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LO1 Analyze and report bond investments held to maturity. p. A-27

LO2 Analyze and report passive investments in securities by using the fair value method. p. A-28

Appendix 7CAccOunting FOr PAssive investments in securities

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Many strategic factors motivate managers to invest in securities. A company that has extra cash and simply wants to earn a return on the idle funds can invest those funds in shares or debt securities issued by other companies, either short-term or long-term. These investments are passive because the managers are not interested in influencing or controlling the other companies.

Sometimes a company decides to invest in another company with the purpose of influencing that company’s policies and activities. In other situations, the investing company may wish to control the operating, investing, and financing activities of the other company. This can be accomplished by purchasing the target company outright or by becoming its majority shareholder. In either of these two cases, the two compa-nies must report their financial positions and the results of their operations in a single set of consolidated financial statements. For example, Nokia Corporation (the focus company of Chapter 8) prepares a set of consolidated financial statements because it controls a number of companies. The assets section of Nokia’s statement of financial position, shown in Exhibit 7C.1, includes both short-term and long-term investments.

This appendix discusses the measurement and reporting of passive investments and uses relevant disclosures by Nokia Corporation for illustrative purposes. The account-ing for active investments in equity securities that provide the investing company with either significant influence or control over another company is covered in Chapter 14, which is available online at www.mcgrawhillconnect.ca.

Passive Investment in Debt and Equity SecuritiesPassive investments are made to earn a return on funds that may be needed for future short-term or long-term purposes. The classification and valuation of passive invest-ments depend on the nature of the investment as well as management’s intent. Invest-ments are classified as cash equivalents if they consist of highly liquid investments with original maturities of three months or less at the date of purchase, such as treasury bills issued by the federal government and certificates of deposit. These are reported at cost plus accrued interest, which approximates fair value.

Passive investments include both investments in debt (treasury bills, bonds,1 and notes) and equity securities (shares). Debt securities are always considered passive

1A bond is a long-term debt requiring repayment of principal at a specific date along with periodic interest payments. Accounting for bonds is covered in Chapter 11.

lib01499_appendix 7C_olc.indd 25 2/12/2011 10:11:13 AM

APPendix 7c Accounting for Passive Investments in SecuritiesA-26

investments. If the company intends to hold the securities until they reach their matu-rity dates, the investments are measured and reported at amortized cost. If they are to be sold before maturity, they are reported at their fair value. For investments in equity securities, the investment is presumed passive if the investment company owns less than 20 percent of the outstanding voting shares of the other company. The fair value method is used to measure and report such investments.

The accounting methods used to record passive investments are directly related to management’s intent for holding the investments. The various types of passive invest-ments and the appropriate measuring and reporting methods are summarized in the chart that follows.

Investments in Debt SecuritiesInvestments in Shares of

Another Company

Level of Ownership Held to maturity Not held to maturity 20% of outstanding

voting shares

Measuring and Reporting Method

Amortized cost method

Fair value method

Nokia CorporatioN

Consolidated Statements of Financial position (assets section)

December 31

Notes

2009 2008

EUrm EUrmassets Non-current assets Capitalized development costs . . . . . . . . . . . . . . . . . . . . . . . . . 12 143 244Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5,171 6,257Other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 2,762 3,913Property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . . 13 1,867 2,090Investments in associated companies . . . . . . . . . . . . . . . . . . . . 14 69 96Available-for-sale investments . . . . . . . . . . . . . . . . . . . . . . . . . 15 554 512Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 1,507 1,963Long-term loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 15, 33 46 27Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 6 10 12,125 15,112Current assets Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 19 1,865 2,533Accounts receivable, net of allowances for doubtful accounts (2009: EUR 391 million, 2008: EUR 415 million) . . . . . . . . . . . 15, 19, 33 7,981 9,444Prepaid expenses and accrued income . . . . . . . . . . . . . . . . . . . . 18 4,551 4,538Current portion of long-term loans receivable . . . . . . . . . . . . . . . 15, 33 14 101Other financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15, 16, 33 329 1,034Investments at fair value through profit and loss, liquid assets . . . 15, 33 580 — Available-for-sale investments, liquid assets . . . . . . . . . . . . . . . . 15, 33 2,367 1,272Available-for-sale investments, cash equivalents . . . . . . . . . . . . . 15, 33 4,784 3,842Bank and cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 1,142 1,706 23,613 24,470total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,738 39,582

Source: Nokia Corporation Annual Report 2009.

Exhibit 7c.1Nokia Corporation Consolidated Statements of Financial Position (Assets section)


APPendix 7c Accounting for Passive Investments in Securities A-27

debt HeLd tO mAturity: AmOrtized cOst metHOdWhen management plans to hold a bond (or note) until its maturity date (when the principal is due), it is reported in an account appropriately called held-to-maturity investments. Bonds should be classified as held-to-maturity investments if manage-ment has the intent and the ability to hold them until maturity. These investments in debt instruments are listed at cost, adjusted for the amortization of any bond discount or premium (the amortized cost method), not at their fair value.

Bond PurchasesOn the date of purchase, a bond may be acquired at the maturity amount (at par), for less than the maturity amount (at a discount), or for more than the maturity amount (at a premium).2 The total cost of the bond, including all incidental acquisition costs, such as transfer fees and broker commissions, is debited to the held-to-maturity invest-ments account.

To illustrate accounting for bond investments, assume that on July 1, 2010, Nokia paid the par value of &100,000 3 for 8 percent bonds that mature on June 30, 2015. The 8 percent interest is paid each June 30 and December 31. Management plans to hold the bonds for five years, until maturity.

The journal entry to record the purchase of the bonds follows:

Analyze and report bond investments held to maturity.

LO1

HELD-TO-MATURITY INVESTMENTS are investments in bonds that management has the intent and ability to hold until maturity.

AMORTIZED COST METHOD reports investments in debt securities held to maturity at cost, net of any discount or premium.

2The determination of the price of the bond is based on the present value techniques discussed in Chapter 11. Many analysts refer to a bond price as a percentage of par. For example, the financial section of a national newspaper might report that a Domtar bond with a par value of $1,000 is selling at 109.85. This means it would cost $1,098.50 (109.85 percent of $1,000) to buy the bond.3When bond investors accept a rate of interest on a bond investment that is the same as the stated rate of interest on the bonds, the bonds will sell at par (i.e., at 100 or 100% of face value).

Assets Liabilities 1 Shareholders’ Equity

Cash 100,000Held-to-maturityInvestments 100,000

Held-to-maturity investments (A) . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Interest EarnedThe bonds in the illustration were purchased at par, or face value. Since no premium or discount needs to be amortized, the carrying amount remains constant over the life of the investment. In this situation, revenue earned from the investment each period is measured as the amount of interest collected in cash or accrued at year-end. The following journal entry records the receipt of &4,000 (&100,000 3 8% 3 6/12) in interest on June 30:

Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Interest revenue (SE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000


Cash 4,000 Interest revenue 4,000

The same entry is made on succeeding interest payment dates.



Principal at MaturityWhen the bonds mature on June 30, 2015, the journal entry to record receipt of the principal payment would be


Cash 100,000Held-to-maturity investments 100,000

Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Held-to-maturity investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

If the bond investment must be sold before maturity, any difference between the market value of the bond (the proceeds from the sale) and its carrying amount would be reported as a gain or loss on sale. If management intends to sell the bonds before the maturity date, the bonds are treated in the same manner as investments in shares classified as securities available for sale, as discussed in the next section.

PAssive investments in sHAres: FAir vALue metHOdWhen the investing company owns less than 20 percent of the outstanding voting shares of another company, the investment is considered passive. Passive investments in securities are reported at fair value on the date of the statement of financial position for two main reasons:

Relevance• . Analysts who study financial statements often attempt to forecast a company’s future cash flows. They want to know how a company can generate cash for purposes such as expansion of the business, payment of dividends, or survival during a prolonged economic downturn. One source of cash is the sale of shares from the company’s portfolio of passive investments. The best estimate of the cash that could be generated by the sale of these securities is their fair value.

Measurability• . Accountants record with a high degree of reliability (an unbiased and verifiable measurement) any item that can be measured in monetary terms. Determining the fair value of most assets is very difficult because they are not actively traded. For example, the head office building of the Toronto Dominion Bank is an important part of the Toronto skyline. The statement of financial posi-tion of the Toronto Dominion Bank reports the building in terms of its original cost less accumulated depreciation, in part because of the difficulty in determin-ing an objective market value for it. Contrast the difficulty of determining the value of a building with the ease of determining the value of securities that TD Bank may own. A quick look at an Internet financial service is all that is neces-sary to determine the current price of shares issued by many companies (e.g., Thomson Reuters, WestJet Airlines) because these securities are traded each day on established stock exchanges.

When an investment account is adjusted to reflect changes in fair value, what other account is affected when the asset account is increased or decreased? Under the double-entry method of accounting, every journal entry affects at least two accounts. The first account is a valuation allowance that reflects changes in the fair value of the investment. The account balance is added to or subtracted from the invest-ment account, which is maintained at cost. The other account affected is unrealized holding gains or losses that are recorded whenever the fair value of investments changes. They are unrealized because no actual sale has taken place; the value of the investment has changed while the shares are being held by the investing company. If the value of the investments increased by &100,000 during the year, an adjusting jour-nal entry records the increase in the allowance account and an unrealized holding gain

Analyze and report passive investments in securities by using the fair value method.

LO2

FAIR VALUE METHOD reports investments at their fair value.

UNREALIZED HOLDING GAINS AND LOSSES are amounts associated with price changes of securities that are currently held.



for &100,000. If the value of the investments decreased by &75,000 during the year, an adjusting journal entry records the decrease in the valuation allowance account and an unrealized holding loss of &75,000. Recording an unrealized holding gain is a departure from the revenue principle, which states that revenues and gains should be recorded when the company has completed the earnings process that generated them. The financial statement treatment of unrealized holding gains or losses depends on the classification of the passive investments in shares.

Classifying Passive Investments in SharesPassive investments may be classified as investments at fair value through profit or loss or as investments available for sale, depending on management’s intent.

investments at Fair value through Profit or Loss Investments are classified in this category if they are actively traded with the objective of generating profits on short-term changes in the price of the securities. This approach is similar to the one taken by many mutual funds. The portfolio manager actively seeks opportunities to buy and sell securities. These investments are initially recorded at fair value. Subse-quent to initial recognition, they are measured at fair value at each reporting date. Fair value adjustments or unrealized holding gains or losses are recognized in the income statement. Securities held for trading are classified as current assets on the statement of financial position because they are intended to be sold within one year.

Available-for-sale investments Most companies do not actively trade the secu-rities of other companies. Instead, they invest to earn a return on funds they may need for future operating purposes. These investments are called available-for-sale investments. They reflect financial assets that are designated by the company as avail-able for sale, or are not classified as (a) held-to-maturity investments, (b) investments at fair value through profit or loss, or (c) loans and receivables. They are classified as current or non-current assets on the statement of financial position, depending on whether management intends to sell the securities during the next year.

Investments at fair value through profit or loss (FVTPL) are most commonly reported by financial institutions that actively buy and sell short-term investments to maximize returns. Most corporations, however, invest in short- and long-term securities available for sale (AFS). We focus on this category in the next section by analyzing Nokia’s investing activities.

Available-for-Sale InvestmentsFor simplification, let us assume that Nokia had no passive investments at December 31, 2009. The following example illustrates the accounting and reporting for available- for-sale investments.

Purchase of shares On January 2, 2010, Nokia purchases 10,000 common shares of Intelligent Mobile Systems Inc. (IMS) for &60 per share.4 IMS has 100,000 out-standing shares, so Nokia owns 10 percent (10,000 4 100,000) of IMS’s shares, which is treated as a passive investment. Such investments are recorded initially at cost:

INVESTMENTS AT FAIR VALUE THROUGH PROFIT OR LOSS are all investments in shares or bonds held primarily for the purpose of active trading (buying and selling) in the near future (classified as current).

AVAILABLE-FOR-SALE INVESTMENTS are passive investments in securities that are not classified as (1) held to maturity, (2) held for trading, or (3) loans and receivables.

4Intelligent Mobile Systems Inc. is a fictitious company.


AFS investments 600,000Cash 600,000

AFS investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000



If management of Nokia intends to hold the AFS investment for a long term, it would be reported on the company’s statement of financial position at December 31, 2010, at &580,000 (&600,000 cost, less the credit balance of &20,000 in the valua-tion allowance account). Nokia would also report an unrealized loss of &20,000 on AFS investments under other comprehensive income. The only item reported on the income statement for 2010 would be investment income of &10,000 from the divi-dends earned, classified under other non-operating items.

Let us assume that Nokia held the IMS shares through fiscal year 2011, and that the price per share was &61 at year-end. The year-end adjustment would be computed as follows:

The adjusting entry at the end of fiscal year 2011 is recorded as follows:

Valuation allowance—AFS Investments

0 Beg. Bal 20,000 AJE 20,000 End. Bal


Net unrealized gains and losses—AFS investments (SE) . . . . . . . 20,000 Valuation allowance—AFS investments (A) . . . . . . . . . . . . . . . . 20,000


Valuation allowance— AFS investments 20,000

Net unrealized gains and losses—AFS investments 20,000

The T-accounts related to this entry and those that follow are illustrated in Exhibit 7C.2.

dividends earned Investments in equity securities earn a return from two sources: (1) price appreciation and (2) dividend income. Price increases (or decreases) are ana-lyzed both at year-end and when a security is sold. Dividends earned are reported as investment income on the income statement and are included in the computation of profit for the period.

Assume that during the fourth quarter of fiscal 2010, Nokia received a cash divi-dend of &1 per share from IMS, which totals &10,000 (&1 3 10,000 shares). The journal entry and transaction effects are as follows:


Cash 10,000 Investment income 10,000

Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Investment income (SE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

This entry is the same for financial assets that are either held for trading or available for sale.

year-end valuation At the end of the accounting period, passive investments are reported on the statement of financial position at fair value. Assume that IMS had a market value of &58 per share at the end of the year. That is, the investment has lost value of &2 (&60 &58) per share. However, the loss is not realized since the investment has not been sold. It simply resulted from holding the shares while their fair value changed.

Reporting the available-for-sale investments at fair value requires adjusting the car-rying amount to fair value at the end of each period. The adjusting entry recognizes the unrealized holding gain or loss and creates a new account, Valuation Allowance – AFS investments. If the valuation allowance account has a debit balance, it is added to the account AFS investments. If it has a credit balance, it is subtracted. The net unrealized gains and losses account in AFS investments is reported in the sharehold-ers’ equity section of the statement of financial position under other comprehensive income. Thus, the statement of financial position remains in balance. Since the AFS investment is expected to be held into the future, the unrealized holding gain or loss is not reported as part of profit. Only when the security is sold are any realized gains or losses included in profit.

The following chart is used to compute any unrealized gain or loss in the AFS investment portfolio:

Fiscal Year Fair Value Cost

Balance Needed in Valuation Allowance

Unadjusted Balance in Valuation Allowance

Amount for Adjusting Entry

2010 €580,000 €600,000 5 €20,000 €0 5 (€20,000)(€58 3 10,000) (€60 3 10,000) (We assume there were no

passive investments at the end of the prior year.)

An unrealized loss for the period


A-31APPendix 7c Accounting for Passive Investments in Securities

sale of shares When available-for-sale investments are sold, three accounts are affected, in addition to cash:

AFS investments•

Valuation allowance—AFS investments•

Net unrealized gains and losses—AFS investments •

Let us assume that Nokia sold its investment in IMS on November 15, 2012, for &62.50 per share. The company would receive &625,000 in cash (&62.50 3 10,000) for shares purchased for &600,000 on January 2, 2010. In entry (1), a gain on sale of &25,000 (&625,000 – &600,000) would be recorded and the AFS investments would be eliminated. In entry (2), the valuation allowance and related net unrealized gains and losses would be eliminated.

(1) Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000 AFS investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Gain on sale of investments (SE) . . . . . . . . . . . . . . . . . . . . . . 25,000

(2) Net unrealized gains and losses—AFS investments (SE) . . . . . . 10,000 Valuation allowance—AFS investments (A) . . . . . . . . . . . . . . . 10,000


Cash 625,000 Gain on sale of investments 25,000AFS investments 600,000

Valuation allowance— AFS investments

10,000 Net unrealized gains and losses—AFS investments

10,000

The effects of these transactions on the various accounts are illustrated in Exhibit 7C.2.

If management of Nokia intends to hold the AFS investment for a long term, it would be reported on the company’s statement of financial position at December 31, 2010, at &580,000 (&600,000 cost, less the credit balance of &20,000 in the valua-tion allowance account). Nokia would also report an unrealized loss of &20,000 on AFS investments under other comprehensive income. The only item reported on the income statement for 2010 would be investment income of &10,000 from the divi-dends earned, classified under other non-operating items.

Let us assume that Nokia held the IMS shares through fiscal year 2011, and that the price per share was &61 at year-end. The year-end adjustment would be computed as follows:

Fiscal Year Fair Value Cost



Amount for Adjusting Entry

2011 €610,000 €600,000 5 €10,000 (€20,000) 5 (€30,000)(€61 3 10,000) (€60 3 10,000) An unrealized gain

for the period


Valuation Allowance—AFS Investments

20,000 Beg. Bal30,000 AJE10,000 End. Bal


Valuation allowance— AFS investments

30,000 Net unrealized gains and losses—AFS investments

30,000

Valuation allowance—AFS investments (A) . . . . . . . . . . . . . . . . . . . 30,000 Net unrealized gains and losses—AFS investments (SE) . . . . . . 30,000



The notes to Nokia’s 2009 financial statements contain the following information concerning its available-for-sale investments:

Exhibit 7c.2 T-Accounts for the Illustrated Transactions

StatEmENt oF FiNaNCial poSitioN aCCoUNtS

aFS investments (at cost) (a)1/1/10 0Purchase 600,00012/31/10 600,00012/31/11 600,000

600,000 2012 Sale12/31/12 0

Valuation allowance—aFS investments (a)0 1/1/10

20,000 AJE 12/31/1020,000 12/31/10

12/31/11 AJE 30,00012/31/11 10,000

10,000 2012 Sale 0 12/31/11

Net Unrealized Gains and losses (SE)1/1/10 012/31/10 AJE 20,00012/31/10 20,000

30,000 AJE 12/31/1110,000 12/31/11

2012 Sale 10,00012/31/12 0

iNComE StatEmENt aCCoUNtS

investment income (SE)10,000 Earned10,000 12/31/10

Gain on Sale of investments (SE)25,000 2012 Sale25,000 12/31/12

reAL WOrLd excerPt

Nokia CorporationANNUAL REPORT

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Accounting PoliciesFinancial assets

available-for-sale investments

The Group classifies the following investments as available for sale based on the

purpose of acquiring the investments as well as ongoing intentions: (1) highly liquid,

interest-bearing investments with maturities at acquisition of less than 3 months,

which are classified in the statement of financial position as current available-for-sale

investments, cash equivalents; (2) similar types of investments as in category (1),

but with maturities at acquisition of longer than 3 months, classified in the statement

of financial position as current available-for-sale investments, liquid assets; and (3)

investments in technology related, publicly quoted equity shares, or unlisted private

equity shares and unlisted funds, classified in the statement of financial position as

non-current, available-for-sale investments.

Current fixed income and money market investments are fair valued by using

quoted market rates, discounted cash flow analyses and other appropriate valuation

models at the statement of financial position date. Investments in publicly quoted

equity shares are measured at fair value using exchange quoted bid prices. Other

available-for-sale investments carried at fair value include holdings in unlisted shares.



This note indicates that Nokia classifies its available-for-sale investments in three different categories, depending on the nature of the investments. It also discusses how the fair values of these investments are determined at each reporting date.

The effects of the available-for-sale investments on Nokia’s profit for 2009 are included in Note 10 to its financial statements.

Fair value is estimated by using various factors, including, but not limited to (1) the

current market value of similar instruments, (2) prices established from a recent arm’s

length financing transaction of the target companies, and (3) analysis of market pros-

pects and operating performance of the target companies, taking into consideration

the public market of comparable companies in similar industry sectors. The remaining

available-for-sale investments, carried at cost less impairment, are technology related

investments in private equity shares and unlisted funds for which the fair value can-

not be measured reliably due to non-existence of public markets or reliable valuation

methods against which to value these assets. The investment and disposal decisions

on these investments are business driven.

….

The fair value changes of available-for-sale investments are recognized in fair

value and other reserves as part of shareholders’ equity…. Dividends on available-

for-sale equity instruments are recognized in profit and loss when the Group’s right

to receive payment is established. When the investment is disposed of, the related

accumulated fair value changes are released from shareholders’ equity and recog-

nized in the income statement....


10. Financial income and expenses

EURm 2009 2008 2007

Dividend income on available-for-sale financial investments 3 1 — Interest income on available-for-sale financial investments 101 357 355Net realized gains (or losses) on disposal of fixed income

available-for-sale financial investments 2 (4) (17)

Net fair value gains (or losses) on investments at fair value through profit and loss

19 — —

Interest income on investments at fair value through profit and loss 11 — —


reAL WOrLd excerPt

Nokia CorporationANNUAL REPORT

Comparing Investments at Fair Value through Profit or Loss to Available-for-Sale InvestmentsThe reporting impact of unrealized holding gains or losses depends on the classifica-tion of the investment.

Portfolio of investments at fair value through profit or loss. The amount of the adjustment to net unrealized holding gains and losses is included in each period’s income statement. Net holding gains increase profit and net holding losses decrease it. This also means that the amount recorded as net unrealized gains and losses on these investments is closed to retained earnings at the end of the period.



Thus, when selling a security, cash and only two other statement of financial position accounts are affected: FVTPL investments, and valuation allowance—FVTPL investments. The gain or loss on sale of FVTPL investments is the differ-ence between the cash proceeds from the sale and the cost of the investment, net of the valuation allowance.

Portfolio of available-for-sale investments. As we learned in the previous section, the balance in net unrealized holding gains and losses is reported as a separate compo-nent of shareholders’ equity (under other comprehensive income). It is not reported on the income statement and does not affect profit. At the time of sale, the difference between the proceeds from the sale and the original cost of the investment is recorded as a gain or loss on available-for-sale investments. At the same time, net unrealized gains and losses—AFS investments and valuation allowance—AFS investments are eliminated.

Exhibit 7C.3 provides comparative journal entries and financial statement balances for the transactions illustrated for Nokia from January 1, 2010, to Novem-ber 15, 2012. Note that the total gain reported for the three years is the same &35,000 for both types of securities. Only the allocation across the three peri-ods differs.

Income in FVTPL Investments AFS Investments

2010 &10,000 dividends &10,000 dividends (20,000) unrealized loss – 2011 30,000 unrealized gain – 2012 15,000 realized gain 25,000 realized gainTotal &35,000 &35,000

Most managers prefer to treat their passive investments as available-for-sale investments.

This treatment generally reduces variations in reported earnings by avoiding recognition

of unrealized holding gains and losses resulting from quarter-to-quarter changes in share

prices. It also allows managers to smooth out earnings fluctuations by selling securities with

unrealized gains when earnings decline and by selling those with unrealized losses when

earnings increase. Diligent analysts can see through this strategy, however, by examining the

required note on investments in the financial statements.5

5In November 2009, the IASB issued IFRS 9 – Financial Instruments, which is effective for fiscal years starting on or after January 1, 2013. The category available-for-sale investment would disappear as a separate category of equity investments. IFRS 9 requires that all passive investments be measured at fair value, and that fair value changes be reported in profit or loss. However, an entity can elect, on initial recognition, to present the fair value changes on an equity investment that is not held for trading in other comprehensive income. The dividends on such investments must be recognized in profit or loss. When the investment is sold, the gain or loss is removed from other comprehensive income and credited or debited directly to retained earnings.

FinAnciAl AnALysis

Equity SEcuritiES and EarningS ManagEMEnt



Exhibit 7c.3Comparison of Accounting for Investments at Fair Value through Profit or Loss and Available-for-Sale Investments

part a: Entries FVtpl investments available-for-Sale investments

Fiscal Year 2010:Purchase (for €600,000 cash)

FVTPL investments (A) . . . . . . . . . . . . . . . Cash (A) . . . . . . . . . . . . . . . . . . . . . . .

600,000600,000

AFS investments (A) . . . . . . . . . . . . Cash (A) . . . . . . . . . . . . . . . . . . .

600,000600,000

Receipt of dividends (€10,000 cash)

Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . Investment income (SE) . . . . . . . . . . . .

10,00010,000

Cash (A) . . . . . . . . . . . . . . . . . . . . . Investment income (SE) . . . . . . . .

10,00010,000

Year-end adjustment to market (market 5 €580,000)

Net unrealized gains/losses— FVTPL investments (SE) . . . . . . . . . . . . . Valuation allowance— FVTPL investments (A) . . . . . . . . . . . . . .

20,000

20,000

Net unrealized gains/losses— SAS (SE) . . . . . . . . . . . . . . . . . . . Valuation allowance— AFS investments (A) . . . . . . . . . . . .

20,000

20,000

Fiscal Year 2011:

Year-end adjustment to market (market 5 €610,000)

Valuation allowance— FVTPL investments (A) . . . . . . . . . . . . . Net unrealized gains/losses— FVTPL investments (SE) . . . . . . . . . . . .

30,000

30,000

Valuation allowance— AFS investments (A) . . . . . . . . . . . . Net unrealized gains/losses— SAS (SE) . . . . . . . . . . . . . . . . . . .

30,000

30,000

Fiscal Year 2012:

Sale (for €625,000) Two statement of financial position accounts are eliminated: Three statement of financial position accounts are eliminated:

Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . 625,000 Cash (A) . . . . . . . . . . . . . . . . . . . . . 625,000

Valuation allowance— FVtpl investments (a) . . . . . . . . . . .

10,000

aFS investments (a) . . . . . . . . . . Gain on sale of investment (SE) . . .

600,00025,000

FVtpl investments (a) . . . . . . . . . . . . 600,000 Net unrealized gains/losses—

Gain on sale of investment (SE) . . . . . . . 15,000 aFS investments (SE) . . . . . . . . . . 10,000

Valuation allowance— aFS investments (a) . . . . . . . . .

10,000

part B: Financial reporting FVtpl investments available-for-Sale investments

Statement of Financial position: assets 2012 2011 2010 assets 2012 2011 2010

FVTPL investments — 600,000 600,000 AFS investments — 600,000 600,000Valuation allowance— PVTPL investments —

10,000

(20,000)

Valuation allowance— AFS investments — 10,000

(20,000)

FVTPL investments—net — 610,000 580,000 AFS investments—net — 610,000 580,000Shareholders’ EquityOther comprehensive income: Net unrealized gains/losses—

AFS investments

10,000

(20,000)

income Statement: 2012 2011 2010 2012 2011 2010

Investment income — — 10,000 Investment income — — 10,000Gain on sale 15,000 — — Gain on sale 25,000 — —Net unrealized gains/ losses—FVTPL

30,000

(20,000)



(Try to solve the requirements for each of the four cases before proceeding to the suggested solu-tion that follows each case.) Howell Equipment Corporation sells and services a major line of farm equipment. Both sales and service operations have been profitable. The following transactions affected the company during 2011:

Jan. 1 Purchased 2,000 common shares of Dear Company at $40 per share. This purchase represented 1 percent of the shares outstanding. Management intends to trade these shares actively.

Dec. 28 Received $4,000 cash dividend on the Dear Company shares.Dec. 31 Determined that the market price of Dear’s common share was $39.

Required:

Prepare the journal entry for each of these transactions.1. What accounts and amounts will be reported on the statement of financial position at the 2. end of 2011? On the income statement for 2011?

DEmonstrAtion cAse A

Answer the following questions, using the T-accounts to help you infer the amounts. Dollar amounts are in thousands.

Statement of Financial Position Accounts

(In Current assets)

aFS investmentsValuation allowance—

aFS investments

1/1 4,022 1/1 1,565Purchase 19,000 ? Sale AJE ? 1,092 Sale12/31 8,875 12/31 5,683

(In Accumulated other comprehensive income)

Net Unrealized Gains and losses—aFS investments

1,565 1/1Sale ? ? AJE

5,683 12/31

income Statement accounts

investment income Gain on Sale of investment ? Earned 2,384 Sale7,771 12/31 2,384 12/31

a. Purchased available-for-sale investments for cash. Prepare the journal entry.

b. Received cash dividends on the investments. Prepare the journal entry.

c. Sold AFS investments at a gain. Prepare the journal entries.

d. At year-end, the AFS investment portfolio had a market value of $14,558. Prepare the adjusting entry.

e. What amounts would be reported on the statement of financial position at December 31 related to the AFS investments? On the income statement for the year?

f. How would year-end reporting change if the investments were categorized as FVTPL investments instead of AFS investments?

After you complete your answers, go check the solution on page A-38.

SELF-STUDY Quiz 14-1


A-37APPendix 7c Accounting for Passive Investments in Securities

Assume the same facts as in Case A except that the securities were purchased as available-for-sale investments rather than investments at fair value through profit or loss.

Required:

Prepare the journal entry for each of these transactions.1. What accounts and amounts will be reported on the statement of financial position at the 2. end of 2011? On the income statement for 2011?

DEmonstrAtion cAse b

1. Jan. 1 FVTPL investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Cash (A) (2,000 shares 3 $40) . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Dec. 28 Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Investment income (SE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Dec. 31 Net unrealized gains/losses—FVTPL investments (SE) . . . . . . . . . 2,000 Valuation allowance—FVTPL investment (A) . . . . . . . . . . . . . . . 2,000

Year Fair Value Cost Balance Needed in

Valuation Allowance Unadjusted Balance in Valuation Allowance

Adjustment to Valuation Allowance

2011 $78,000 $80,000 5 $(2,000) $0 5 $(2,000)($39 3 2,000) An unrealized loss

for the period

On the Statement of Financial Position: On the Income Statement:

Current Assets Other Non-operating ItemsFVTPL Investments $78,000 Investment income $4,000 ($80,000 cost $2,000 allowance) Net unrealized loss on FVTPL investments (2,000)

2.

suggEstED sOLutiOn FOr cAse A

1. Jan. 1 AFS investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Cash (A) (2,000 shares 3 $40) . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Dec. 28 Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Investment income (SE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Dec. 31 Net unrealized gains/losses—AFS investments (SE) . . . . . . . . . . . 2,000 Valuation allowance—AFS investments (A) . . . . . . . . . . . . . . . . 2,000

Year Fair Value Cost Balance Needed in

Valuation Allowance Unadjusted Balance in Valuation Allowance


2011 $78,000 $80,000 5 $(2,000) $0 5 $(2,000)($39 3 2,000) An unrealized loss

for the period

On the Statement of Financial Position: On the Income Statement:

Current Assets Other Non-operating ItemsAFS investments $78,000 Investment income $4,000 ($80,000 cost $2,000 allowance)Shareholders’ EquityAccumulated other comprehensive income:Net unrealized loss on AFS investments (2,000)

suggEstED sOLutiOn FOr cAse b

2.


APPendix 7c Accounting for Passive Investments in SecuritiesA-38A-38

AFS investments (A) a. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 The cost of investments is reported in the AFS investments account.

Cash (A)b. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,771 Investment income (SE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,771 The amount of dividends earned is reported in the AFS

investments account.(1) Cash (A)c. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,531

Gain on sale of investments (SE) . . . . . . . . . . . . . . . . . . . . . . . 2,384 AFS investments (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,147 The cost of investments sold is derived from details reported in

the AFS investments account. (2) Net unrealized gains/losses—AFS (SE) . . . . . . . . . . . . . . . . . . . . . 1,092 Valuation allowance—AFS investments (A) . . . . . . . . . . . . . . . . 1,092

Valuation allowance—AFS investments (A) . . . .d. . . . . . . . . . . . . . . . . . 5,210 Net unrealized gains/losses—AFS (SE) . . . . . . . . . . . . . . . . . . . . . 5,210

Fair Value Cost




$14,558 $8,875 5 $5,683 $473 5 $5,210($1,565 beg. bal. $1,092 sale)

Statement of Financial Position Income Statemente. Assets Non-operating Items Other investments $14,558 Investment income $7,771

Shareholders’ Equity Gain on sale of investments 2,384 Net unrealized gains/losses 5,683 (in Accumulated other

comprehensive income)If the securities were held for trading, no net unrealized gain would appear on the f. statement of financial position. Therefore, when the securities were sold in c., no debit would be made to the Net unrealized gains/losses account. Rather, there would be a gain on the sale of $1,292 [$16,531 cash ($14,147 cost $1,092 allowance)] reported on the income statement. Then at year-end, the net unrealized gain of $5,210 would be reported on the income statement (not in shareholders’ equity).

SoLUTIon To SELF-STUDY Quiz

SUPPLEMEnT tAKe-AWAys

Analyze and report bond investments held to maturity. p. A-271. When management intends to hold a bond investment until it matures, the held-to-maturity bond is recorded at cost when acquired and reported at amortized cost on the statement of financial position. Any interest earned during the period is reported on the income statement.

Analyze and report passive investments in securities by using the fair value method. 2. p. A-28

Acquiring less than 20 percent of the outstanding voting shares of an investee’s common •shares is presumed to be a passive investment. Passive investments may be classified in one of two categories, depending on management’s intent, as investments at fair value through profit or loss (actively traded to maximize return) or available-for-sale investments (acquired to earn a return but are not as actively traded).The investments are recorded at cost and adjusted to fair value at year-end. A valuation •allowance is increased or decreased to arrive at fair value with the resulting unrealized holding gain or loss that is recorded and reported on the income statement for investments at fair value through profit or loss, or as a component of shareholders’ equity in other comprehensive income for available-for-sale investments.Any dividends earned are reported as income, and any gains or losses on sales of passive •investments are reported on the income statement.



FInDInG FinAnciAL inFOrmAtiOn

stAtement OF FinAnciAL POsitiOnCurrent Assets

Investments at fair value through profit or loss (net of valuation allowance)

Available-for-sale investments (net of valuation allowance)

Non-current AssetsAvailable-for-sale investments (net of

valuation allowance)Investments held to maturity

Shareholders’ EquityAccumulated other comprehensive

incomeNet unrealized gains and losses on

available-for-sale investments

incOme stAtementUnder “Non-operating Items”

Investment incomeLoss or gain on sale of investmentsNet unrealized gains and losses on

investments at fair value through profit or loss

Equity in investee earnings or losses

nOtesIn Various Notes

Accounting policies for investmentsDetails on passive investments

stAtement OF cAsH FLOWsOperating Activities

Profit adjusted for:Gains/losses on sale of investmentsDividends received Net unrealized gains/losses on

investments at fair value through profit or loss

Amortized Cost Method p. A-27

Available-for-Sale Investments p. A-29

Fair Value Method p. A-28

Held-to-Maturity Investments p. A-27

Investments at Fair Value through Profit or Loss p. A-29

Unrealized Holding Gains or Losses p. A-28

Key terms

QuestiOns

Explain the difference between a short-term investment and a long-term investment.1. Explain the difference in accounting methods used for passive investments, investments in 2. which the investor can exert significant influence, and investments in which the investor has control over another entity.Explain how bonds held to maturity are reported on the statement of financial position.3. When and how does the investor company measure investment income under the fair value 4. method?

exercises

Recording Bonds Held to MaturityThe Forzani Group Limited is Canada’s largest retailer of sporting goods, offering a comprehensive assortment of products, operating stores from coast to coast under the names Sport Chek, Sports Experts, Coast Mountain Sports, Sport Mart, and National Sports. The company does more than $1 billion in sales each year.

LO1

Forzani Group Limited

E–1



Assume that as part of its cash management strategy, Forzani purchased $10 million in bonds at par for cash on July 1, 2012. The bonds pay 10 percent interest each June 30 and December 31 and mature in 10 years. Forzani plans to hold the bonds until maturity.

Required:

Record the purchase of the bonds on July 1, 2012.1.

Record the receipt of interest on December 31, 2012.2.

Recording Transactions in the Portfolio of Investments at Fair Value through Profit or LossOn June 30, 2011, MetroMedia Inc. purchased 10,000 of Mitek’s common shares for $20 per share. Management purchased the shares for speculative purposes and designated them as investments at fair value through profit or loss. The following information pertains to Mitek’s price per share:

Date Price

12/31/2011 $2412/31/2012 3112/31/2013 25

MetroMedia sold its investment in Mitek’s shares on February 14, 2014, at a price of $22 per share. Prepare any journal entries that are required by the facts presented in this case.

Recording Transactions in the Portfolio of Securities Available for SaleUsing the data in E–2, assume that MetroMedia management designated Mitek’s shares as available-for-sale investments instead of investments at fair value through profit or loss. Prepare any journal entries that are required by the facts presented in the case.

Recording Passive Investments in Securities and Determining Financial Statement EffectsOn June 30, 2011, Forlini Company acquired some of the 50,000 outstanding common shares of Como Corporation. The fiscal years for both companies ends on December 31. The following transactions occurred during 2011:

Dec. 2 Purchased 8,000 shares of Cox common stock at $28 per share.Dec. 15 Cox Corporation declared and paid a cash dividend of $2 per share.Dec. 31 Determined that the current market price of Cox stock to be $25 per share.

Required:

Assume that Forlini Company purchased Como’s shares for trading purposes. Prepare the 1. journal entries to record each of the transactions listed above.

Assume that Forlini Company purchased Como’s shares for inclusion in its available-for-sale 2. portfolio. Prepare the journal entries for the same transactions above.

Using the following categories, indicate the effects of each transaction assuming that Como’s 3. shares are (a) held for trading and (b) purchased for the available-for-sale portfolio.

Statement of Financial Position Income Statement

Transaction Assets Liabilities Shareholders’ Equity Revenues Expenses Profit

Shares at fair value through profit or loss

Dec. 2

Dec. 15

Dec. 31

Shares available for sale

Dec. 2

Dec. 15

Dec. 31

LO2 E–2

LO2 E–3

LO2 E–4



Reporting Gains and Losses in Passive Investments in SecuritiesOn March 10, 2011, General Solutions Inc. purchased 5,000 of MicroTech’s common shares for $50 per share. The following information pertains to MicroTech’s price per share:

Date Price

12/31/2011 $5512/31/2012 4012/31/2013 42

General Solutions sold its investment in MicroTech’s shares on September 12, 2014, at a price of $39 per share.

Required:

Assume that management purchased the shares for speculative purposes and recorded this 1. transaction as an investment at fair value through profit or loss. Prepare any journal entries that are required by the facts presented in this case.

Assume that management classified MicroTech’s shares as available-for-sale investments. 2. Prepare any journal entries that are required by the facts presented in this case.

PrObLems

Determining Financial Statement Effects for Bonds Held to Maturity (AP–1)Starbucks Corporation provides high-quality coffee products. Assume that as part of its expansion strategy, Starbucks plans to open numerous new stores internationally over the next five years. The company has US$5 million to support the expansion and has decided to invest the funds in corporate bonds until the money is needed. Assume that Starbucks purchased bonds with US$5 million face value at par for cash on July 1, 2011. The bonds pay 8 percent interest each June 30 and December 31 and mature in five years. Starbucks plans to hold the bonds until maturity.

Required:

What accounts are affected when the bonds are purchased on July 1, 2011?1.

What accounts are affected when interest is received on December 31, 2011?2.

Should Starbucks prepare a journal entry if the market value of the bonds decreased to 3. US$4 million on December 31, 2011? Explain.

Recording Passive Investments (AP–2)On March 1, 2010, HiTech Industries purchased 10,000 common shares of Integrated Services Company for $20 per share. The following information applies to Integrated’s price per share:

Date Price

12/31/2011 $1712/31/2012 2412/31/2013 31

Required:

Prepare journal entries to record the facts in the case, assuming that HiTech purchased the shares 1. as investments at fair value through profit or loss.

Prepare journal entries to record the facts in the case, assuming that HiTech purchased the shares 2. for its available-for-sale investment portfolio.

Reporting Passive Investments (AP–3)During January 2011, Ka-Shing Company purchased shares of the following companies as a non-current investment:

Company and Type of ShareNumber of Shares

Outstanding PurchaseCost per

Share

Q Corporation—Common 90,000 12,600 $5R Corporation—Preferred, nonvoting 20,000 12,000 30

LO2E–5

LO1

Starbucks Corporation

P–1

LO2 P–2

LO2P–3



Subsequent to acquisition, the following data were available:

2011 2012

Profit reported at December 31: Q Corporation $30,000 $36,000 R Corporation 40,000 48,000Dividends declared and paid during the year (per share): Q Corporation—Common $0.85 $0.90 R Corporation—Preferred 1.00 1.10Market value per share at December 31: Q Corporation—Common $ 4.00 $ 4.00 R Corporation—Preferred 29.00 30.00

Required:

What accounting method should be used for the investment in Q Corporation’s common shares? 1. R Corporation’s preferred shares? Why?

Prepare the journal entries to record the following events for each year by using parallel columns 2. (if no entry is required, explain why):

Purchase of the investments.a. Income reported by Q and R Corporations.b. Dividends received from Q and R Corporations.c. Fair value effects at year-end.d.

For each year, show how the following amounts should be reported on the financial statements 3. of Ka-Shing Company:

Non-current investment.a. Shareholders’ equity—net unrealized gains and losses.b. Investment income.c.

Recording Passive InvestmentsOn August 4, 2010, Osaka Corporation purchased 1,000 common shares of Tremblay Ltée for $45,000. The following information applies to the Tremblay’s shares:

Date Price

12/31/2010 $5212/31/2011 4712/31/2012 38

Tremblay Ltée declares and pays cash dividends of $2 per share on June 1 of each year.

Required:

Prepare journal entries to record the facts in the case, assuming that Osaka purchased the shares 1. for the portfolio of investments at fair value through profit or loss.

Prepare journal entries to record the facts in the case, assuming that Osaka purchased the shares 2. for the portfolio of securities available for sale.

ALternAte PrObLems

Determining Financial Statement Effects for Bonds Held to Maturity (P–1)Krispy Kreme Doughnuts Inc. operates and franchises a worldwide chain of quick-service drive-in doughnut stores. Customers drive up to a parking space and order doughnuts through an intercom speaker system. The ordered quantity is then delivered to the customer. Assume that Krispy Kreme has $10 million in cash to support future expansion and has decided to invest the funds in corporate bonds until the money is needed. Krispy Kreme purchases bonds with $10 million face value for $10.3 million cash on January 1, 2012. The bonds pay 8 percent interest each June 30 and December 31 and mature in four years. Krispy Kreme plans to hold the bonds until maturity.

LO2 P–4

LO1 AP–1Krispy Kreme Doughnuts Inc.



Required:

What accounts were affected when the bonds were purchased on January 1, 2012?1.

What accounts were affected when interest was received on June 30, 2012?2.

Should Krispy Kreme prepare a journal entry if the market value of the bonds decreased to 3. $9,700,000 on December 31, 2012? Explain.

Recording Passive Investments (P–2)On September 15, 2011, MultiMedia Corporation purchased 10,000 common shares of Community Broadcasting Company for $32 per share. The following information applies to Community Broadcasting’s price per share:

Date Price

12/31/2011 $3412/31/2012 2412/31/2013 21

Required:

Prepare journal entries to record the facts in the case, assuming that MultiMedia purchased the 1. shares for the portfolio of investments at fair value through profit or loss.

Prepare journal entries to record the facts in the case, assuming that MultiMedia purchased the 2. shares for its available-for-sale investment portfolio.

Reporting Passive Investments (P–3)During January 2011, Hexagon Company purchased 12,000 of the 200,000 outstanding common shares of Smiley Corporation at $30 per share. This block of shares was purchased as a long-term investment. Assume that the fiscal year for each company ends on December 31. Subsequent to acquisition, the following data were available:

2011 2012

Profit reported by Smiley Corporation at December 31 $40,000 $60,000Cash dividends declared and paid by Smiley Corporation during the year 60,000 80,000Market price of Smiley Corporation’s share at December 31 28 29

Required:

What accounting method should Hexagon Company use to record the investment in Smiley 1. Corporation’s common shares? Why?

Prepare the journal entries to record the following events for each year by using parallel columns 2. (if no entries are required, explain why):

Acquisition of Smiley Corporation’s shares.a. Profit reported by Smiley Corporation.b. Dividends received from Smiley Corporation.c. Fair value effects at year-end.d.

For each year, show how the following amounts should be reported on the financial statements 3. of Hexagon Company:

Non-current investment.a. Shareholders’ equity—net unrealized gains and losses.b. Revenues.c.

cAses And PrOJectsCRITICAL THINkING CASESEvaluating an Ethical Dilemma: Using Inside InformationAssume that you are on the board of directors of a company that has decided to buy 80 percent of the outstanding shares of another company within the next three or four months. The discussions have convinced you that this company is an excellent investment opportunity, so you decide to buy $10,000 worth of the company’s shares for your personal portfolio. Is there an ethical problem with your decision? Would your answer be different if you planned to invest $500,000? Are there different ethical considerations if you don’t buy the shares but recommend that your brother do so?

LO2AP–2

LO2AP–3

CP–1


Documents

Appendix 7C - McGraw Hill Educationhighered.mheducation.com/.../900485/lib01499_appendix7C_olc.pdfsecurities by using the fair value method. p. A-28 Appendix 7C ... be able to do the