COPYRIGHT © 2007Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are

trademarks used herein under license.

Investments in Debt & Equity Securities

Chapter 14

S t I c e | S t I c e | S k o u s e n

Intermediate Accounting16E

Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives1. Determine why companies invest in

other companies.2. Understand the varying

classifications associated with investment securities.

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

4. Account for the recognition of revenue from investment securities.

Learning Objectives5. Account for the change in value of

investment securities.6. Account for the sale of investment

securities.7. Record the transfer of investment

securities between categories.8. Properly report purchases, sales,

and changes in value of investment securities in the statement of cash flows.

Learning Objectives9. Explain the proper classification and

disclosure of investments in securities.10.Compare the accounting for investment

securities under U.S. GAAP with the international standard in IAS 39.

11.Account for the impairment of a loan receivable.

Classifications of Investment Securities

• Debt securities typically have the following characteristics:

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.

Classifications of Investment Securities

• Equity securities represent ownership in a company:

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

2. Equity securities have the potential for significant increases in price.

Equity Method Securities• Represents ownership in a company. • Includes rights to collect dividends

and to vote on corporate matters.• Potentially purchased with the intent

to control or significantly influence the operations of the investee.

• Despite the general criteria, a 20% investment does not necessarily guarantee significant influence.

Determining the Appropriate Determining the Appropriate Accounting MethodAccounting Method

• Equity securities are classified as trading or available for sale when ownership is less than 20 percent.

• The equity method is used when the investor has the ability to significantly influence or control the investee’s operations.

Revenue for Equity Securities Classified as Trading and AFS

Deli Co. announces Deli Co. announces dividends of $0.25 dividends of $0.25 per share. Assume per share. Assume that Citty Co. owns that Citty Co. owns

1,000 shares1,000 shares

Cash 250Dividend Revenue 250

Revenue for Equity Securities Classified as Trading and AFS

Deli Company Deli Company announces dividends of announces dividends of

$0.25 per share. Assume $0.25 per share. Assume that Citty Co. owns that Citty Co. owns

100,000 which 100,000 which represents 50 percent of represents 50 percent of the outstanding voting the outstanding voting

stock.stock.Cash 25,000

Investment in Deli Co Stock 25,000

Revenue for Equity Securities Classified as Trading and AFS

Deli Company reports Deli Company reports income for the year, income for the year,

$250,000. Assume Citty $250,000. Assume Citty owns 50% of owns 50% of

outstanding voting outstanding voting stock.stock.

Investment in Deli Co Stock 125,000Income from Investment in Deli Co Stock 125,000

Equity Method: Purchase for More than Book Value

Deli Company reports Deli Company reports income for the year, income for the year,

$250,000. Assume Citty $250,000. Assume Citty owns 50% of owns 50% of

outstanding voting outstanding voting stock.stock.

Investment in Deli Co Stock 125,000Income from Investment in Deli Co Stock 125,000

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 on January 1, 2005. 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.$250,000 $250,000 ÷ .40÷ .40The average remaining life of the depreciable assets is 10 years and the

special operating license is to be amortized over 20 years.

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

$3,500

Equity Method: Purchase for More than Book Value

Investment in Stewart Inc. Common StockAcquisition cost 250,000Share of earnings60,000

Dividends 28,000Additional depreciation 2,000Additional amortization 1,500

310,000 31,500Balance 278,500

Stewart Inc. declared and paid dividends of $70,000 to common stockholders during 2005, and it reported net income of $150,000 for the

year ended December 31, 2005.

Accounting for the Change in Value of Securities

FASB No. 115 puts an end to “cherry-picking.” This is the practice of selectively selling securities whose prices have increased,

while keeping those that have experienced losses or have maintained their

historical cost.

Accounting for the Change in Value of SecuritiesPartial Balance Sheet for Eastwood Inc.

AssetsInvest. 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

Partial Income Statement for Eastwood Inc.

Other expenses and losses:Unrealized loss on trading

securities $500

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

Investment in Held-to Maturity Securities 395

Interest Revenue 2,105Entry to record sale:Apr. 1 Cash 103,000Realized Loss on Sale of Securities 4,353

Interest Receivable 2,500Investment in Held-to

Maturity Securities 104,853

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

Caesh Company began with a $1,000 investment on January 1, 2007.

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, 2005.

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

Sales $1,700Expenses (1,400

)Operating income $ 300Realized loss on sale of securities (30

) Net income $ 270Caesh Company will report a $100 unrealized increase in the value of it available-for-sale

portfolio.

This $100 unrealized increase is reported as an increase in Accumulated Other Comprehensive

Income.

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

The statement of cash flows for Caesh Company for 2007 appear as follows:

Operating activities:Net income $ 270Plus realized loss on sale of securities 30 $

300Investing activities:

Purchase of investment securities $(600)Sale of investment securities 170 (430)

Financing activities:Initial investment by owner 1,000

Net increase in cash $ 870

Classification and Disclosure• Trading securities

– The change in net unrealized holding gain or loss that is included in the income statement.• 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.

• Available-for-sale securities (continued):– The change in net unrealized holding gain

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

• Held-to-maturity securities:– Aggregate fair value, gross unrealized holding gains

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

– The company should disclose information about contractual maturities.

Classification and Disclosure

International Accounting for Investment Securities

• The differences in U.S. and international accounting standards are disappearing.

• However, understanding the differences allows the user to better use and interpret the global statements.

• IAS 39 covers the accounting for investment securities.

IAS 39 Provisions1. All financial assets and financial liabilities are

initially measured at cost.2. After initial recognition, all financial assets are

to be remeasured to fair value except for:• Debt securities intended to be held until maturity• Financial assets whose fair value cannot be reliably

determined.3. After acquisition, financial liabilities are to be

measured at the original recorded amount, less repayments and amortization.

4. A company can report unrealized gains and losses in one of two ways:

• In net income of the period or• In net income for unrealized gains and losses on

trading securities and as part of equity for “nontrading” securities.

Accounting for the Impairment of a Loan

• Occasionally, market value may not exist for the investment.

• The investor must assess the collectibility of the investment and if and “impairment exists.

• An adjustment must be made to the value of the receivable.

• Impairment is measured by comparing the present value of expected future cash flows with the carrying value of the investment.