Chapter 18: Investments

1. Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 18: Investments Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

2. Part 1 : Investments in Debt Securities Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

3. Accounting Guidelines: History • There are two standards involved: APB No. 18 and SFAS 115. • Under APB No. 18: Investments are classified as either short term or long term depending on management’s intent, and • Valuation is lower of cost-or-market (LCM) • SFAS 115 applies to periods beginning after Dec 15, 1993. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

4. History: continued --- • SFAS 115 applies to the following investments: • all investments in debt securities • investments in equity securities (with less than 20% of voting stock) • APB No. 18 applies to other investments in equity securities with voting stock of 20% or more Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

5. All debt securities transactions Equity securities, if they are 20% or more of voting stock Equity securities transactions, if they are less than 20% of voting stock 20 to 50% > 50% Scopes of APB No.18 and SFAS No. 115 Scope: SFAS 115 Scope: APB No. 18 Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

6. Debt Securities Equity Securities Trading Available for Sale Held to Maturity Available for Sale Trading Investment Categories under SFAS 115 SFAS No. 115 Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

7. Equity Method Consolidations If 20% to 50% voting stock If more than 50% voting stock APB No. 118: Scope APB No. 118 applies to Equity Securities Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

8. TRADING Securities Available for Sale Held-to- Maturity Record at fair value Record at fair value Record at Amortized cost M.V.changes recorded as part of income M.V.changes recorded as other income or as part of equity M.V. changes not recognized Debt Securities: Types and Reported Amounts Debt Instruments representing a CREDITOR relationship Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

9. Held-to-Maturity Debt Securities • The operating entity has both: • a positive intent to hold the securities, and • the ability to hold them to maturity • These securities are accounted for at amortized cost, not fair value. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

10. Available-for-Sale Debt Securities • These investments are reported at fair value in the balance sheet. • Differences between the fair value and amortized cost are reported as unrealized holding gains and losses (part of equity) • When realized, gains and losses in fair value are reported as part of net income Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

11. Trading Securities • Trading securities are used to generate profits from short term differences in prices. • The holding period is usually less than 3 months • The securities are reported at fair value • Unrealized gains and losses are reported as part of net income • Any discount or premium is not amortized. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

12. Investments in Debt Securities: Example • Investment in debt security: (Issue at a discount) • Cost to investing entity: $ 924,183 • Par value: $ 1,000,000 • Discount $ 75,817 • Effective rate of interest: 10% • Stated (contractual) rate: 8% • Fair value of security: • End of year 1 $1,000,000 • End of year 2 $ 975,000 • Compute gains or losses for the three types of debt securities Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

13. Given:Investment in Debt Security Amortization Schedule (Discount Issue) Carrying Interest Cash Received Amortized Value (beg)Revenuefor Interestcost (end) 924,183 924,183 92,418 80,000 936,601 936,601 93,660 80,000 950,262 End of year Fair Value (in mil) 1,000,000 975,000 Effective rate = 10%; Stated Rate = 8%; Par = $1,000,000 Investments in Debt Securities: Example Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

14. Add to Trading Securities in balance sheet Report as income Investments in Debt Securities: Trading Security Compute gain: FMV less Acquisition cost $1,000,000 less $924,183 = $75,817 Securities Fair Value (Trading) 75,817 Unrealized Holding Gain or Loss - Income 75,817 Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

15. Report as part of equity Add to Trading Securities in balance sheet Investments in Debt Securities: Available-for-Sale Security (year 1) Determining Unrealized gain or loss: FMV end of year 1: $1,000,000 Amortized cost end of year 1 $ 936,601 Unrealized gain (year 1): $ 63,399 Securities Fair Value Adjustment 63,399 Unrealized Holding Gain or Loss 63,399 Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

16. Investments in Debt Securities: Available-for-Sale Security (year 2) Determining Unrealized gain or loss: FMV end of year 2: $ 975,000 Amortized cost end of year 2 $ 950,262 Unrealized gain (year 2): $ 24,738 Unreal. g & L: End of year 1: $63,399 credit End of year 2: $24,738 credit Reverse $38661 debit Unrealized Holding Gain or Loss 38661 Securities Fair Value Adjustment 38661 Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

17. Investments in Debt Securities: Held-to-Maturity Security • No entry is needed for fair value adjustment. • Fair value changes are not recognized at balance sheet date • Show security at amortized cost Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

18. Debt securities: TRANSFERS between categories • Concerns: • At what value is the security transferred? • How are gains and losses accounted for? • What is the effect of the gain/loss accounting on income and equity? Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

19. Transfers between Categories (1 of 4) Type of Measurement Impact of Impact of Transfer Basis Transfer on Transfer on Stockholders’ Equity Net Income Trading Transferred at Unrealized gains or Unrealized gains or tofair value to losses at date of losses at date of Available Available for transfer increase transfer are for Sale Sale category or decrease recognized in income. and is the new stockholders’ COST basis equity. of security Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

20. Transfers between Categories (2 of 4) Type of Measurement Impact of Impact of Transfer Basis Transfer on Transfer on Stockholders’ Equity Net Income From Transferred at The unrealized The unrealized Available fair value at the gains or losses at gains or losses at for date of transfer the date of the date of transfer Sale and becomes transfer increase is recognized to the new cost or decrease in income Trading basis of security stockholders’ equity Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

21. Transfers between Categories (3 of 4) Type of Measurement Impact of Impact of Transfer Basis Transfer on Transfer on Stockholders’ Equity Net Income From Transferred at Unrealized gains or None Held fair value at losses at date of to date of transfer transfer increase or Maturity decrease a separate to component of equity Available for Sale Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

22. Transfers between Categories (4 of 4) Type of Measurement Impact of Impact of Transfer Basis Transfer on Transfer on Stockholders’ Equity Net Income From Transferred at The unrealized gain None Available fair value at or loss (at date of for date of transfer transfer) is carried Sale as a separate to component of equity Held and is amortized to over the remaining Maturity life of the security Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

23. Part 2 : Investments in Equity Securities Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

24. Equity Securities • Equity securities represent ownership interests such as common, preferred, or other capital stock. • They include rights to buy and sell the ownership interests • Convertible debt and redeemable preferred stock are not equity securities for this purpose • The extent of ownership in common stock by an investor in an investee determines the accounting treatment forequity securities. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

25. Investments in Equity Interests: Control Ownership Percentage 0% 20%50% 100% Little Significant CONTROL or none Level of Influence Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

26. Investment in Equity Securities: Available for Sale Securities • Securities when acquired are recorded at cost • Subsequent to acquisition, the investments are valued and reported at fair value • Investor does not recognize its proportionate share of investee’s net income, unless dividends are declared by investee. • Unrealized holding gains and losses are reported as: • part of comprehensive income, and • a component of stockholders’ equity Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

27. Investment in Equity Securities: Trading • The accounting guidelines are the same as for the available for sale securities. • Unrealized gains and losses, however, are reported in net income. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

28. Investments in Equity Securities: Equity Method • A substantive economic relationship is acknowledged between the investor and the investee • The investment’s carrying value is increased by investor’s proportionate share of earnings • The investment’s carrying value is decreased by: • investor’s proportionate share of losses • dividends received by investee Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

29. Absence of Significant Influence by Investor: Examples • The FASB has provided examples of cases in which significant influence may not exist: • Investee opposes investor’s acquisition of stock • Investor surrenders significant shareholder rights • Investor is unable to obtain needed financial information from investee • Investor is unable to obtain representation on investee’s board of directors Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

30. Investments in Equity Securities: Consolidation • A voting interest of more than 50% results in a controlling interest • The investor is the parent corporation; the investee is the subsidiary corporation. • The investor prepares consolidated financial statements for the parent and the subsidiary • The investor accounts for the investment on its books by the equity method Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

31. Ownership in Capital Stock less than 20% of voting 20 - 50% of voting more than 50% voting Available for Sale Equity method Equity method Consolidation No Consolidation Trading Fair value Fair value Investments in Equity Securities: Summary Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

32. Equity Securities: Accounting by Category Category Valuation Unrealized Holding Other Income Gains and Losses Effects <20% Fair value Other income and Dividends and Avail for sale Equity G & L (sale) <20% Fair value Net income Dividends; Trading G & L (sale) 20% - Equity Not recognized Proportionate 50% investee’s inc >50% Consolidate Not recognized Not applicable Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

33. Derivatives in General • Derivatives are financial products, used for risk management • They are used primarily for purposes of hedging a company’s exposure to: • fluctuations in interest rates, • foreign currency exchange rates, and • commodity prices. • Speculators and arbitrageurs in the derivatives market provide liquidity to the market Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

34. Reporting Derivatives in Financials • Derivatives are reported as assets and liabilities and at fair value • Derivative gains and losses from speculation must be reported in income. • Derivative gains and losses from hedging transactions are reported in different ways, depending upon the type of the hedging transaction. Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

35. Accounting for Fair Value Hedges • The derivative in a qualifying fair value hedge is recorded at fair value in the balance sheet • The gains and losses (from adjustment to the hedged fair value) are recorded in income • The items hedged also are accounted for at fair value • Derivatives from cash hedges are accounted for at fair value. • The gains and losses from cash hedges are reported as other comprehensive income (in equity) Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)

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