Chapter 9--Learning Objectives 1. Explain the recognition and measurement issues associated with investments 1

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 2

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 3

Passive investments and significant influence A 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 11

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 12

Accounting requirements for Trading securities (investments less than 20 percent) Changes in market value recognized as gain or loss in current period income Securities reported at market value 4

Accounting requirements for Available-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 5

Accounting requirements for Held-to-maturity securities (debt securities only) Changes in market value not recognized Securities reported at amortized cost 6

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 7

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 8

(so much GAAP, so little time) Consolidate financial statements (equity investments of more than 50 percent) This material is beyond the scope of our course (so much GAAP, so little time) 9

Chapter 9--Learning Objectives 2. Record and report transactions for debt-security investments and equity-security investments of less than 20% 10

Held to maturity debt securities Record acquisitions at cost Investment in Debt Securities XXX Cash XXX Record interest as income Interest Income XXX 18

Held to maturity debt securities If purchased at premium, include in cost Investment in Debt Securities XXX Cash XXX Amortize by reducing investment value Interest Revenue XXX Investment in Debt Securities XXX 19

Held to maturity debt securities If purchased at discount, record at cost Investment in Debt Securities XXX Cash XXX Amortize by increasing investment value Interest Revenue XXX 20

Held to maturity debt securities Ignore market value changes for held to maturity debt securities ! 21

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 25

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 22

Available for sale debt securities If market value is above amortized cost Adjustment to Market XXX Unrealized 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 23

Available for sale debt securities If market value is below amortized cost Unrealized Holding Loss XXX Adjustment 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 24

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 XXX Cash XXX Record dividends and interest as income Dividend Income XXX 13

Accounting for equity trading securities If market value on reporting date is lower than original cost Loss on Holding Equity Securities XXX Invest. in Trading Securities XXX If market value is higher than cost Invest. in Trading Securities XXX Gain on Holding Equity Sec. XXX 14

Available for sale equity securities Record acquisitions at cost Investment in AFS Securities XXX Cash XXX Record dividends and interest as income Dividend Income XXX 15

Available for sale equity securities If market value on reporting date is lower than original cost Unrealized Loss on AFS Sec. XXX Investment 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 16

Available for sale equity securities If market value on reporting date is higher than original cost Investment in AFS Securities XXX Unrealized 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 17

Transfers between categories Base classification on management intent Transfer between categories based on fair market value at time of transfer Recognize any unrealized holding gain or loss at time of transfer Include in income for securities transferred into or from trading category Show as separate stockholders’ equity item for securities transferred into available for sale category from held-to-maturity 26

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% 27

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 28

Equity method procedures Record purchase of investment at cost Investment in Other Company XXX Cash XXX 29

Equity method procedures Increase investment value on reported earnings Investment in Other Company XXX Investment Income XXX Decrease investment value on reported losses Investment Income (Loss) XXX Investment in Other Company XXX 30

Equity method procedures Decrease investment value on dividends Cash XXX Investment in Other Company XXX 31

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) 32

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 33

Chapter 9--Learning Objectives 4. Record and report transactions for funds and life insurance investments 34

Funds set aside for retirement of debts Sinking funds Funds set aside for retirement of debts 35

Accounting for funds Recording contributions to fund Sinking Fund Cash XXX Cash XXX Recording purchase of fund investments Sinking Fund Investments XXX Sinking Fund Cash XXX 36

Accounting for funds Receipt of investment income Sinking Fund Cash XXX Sinking Fund Revenue XXX Payment of expenses Sinking Fund Expense XXX Sinking Fund Cash XXX 37

Accounting for funds Sale of investments Sinking Fund Cash XXX Sinking Fund Investments XXX Gain on Sale of Inv. XXX 38

Accounting for funds Bond maturity and closing of fund Bonds Payable XXX Cash XXX Sinking Fund Cash XXX 39

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 40

Life insurance entries for policies with cash surrender value Payment of premium Life Insurance Expense XXX Cash Surrender Value of LI XXX Cash XXX 41

Life insurance entries for 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 42

Chapter 9--Learning Objectives 5. Analyze the impact of the different accounting methods for investments on profitability and liquidity measures 43

The differences between the methods of accounting for investments can 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 44

The differences between the methods of accounting for investments can affect liquidity Trading securities and some available for sale securities are treated as current assets But other investments are not classified as current assets 45

Chapter 9--Learning Objectives 6. Understand the concept and complexities associated with derivative financial instruments 46

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 47

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