1. 14-1 Intermediate Accounting,17E Stice | Stice | Skousen © 2010 Cengage Learning PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University Investments in Debt and Equity Securities

2. 14-2 Why Companies Invest in Other Companies Safety cushion Cyclical cash needs Investment for a return Investment for influence Purchase for control

3. 14-3 Classifications of Investment Securities Debt securities are financial instruments issued by a company that (1) have a maturity value, (2) have a fixed or variable interest rate that specifies the periodic interest payments, and (3) a maturity date. Equity securities represent ownership in a company.

4. 14-4

5. 14-5 Held-to-Maturity Securities Held-to-maturity securities are debt securities purchased by a company with the intent to hold those securities until they mature. This category includes only debt securities because equity securities typically do not mature.

6. 14-6 Available-for-Sale Securities Available-for-sale securities are equity securities that are not considered trading securities and are not accounted for using the equity method. Debt securities that are not being held until maturity and are not classified as trading securities are considered to be “available-for-sale” securities.

7. 14-7 Trading Securities Trading securities are debt and equity securities purchased with the intent of selling them in the near future.

8. 14-8 Equity Method Securities Equity method securities are equity securities purchased with the intent of being able to control or significantly influence the operations of the investee. A large block of stock (presumably at least 20% of the outstanding stock) must be owned to be considered for classification as an equity method security.

9. 14-9 Classification of Investment Securities According to IFRS The classification of investment securities under IFRS, specifically IAS 39, is essentially the same as under U.S. GAAP. IAS 39 is broader in scope than SFAS No 115. IAS 39 includes guidance on accounting for derivatives and accounting for loans and receivables.

10. 14-10 Purchase of Debt Securities On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9% payable semiannually on January 1 and July 1. The debt securities are classified by the purchaser as trading securities. Accrued interest on May 1 is $3,000, calculated as follows: $100,000 ×.09 × 4/12 = $3,000

11. 14-11 Purchase of Debt Securities Asset Approach May 1Investment in Trading Securities 104,250 Interest Receivable 3,000 Cash 107,250 July 1Cash 4,500 Interest Receivable 3,000 Interest Revenue 1,500

12. 14-12 Purchase of Debt Securities Revenue Approach May 1Investment in Trading Securities 104,250 Interest Revenue 3,000 Cash 107,250 July 1Cash 4,500 Interest Revenue 4,500

13. 14-13 Purchase of Equity Securities Gondor Enterprises purchased 300 shares of Boromir Co. stock at $75 per share plus brokerage fees of $80 (as trading securities) and 500 shares of Faramir Inc. stock at $50 per share plus brokerage fees of $30 (as available-for-sale securities). Investment in Trading Securities— Boromir Co.22,580 Investment in Available-for-Sale Securities—Faramir Inc.25,030 Cash47,610

14. 14-14 Recognition of Revenue from Debt Securities Assume that on January 1, 2010, Silmaril Technologies purchased 5- year, 10% bonds with a face value of $100,000 and interest payable semiannually on January 1 and July 1. The market rate on similar bonds is 8%. The first step is to calculate the market price of the bonds. (continues)

15. 14-15 Present value of principal: FV = $100,000; N = 10; I = 4%$ 67,556 Present value of interest payments: PMT = $5,000; N = 10; I = 4% 40,554 Recognition of Revenue from Debt Securities When interest is received: Cash5,000 Interest Revenue5,000 Total present value of the bonds$108,110 Investment in Trading Securities108,110 Cash108,110 When trading securities are purchased:

16. 14-16 Interest Revenue for Debt Securities (Held-to-Maturity) The initial purchase: Investment in Held-to-Maturity Securities108,110 Cash108,110

17. 14-17 Interest Revenue for Debt Securities (Held-to-Maturity) When the first interest payment is received: Cash5,000 Interest Revenue4,324 Investment in Held-to-Maturity Securities676 (continues)

18. 14-18 Interest Revenue for Debt Securities (Held-to-Maturity) When the second interest payment is received: Cash5,000 Interest Revenue4,297 Investment in Held-to-Maturity Securities703

19. 14-19 Recognition of Revenue from Equity Securities In those instances where the level of ownership in the investee is such that the investor is able to control or significantly influence decisions made by the investee, the use of the equity method is appropriate.

20. 14-20 Recognition of Revenue from Equity Securities Significant influence may be indicated by decisions affecting—  Dividend distribution  Participation in the policy-making process  Intercompany transactions  Interchange of management personnel  Technical dependency of investee on investor  Percentage of outstanding voting stock owned

21. 14-21 Determining the Appropriate Accounting Method 0% 20%50%100% No significant influence Significant influence Control Ownership Percentage Account for as trading or available-for-sale Equity method Equity method and consolidation procedures

22. 14-22 Revenue for Equity Securities Classified as Trading and Available for Sale The journal entry to record receipt of the dividends would be: Cash2,475 Dividend Revenue2,475 [(300 × $2.00) + (500 × $3.75) = $2,475]

23. 14-23 Revenue for Securities Classified As Equity Method Securities BioTech Inc. purchased 40% of the outstanding stock of Medco Enterprises on January 1 of the current year by paying $200,000. During the year, Medco reported net income of $50,000 and paid dividends of $10,000. (continues) Investment in Medco Enterprise Stock: Investment in Medco Enterprise Stock200,000 Cash200,000 To record the purchase of 40% of Medco stock.

24. 14-24 Recognize a percentage of net income: Investment in Medco Enterprise Stock20,000 Income from Investment in Medco Enterprises Stock ($50,000 × 0.40)20,000 To record the recognition of revenue from investment in Medco. Record receiving a dividend: Cash ($10,000 × 0.40)4,000 Investment in Medco Enterprises Stock 4,000 To record the receipt of dividend on Medco stock. Revenue for Securities Classified As Equity Method Securities

25. 14-25 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. Based on the ownership interest, 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. The remaining $75,000 is attributed to a special operating license. (continues)

26. 14-26 Equity Method: Purchase for More than Book Value The average remaining life of the depreciable assets is 10 years and the license is to be amortized over 20 years. Phillips Manufacturing Co. would adjust its share of Stewart Inc.’s net income as follows: (continues) Additional depreciation ($50,000 × 0.40)/10$2,000 License amortization ($75,000 × 0.40)/20 1,500 $3,500

27. 14-27 Equity Method: Purchase for More than Book Value Each year for the first 10 years, Phillips would make the following entry in addition to entries made to recognize its share of Stewart’s income and dividends. (continues) Income from Investments in Stewart Inc. Stock3,500 Investment in Stewart Inc. Stock3,500 To adjust share of income on Stewart Inc. common stock for proportionate depreciation on excess of market value of depreciable property, $2,000, and for amortization of the unrecorded license, $1,500.

28. 14-28 Equity Method: Purchase for More than Book Value After the 10 th year, the adjustment would be for $1,500 until the license amount is fully amortized. Stewart Inc. declared and paid dividends of $70,000 during 2011 and reported net income of $150,000 for the year. The investment would be shown on Philip’s balance sheet as follows:

29. 14-29 Equity Method: Joint Venture A joint venture is a form of off- balance-sheet financing. Joint ventures are accounted for using the equity method. Even if the joint venture does not have a 50–50 ownership structure, the minority interest will still account for the joint venture using the equity method.

30. 14-30 Eastwood Incorporated purchased the following securities on March 23, 2011. Their fair value is shown as of December 31, 2011. (continues) Accounting for the Change in Value of Securities

31. 14-31 Initial Purchase Entry—2011 Investment in Trading Securities11,000 Investment in Available-for-Sale Securities17,000 Investment in Held-to-Maturity Securities20,000 Cash 48,000 (continues) Accounting for the Change in Value of Securities

32. 14-32 By the end of 2011, the value of the trading securities decreased from $11,000 to $10,500. December 31, 2011: Unrealized Loss on Trading Securities500 Market Adjustment—Trading Securities500 Trading Securities—2011 (continues) Accounting for the Change in Value of Securities

33. 14-33 December 31, 2011: Market Adjustment—Available-for-Sale Securities600 Unrealized Increase/Decrease in Value of Available-for-Sale Securities600 By the end of 2011, the value of the available-for-sale securities increased from $17,000 to $17,600. Available-for-Sale Securities—2011 (continues) Accounting for the Change in Value of Securities

34. 14-34 Accounting for the Change in Value of Securities Note below that Security 5 has decreased in value from $20,000 to $19,000. However, because this security is classified as held-to- maturity, no adjustment is made. Held-to-Maturity Securities—2011 (continues)

35. 14-35 (continues) Trading Securities—2012 Accounting for the Change in Value of Securities By the end of 2012, trading securities have increased in value from $10,500 to $11,300.

36. 14-36 Accounting for the Change in Value of Securities The adjusting entry is as follows: Market Adjustment—Trading Securities800 Unrealized Gain on Trading Securities800 (continues) Trading Securities—2012

37. 14-37 Accounting for the Change in Value of Securities Available-for-Sale Securities—2012 (continues) At the end of 2011, available-for-sale securities had a fair value of $17,600. At the end of 2012, the fair value is $17,200.

38. 14-38 Accounting for the Change in Value of Securities (continues) The adjusting entry is as follows: Unrealized Increase/Decrease in Value of Available- for-Sale Securities ($17,600 ─ $17,200)400 Market Adjustment—Available-for-Sale Securities400 Available-for-Sale Securities—2012

39. 14-39 Held-to-Maturity Securities—2012 By the end of 2012, Security 5 had increased in value from $19,000 to $20,700. Recall in Slide 14-51 that no loss was recorded when the fair value dropped to $19,000. (continues) Accounting for the Change in Value of Securities

40. 14-40 Held-to-Maturity Securities—2012 The fair value of the held-to-maturity securities of $20,700 would not be used to adjust the reported balance sheet amount. The $20,700 fair value would be disclosed in the notes to the financial statements. Accounting for the Change in Value of Securities

41. 14-41 Determining Whether a Decline in Fair Value is Other Than Temporary In SAB No. 59, the SEC staff suggests that one consider the following in determining whether a decline in fair value is other than temporary:  How long has the fair value of the security been below its original cost?  What is the current financial condition of the investee and its industry?  Will the investor’s plans involve holding the security long enough for it to recover its value?

42. 14-42 Sale of Securities For Silmaril Technologies (from Slide 14-14), assume that the debt securities are sold on April 1, 2012, for $103,000, which includes accrued interest of $2,500. The carrying value of the debt security on January 1, 2012, is $105,240. (continues) To go to Slide 14-14, left click on the button using your mouse. To return, type “42” and press “Enter.”

43. 14-43 Sale of Securities To record accrued revenue and amortize premium: Apr. 1 Interest Receivable2,500 Investment in Held-to-Maturity Securities395 Interest Revenue2,105 Entry to record sale: Apr. 1 Cash 103,000 Realized Loss on Sale of Securities 4,345 Interest Receivable2,500 Investment in Held-to-Maturity Securities104,845

44. 14-44 Impact of Sale of Securities on Unrealized Gains and Losses At the beginning of Year 1, Levi Company purchased trading securities for $10. At the end of Year 1, the securities had a value of $12. At the end of Year 2, the same securities are sold for $9. Unrealized Loss— Trading 2 Trading 2 Market Adjust- Market Adjust- ment—Trading 2 ment—Trading 2 (continues)

45. 14-45 Impact of Sale of Securities on Unrealized Gains and Losses When the securities are sold at the end of Year 2 for $9, the entry will reflect only a $1 loss. Year 2 Cash9 Realized Loss—Trading1 Investment Securities—Trading10

46. 14-46 Derecognition Bank A has the following balance sheet: (continues) Bank A is required by government regulation to maintain equity of at least 5% of total assets and is currently in compliance.

47. 14-47 Derecognition If Bank A gets a normal loan for $100, its balance sheet will appear as follows: (continues) Bank A is now in violation of its equity requirement; equity is just 2.5% of total assets.

48. 14-48 Derecognition As an option, Bank A can set up a service entity called QSPE (qualifying special purpose entity). Under the supervision of Bank A, QSPE raises $100 cash by borrowing $90 and receiving $10 as an investment from Bank A. QSPE uses that money to “buy” the mortgage receivable from Bank A. (continues)

49. 14-49 Derecognition After Bank A “sells” the $100 mortgage receivable asset to QSPE, the balance sheet appears as follows: The process described in Slides14-46 through 14-49 is called derecognition.

50. 14-50 Derecognition According to SFAS No. 140, a transfer of a financial asset is accounted for as a sale (resulting in derecognition) when the transfer satisfies the following three conditions: Legal control: The transferor has given up legal claim to the assets meaning that even if it declares bankruptcy its creditors cannot go after the transferred assets. (continues)

51. 14-51 Derecognition Actual control: The transferor cannot prevent the transferee from using the transferred assets however desired, such as selling them or pledging them as collateral for a loan. Effective control: The transferor does not have the right to force the transferee to return the assets, such as with a repurchase agreement.

52. 14-52 Transferring Securities Between Categories The Eastwood Inc. example used earlier will serve to demonstrate transferring securities between categories. As of December 31, 2012, Eastwood Inc. had the following securities: (continues)

53. 14-53 Transferring Securities Between Categories During 2013, Eastwood Inc. elects to reclassify certain of its securities as shown below. (continues)

54. 14-54

55. 14-55 From the Trading Security Category Eastwood Inc. elects to reclassify security 2 from a trading security to an available-for-sale security. Investment in Available-for-Sale Securities3,800 Market Adjustment—Trading Securities600 Unrealized Gain on Transfer of Securities 200 Investment in Trading Securities 3,000

56. 14-56 Into the Trading Security Category Eastwood Inc. elects to reclassify security 4 from an available-for-sale security to a trading security. Investment in Trading Securities10,300 Market Adjustment—Available-for- Sale Securities1,300 Unrealized Loss on Transfer of Securities1,700 Unrealized Increase/Decrease in Value of Available-for-Sale Securities1,300 Investment in Available-for-Sale Securities 12,000

57. 14-57 From the Held-to-Maturity to the Available-for-Sale Category Eastwood Inc. elects to reclassify security 5 from a security being held until maturity to one that is available to be sold. Investment in Available-for-Sale Securities20,400 Unrealized Increase/Decrease in Value of Available-for-Sale Securities400 Investment in Held-to-Maturity Securities 20,000

58. 14-58 Eastwood Inc. elects to reclassify security 3 from one that is available to be sold to a security that will be held until maturity. Investment in Held-to-Maturity Securities5,900 Unrealized Increase/Decrease in Value of Available-for-Sale Securities600 Investment in Available-for-Sale Securities 5,000 Market Adjustments—Available-for- Sale Securities1,500 From the Held-to-Maturity to the Available-for-Sale Category

59. 14-59 Cash Flows from Gains and Losses on Available-for-Sale Securities Caesh Company began with a $1,000 investment on January 1, 2011. Cash sales $1,700 Cash 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, 2011. (continues)

60. 14-60 (continues) Cash Flows from Gains and Losses on Available-for-Sale Securities Caesh Company’s net income for 2011 can be computed as follows: Sales $1,700 Expenses (1,400) Operating income$300 Realized loss on sale of securities ($200 ─ $170) (30) Net income$ 270

61. 14-61 The statement of cash flows for Caesh Company for 2011 can be prepared as follows: Cash Flows from Gains and Losses on Available-for-Sale Securities

62. 14-62 If the investment securities purchased by Caesh Company are classified as trading securities and are deemed to have been acquired for operating purposes, the unrealized gain appears in the operating activities section. Cash Flows from Gains and Losses on Trading Securities

63. 14-63 Required Additional Disclosures 1. Trading securities  The change in net unrealized holding gain or loss that is included in the income statement. 2. 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. (continues)

64. 14-64 Available-for-sale securities (continues):  The change in net unrealized holding gain or loss on available-for-sale securities that has been included in stockholders’ equity during the period. 3. Held-to-maturity securities:  Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type. (continues) Required Additional Disclosures

65. 14-65 4.Transfer of securities between categories:  Gross gains and losses included in earnings from transfers of securities from available- for-sale into the trading category.  For securities transferred from held-to- maturity, the company should disclose the amortized cost amount transferred, the related realized or unrealized gain or loss, and the reason for transferring the security. Required Additional Disclosures

66. 14-66 Accounting for the Impairment of a Loan A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. For loans with no market value, impairment is measured by comparing the present value of expected future cash flows with the carrying value of the investment.

67. 14-67 Accounting for the Impairment of a Loan Malone Enterprises reports a loan receivable from Stockton Co. in the amount of $500,000. The repayment terms include a 10% interest rate plus annual principal payments of $100,000 on January 1 of each year. The loan was made on January 1, 2009. Stockton made the $50,000 interest payment in 2009 but did not make the $100,000 principal payment nor the $50,000 interest payment in 2010. (continues)

68. 14-68 Accounting for the Impairment of a Loan Analysis of Stockton’s financial condition indicates the principal and interest currently due can probably be collected, but it is probable that no further interest can be collected. The probable amount and timing of the collections is determined as follows: (continues)

69. 14-69 Accounting for the Impairment of a Loan The present value at December 31, 2010, of the expected future cash flows discounted at 10% for the Stockton receivable is $455,860. (continues)

70. 14-70 Accounting for the Impairment of a Loan The impairment loss to be reported for 2010 is $94,140, or the carrying value ($550,000) less the present value ($455,680). (continues) 2010 Dec. 31 Bad Debt Expense94,140 Allowance for Loan Impairment94,140 If Stockton makes the payments as projected, the amortization schedule in Slide 14-71 provides information for the necessary entries.

71. 14-71 Accounting for the Impairment of a Loan