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Chapter 9--Learning Objectives
1. Explain the recognition and measurement issues associated with investments
The primary accounting standards for investments are:
FASB SFAS No. 115
For all debt securities
For equity investments of less than 20 percent
APB Opinion No. 18
For equity investments of more than 20 percent
Major provisions of SFAS No. 115
Investments accounted for at fair value or amortized cost
Investments classified as:
1. Trading securities
2. Available-for-sale
3. Held-to-maturity
Passive investments and significant influenceA passive investment is one in which the
investor has no ability to exercise significant influence over the investee
Significant influence is presumed to exist with ownership of 20 percent to 50 percent of the voting stock of the investee
Investment classifications
Trading securities
Debt and equity securities bought and held principally for the purpose of sale in the near term
Available-for-sale securities
Debt and equity securities neither trading nor held-to-maturity
Held-to-maturity securities
Debt securities that the entity has the positive intent and ability to hold to maturity
Accounting requirements forTrading securities(investments less than 20 percent)
Changes in market value recognized as gain or loss in current period income
Securities reported at market value
Accounting requirements forAvailable-for-sale securities(investments less than 20 percent)Changes in market value recognized as
separate component of shareholders’ equity until realized
Securities reported at market value
Accounting requirements forHeld-to-maturity securities(debt securities only)Changes in market value not recognized
Securities reported at amortized cost
Major provisions of APB Opinion No. 18
Applies to ownership of equity securities greater than 20 percent
For ownership of 20 to 50 percent, use the equity method
For ownership of greater than 50 percent, use consolidated financial statements
The equity method(equity investments of 20 to 50 %)
Investments recorded at cost
Investment increased for proportionate share of net income
Investment decreased for:
1. Dividends received
2. Extra depreciation
3. Amortization of goodwill
Consolidate financial statements(equity investments of more than50 percent)
This material is
beyond the scope
of our course
(so much GAAP, so little time)
Chapter 9--Learning Objectives
2. Record and report transactions for debt-security investments and equity-security investments of less than 20%
Held to maturity debt securities
Record acquisitions at cost
Investment in Debt Securities XXXCash XXX
Record interest as income
Cash XXXInterest Income XXX
Held to maturity debt securities
If purchased at premium, include in cost
Investment in Debt Securities XXXCash XXX
Amortize by reducing investment valueCash XXX
Interest Revenue XXXInvestment in Debt Securities XXX
Held to maturity debt securities
If purchased at discount, record at cost
Investment in Debt Securities XXXCash XXX
Amortize by increasing investment valueCash XXXInvestment in Debt Securities XXX
Interest Revenue XXX
Held to maturity debt securities
Ignore market value changes for held to maturity debt securities !
Sale of held to maturity debt securities before maturity
Accrue interest as required
Determine amortized cost
Compare with selling price
Recognize gain or loss based on difference between amortized cost (book value) and selling price
Available for sale debt securities
Procedures for purchase, interest, and premium or discount amortization are same as for held to maturity debt securities
Exception: Market value changes are adjusted for
Available for sale debt securities
If market value is above amortized cost
Adjustment to Market XXXUnrealized Holding Gain XXX
“Adjustment to Market” is shown on the balance sheet along with the investment account
“Unrealized Gain” is shown as a separate account in the equity section
Available for sale debt securities
If market value is below amortized cost
Unrealized Holding Loss XXXAdjustment to Market XXX
“Adjustment to Market” is shown on the balance sheet along with the investment account as a reduction of value
“Unrealized Loss” is shown as a separate negative account in the equity section
Debt Securities--Trading
Recorded at cost Amortization ignored Changes in fair value recorded in current
income
Accounting for equity trading securities
Record acquisitions at cost
Investment in Trading Securities XXXCash XXX
Record dividends and interest as income
Cash XXXDividend Income XXX
Accounting for equity trading securities
If market value on reporting date is lower than original cost
Loss on Holding Equity Securities XXXInvest. in Trading Securities XXX
If market value is higher than costInvest. in Trading Securities XXX
Gain on Holding Equity Sec. XXX
Available for sale equity securities
Record acquisitions at cost
Investment in AFS Securities XXXCash XXX
Record dividends and interest as income
Cash XXXDividend Income XXX
Available for sale equity securities
If market value on reporting date is lower than original cost
Unrealized Loss on AFS Sec. XXXInvestment in AFS Securities XXX
The “Unrealized Loss” account is shown as a separate component of stockholders’ equity (a reduction in this case)
It is NOT shown on the income statement
Available for sale equity securities
If market value on reporting date is higher than original cost
Investment in AFS Securities XXXUnrealized Gain on AFS Sec. XXX
The “Unrealized Gain” account is shown as a separate component of stockholders’ equity (an increase in this case)
It is NOT shown on the income statement
Transfers between categories
Base classification on management intentTransfer between categories based on fair market
value at time of transferRecognize any unrealized holding gain or loss at
time of transferInclude in income for securities transferred into or
from trading categoryShow as separate stockholders’ equity item for
securities transferred into available for sale category from held-to-maturity
Impairment of Securities
Permanent loss.Security written down to fair value
Loss included in earnings as realized
Chapter 9--Learning Objectives
3. Record and report equity-security investment transactions of greater than 20%
The equity method
Used for situations in which more than 20 percent of the voting stock is owned
If more than 50 percent is owned, consolidated financial statements are prepared
Thus, the equity method applies to situations of 20 to 50 percent
Equity method procedures
Record purchase of investment at cost
Investment in Other Company XXX
Cash XXX
Equity method procedures
Increase investment value on reported earnings
Investment in Other Company XXXInvestment Income XXX
Decrease investment value on reported losses
Investment Income (Loss) XXXInvestment in Other Company XXX
Equity method procedures
Decrease investment value on dividends
Cash XXX
Investment in Other Company XXX
Equity method procedures
Amortize differences between the book value and the fair market value of investee depreciable assets over the asset lives
Amortization of goodwill reduces investment income and investment value
Investor’s share of any extraordinary items or changes in accounting principle are shown as such (must be material)
Investments and cash flows
Cash flows from purchases, sales and maturities of trading securities are operating activities on the cash flow statement
Cash flows from purchases, sales and maturities of available for sale and held to maturity securities are investing activities on the cash flow statement
Chapter 9--Learning Objectives
4. Record and report transactions for funds and life insurance investments
Sinking funds
Funds set aside for retirement of debts
Accounting for funds
Recording contributions to fund
Sinking Fund Cash XXXCash XXX
Recording purchase of fund investments
Sinking Fund Investments XXXSinking Fund Cash XXX
Accounting for funds
Receipt of investment income
Sinking Fund Cash XXXSinking Fund Revenue XXX
Payment of expenses
Sinking Fund Expense XXXSinking Fund Cash XXX
Accounting for funds
Sale of investments
Sinking Fund Cash XXX
Sinking Fund Investments XXX
Gain on Sale of Inv. XXX
Accounting for funds
Bond maturity and closing of fund
Bonds Payable XXX
Cash XXX
Sinking Fund Cash XXX
Cash surrender value of life insurance
Businesses frequently purchase life insurance policies on key personnel
Term life insurance is accounted for simply as an expense
Whole-life policies have cash surrender values and loan values
The increase in cash value is accounted for as an investment
Life insurance entriesfor policies with cash surrender value
Payment of premium
Life Insurance Expense XXX
Cash Surrender Value of LI XXX
Cash XXX
Life insurance entriesfor policies with cash surrender value
Death of key person, receipt of benefit
Cash XXX
Cash Surrender Value of LI XXX
Gain on Life Insurance XXX
Chapter 9--Learning Objectives
5. Analyze the impact of the different accounting methods for investments on profitability and liquidity measures
The differences between the methods of accounting for investmentscan affect income
Changes in market value are
included in income for trading securities
but not for others
Investee reported profits are included
in income under the equity method
but not under the cost method
The differences between the methods of accounting for investmentscan affect liquidity
Trading securities and some available
for sale securities are treated as
current assets
But other investments are not classified
as current assets
Chapter 9--Learning Objectives
6. Understand the concept and complexities associated with derivative financial instruments
What are derivatives ?
Financial instruments that provide the holder with the right or obligation to participate in the price changes of an underlying asset
Underlying assets may involve interest rates, price indexes, or other market indicators
Example
Derivative Financial Instruments
Manage financial risk due to changes in– Fair values– Cash flows– Foreign currency exchange rates
Derivatives as Hedges
Fair value hedges Cash flow hedges Foreign currency hedges
Accounting for gains & losses
Report gains & losses in income for– Hedges with no designation– Fair value hedges
Report gains & losses in other comprehensive income for– Effective cash flow hedges– Foreign currency hedges