. common stock for proportionatedepreciation on excess of market valueof depreciable property, $2,000, and foramortization of the unrecorded license,$1,500.

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Equity Method: Purchase for More than Book Value

• After the 10th year, the adjustment would be for $1,500 until the license amount is fully amortized.

• Stewart Inc. declared and paid dividends of $70,000 during 2011 and reported net income of $150,000 for the year. The investment would be shown on Philip’s balance sheet as follows:

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Equity Method: Joint Venture• A joint venture is a form of off-

balance-sheet financing.• Joint ventures are accounted for

using the equity method.• Even if the joint venture does not

have a 50–50 ownership structure, the minority interest will still account for the joint venture using the equity method.

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Eastwood Incorporated purchased the following securities on March 23, 2011. Their fair value is shown as of December 31, 2011.

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Accounting for the Change in Value of Securities

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Initial Purchase Entry—2011Initial Purchase Entry—2011

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

Cash 48,000

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Accounting for the Change in Value of Securities

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By the end of 2011, the value of the trading securities decreased from $11,000 to $10,500.December 31, 2011:Unrealized Loss on Trading Securities 500

Market Adjustment—Trading Securities 500

Trading Securities—2011Trading Securities—2011

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Accounting for the Change in Value of Securities

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December 31, 2011:Market Adjustment—Available-for-Sale

Securities 600Unrealized Increase/Decrease in Value of Available-for-Sale Securities600

By the end of 2011, the value of the available-for-sale securities increased from $17,000 to $17,600.

Available-for-Sale Securities—2011Available-for-Sale Securities—2011

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Accounting for the Change in Value of Securities

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Accounting for the Change in Value of Securities

Note below that Security 5 has decreased in value from $20,000 to $19,000. However, because this security is classified as held-to-maturity, no adjustment is made.

Held-to-Maturity Securities—2011Held-to-Maturity Securities—2011

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Trading Securities—2012Trading Securities—2012

Accounting for the Change in Value of Securities

By the end of 2012, trading securities have increased in value from $10,500 to $11,300.

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Accounting for the Change in Value of Securities

The adjusting entry is as follows:Market Adjustment—Trading Securities 800

Unrealized Gain on Trading Securities 800

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Trading Securities—2012Trading Securities—2012

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Accounting for the Change in Value of Securities

Available-for-Sale Securities—2012Available-for-Sale Securities—2012

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At the end of 2011, available-for-sale securities had a fair value of $17,600. At the end of 2012, the fair value is $17,200.

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Accounting for the Change in Value of Securities

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The adjusting entry is as follows:Unrealized Increase/Decrease in Value of Available-

for-Sale Securities ($17,600 ─ $17,200) 400Market Adjustment—Available-for-Sale Securities 400

Available-for-Sale Securities—2012Available-for-Sale Securities—2012

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Held-to-Maturity Securities—2012Held-to-Maturity Securities—2012

By the end of 2012, Security 5 had increased in value from $19,000 to $20,700. Recall in Slide 14-51 that no loss was recorded when the fair value dropped to $19,000.

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Accounting for the Change in Value of Securities

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Held-to-Maturity Securities—2012Held-to-Maturity Securities—2012

• The fair value of the held-to-maturity securities of $20,700 would not be used to adjust the reported balance sheet amount.

• The $20,700 fair value would be disclosed in the notes to the financial statements.

Accounting for the Change in Value of Securities

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Determining Whether a Decline in Fair Value is Other Than Temporary

In SAB No. 59, the SEC staff suggests that one consider the following in determining whether a decline in fair value is other than temporary: How long has the fair value of the security

been below its original cost? What is the current financial condition of the

investee and its industry? Will the investor’s plans involve holding the

security long enough for it to recover its value?

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Sale of SecuritiesFor Silmaril Technologies (from Slide 14-14), assume that the debt securities are sold on April 1, 2012, for $103,000, which includes accrued interest of $2,500. The carrying value of the debt security on January 1, 2012, is $105,240.

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To go to Slide 14-14, left click on the button using your mouse. To return, type “42” and press “Enter.”

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Sale of SecuritiesTo record accrued revenue and amortize premium:Apr. 1Interest Receivable 2,500

Investment in Held-to-Maturity Securities 395Interest Revenue 2,105

Entry to record sale:Apr. 1 Cash 103,000Realized Loss on Sale of Securities 4,345

Interest Receivable 2,500Investment in Held-to-Maturity Securities 104,845

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Impact of Sale of Securities on Unrealized Gains and Losses

At the beginning of Year 1, Levi Company purchased trading securities for $10. At the end of Year 1, the securities had a value of $12. At the end of Year 2, the same securities are sold for $9.

Unrealized Loss—Unrealized Loss— Trading 2Trading 2 Market Adjust-Market Adjust- ment—Trading 2ment—Trading 2

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Impact of Sale of Securities on Unrealized Gains and Losses

When the securities are sold at the end of Year 2 for $9, the entry will reflect only a $1 loss.Year 2Cash 9Realized Loss—Trading 1

Investment Securities—Trading 10

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DerecognitionBank A has the following balance sheet:

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Bank A is required by government regulation to maintain equity of at least 5% of total assets and is currently in compliance.

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DerecognitionIf Bank A gets a normal loan for $100, its balance sheet will appear as follows:

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Bank A is now in violation of its equity requirement; equity is just 2.5% of total assets.

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DerecognitionAs an option, Bank A can set up a service entity called QSPE (qualifying special purpose entity). Under the supervision of Bank A, QSPE raises $100 cash by borrowing $90 and receiving $10 as an investment from Bank A. QSPE uses that money to “buy” the mortgage receivable from Bank A.

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DerecognitionAfter Bank A “sells” the $100 mortgage receivable asset to QSPE, the balance sheet appears as follows:

The process described in Slides14-46 through 14-49 is called derecognition.

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DerecognitionAccording to SFAS No. 140, a transfer of a financial asset is accounted for as a sale (resulting in derecognition) when the transfer satisfies the following three conditions:• Legal control: The transferor has given

up legal claim to the assets meaning that even if it declares bankruptcy its creditors cannot go after the transferred assets.

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Derecognition• Actual control: The transferor cannot

prevent the transferee from using the transferred assets however desired, such as selling them or pledging them as collateral for a loan.

• Effective control: The transferor does not have the right to force the transferee to return the assets, such as with a repurchase agreement.

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Transferring Securities Between Categories

The Eastwood Inc. example used earlier will serve to demonstrate transferring securities between categories. As of December 31, 2012, Eastwood Inc. had the following securities:

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Transferring Securities Between Categories

During 2013, Eastwood Inc. elects to reclassify certain of its securities as shown below.

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From the Trading Security Category

Eastwood Inc. elects to reclassify security 2 from a trading security to an available-for-sale security.Investment in Available-for-Sale Securities 3,800

Market Adjustment—Trading Securities 600 Unrealized Gain on Transfer of Securities 200 Investment in Trading Securities 3,000

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Into the Trading Security Category

Eastwood Inc. elects to reclassify security 4 from an available-for-sale security to a trading security.Investment in Trading Securities 10,300Market Adjustment—Available-for- Sale Securities 1,300Unrealized Loss on Transfer of Securities 1,700

Unrealized Increase/Decrease in Value of Available-for-Sale Securities 1,300Investment in Available-for-Sale Securities 12,000

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From the Held-to-Maturity to the Available-for-Sale

CategoryEastwood Inc. elects to reclassify security 5 from a security being held until maturity to one that is available to be sold.Investment in Available-for-Sale Securities 20,400

Unrealized Increase/Decrease in Value of Available-for-Sale Securities 400Investment in Held-to-Maturity Securities 20,000

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Eastwood Inc. elects to reclassify security 3 from one that is available to be sold to a security that will be held until maturity.Investment in Held-to-Maturity Securities 5,900Unrealized Increase/Decrease in Value of Available-for-Sale Securities 600

Investment in Available-for-Sale Securities 5,000Market Adjustments—Available-for- Sale Securities 1,500

From the Held-to-Maturity to the Available-for-Sale

Category

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Cash Flows from Gains and Losses on Available-for-Sale Securities

Caesh Company began with a $1,000 investment on January 1, 2011. Cash sales $1,700Cash expenses (1,400)Purchases of investment securities (600)Sale of investment securities (costing $200) 170

The market value of the remaining securities was $500 on December 31, 2011.

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Cash Flows from Gains and Losses on Available-for-Sale Securities

Caesh Company’s net income for 2011 can be computed as follows: Sales $1,700Expenses (1,400)Operating income $300Realized loss on sale of securities ($200 ─ $170) (30) Net income $ 270

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The statement of cash flows for Caesh Company for 2011 can be prepared as follows:

Cash Flows from Gains and Losses on Available-for-Sale Securities

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If the investment securities purchased by Caesh Company are classified as trading securities and are deemed to have been acquired for operating purposes, the unrealized gain appears in the operating activities section.

Cash Flows from Gains and Losses on Trading Securities

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Required Additional Disclosures

1. Trading securities The change in net unrealized holding gain or loss

that is included in the income statement.2. Available-for-sale securities

Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type.

The proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales and the basis on which cost was determined in computing realized gains and losses.

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Available-for-sale securities (continues): The change in net unrealized holding gain

or loss on available-for-sale securities that has been included in stockholders’ equity during the period.

3. Held-to-maturity securities: Aggregate fair value, gross unrealized

holding gains and gross unrealized holding losses, and amortized cost basis by major security type.

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Required Additional Disclosures

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4. Transfer of securities between categories: Gross gains and losses included in earnings

from transfers of securities from available-for-sale into the trading category.

For securities transferred from held-to-maturity, the company should disclose the amortized cost amount transferred, the related realized or unrealized gain or loss, and the reason for transferring the security.

Required Additional Disclosures

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Accounting for the Impairment of a Loan

• A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.

• For loans with no market value, impairment is measured by comparing the present value of expected future cash flows with the carrying value of the investment.

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Accounting for the Impairment of a Loan

Malone Enterprises reports a loan receivable from Stockton Co. in the amount of $500,000. The repayment terms include a 10% interest rate plus annual principal payments of $100,000 on January 1 of each year. The loan was made on January 1, 2009. Stockton made the $50,000 interest payment in 2009 but did not make the $100,000 principal payment nor the $50,000 interest payment in 2010.

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Accounting for the Impairment of a Loan

Analysis of Stockton’s financial condition indicates the principal and interest currently due can probably be collected, but it is probable that no further interest can be collected. The probable amount and timing of the collections is determined as follows:

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Accounting for the Impairment of a Loan

The present value at December 31, 2010, of the expected future cash flows discounted at 10% for the Stockton receivable is $455,860.

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Accounting for the Impairment of a Loan

The impairment loss to be reported for 2010 is $94,140, or the carrying value ($550,000) less the present value ($455,680).

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2010Dec. 31 Bad Debt Expense 94,140 Allowance for Loan Impairment 94,140

If Stockton makes the payments as projected, the amortization schedule in Slide 14-71 provides information for the necessary entries.

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Accounting for the Impairment of a Loan