1. CHAPETR 12: INVESTMENTS Learning Objectives
Demonstrate how to identify and account for investments classified for reporting purposes as held-to-maturity.
2. Demonstrate how to identify and account for investments classified for reporting purposes as trading securities.
Demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale securities.
8. Discuss the primary differences between U.S. GAAP and IFRS with respect to investments.
NOT COVERED
4. Explain what constitutes significant influence by the investor over the operating and financial policies of the investee.
5. Demonstrate how to account for investments accounted for under the equity method.
6. Explain the adjustments made in the equity method when the fair value of the net assets underlying the investment exceeds their book value.
7. Explain how electing the fair value option affects accounting for investments.

2. Common and preferred stock
Nature of Investments
Bonds and notes
(Debt securities)
Common and preferred stock
(Equity securities)
To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities, also called financial instruments, are purchased as investments by individual investors, mutual funds, and also by other corporations. Our focus in this chapter is on the corporations that invest in securities issued by other corporations as well as those issued by governmental units (bonds, Treasury bills, and Treasury bonds).
Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

3. Reporting Categories for Investments
To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities are purchased as investments by individual investors, mutual funds, and also by other corporations. In later chapters we discuss equity and debt securities from the perspective of the issuing company. Our focus in this chapter is on the corporations that invest in debt and equity securities issued by other corporations as well as debt securities issued by governmental units (bonds, Treasury bills, and Treasury bonds).
Most companies invest in financial instruments issued by other companies. For some investors, these investments represent ongoing affiliations with the companies whose securities are acquired.

4. Investor Lacks Significant Influence
When the investor lacks significant influence over the investee, the investment is classified in one of three categories: held-to-maturity securities (HTM), trading securities (TS), and available-for-sale securities (AFS). Each type of investment has its own reporting method. However, regardless of the investment type, investors can elect the “fair value option” that we discuss later in the chapter and classify HTM and AFS securities as TS. The key difference among the reporting approaches is how we account for unrealized holding gains and losses.

5. Securities to Be Held to Maturity
Securities are investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the “positive intent and ability” to hold the securities to maturity and can therefore be classified as held-to-maturity (HTM).
They are reported on the balance sheet at “amortized cost.”
Amortized cost (Face amount less unamortized discount, or plus unamortized premium).
Securities are investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the “positive intent and ability” to hold the securities to maturity and can therefore be classified as held-to-maturity (HTM).
They are reported on the balance sheet at “amortized cost.” Amortized cost is equal to the face amount of the debt less any unamortized discount, or plus any unamortized premium. If management decides to sell the securities prior to maturity, they will be reclassified to trading securities. We will discuss trading securities later in the presentation.
Balance
Sheet

6. Securities to Be Held to Maturity
On January 1, 2013, Matrix Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%. Let’s look at the calculation of the present value of the bond issue.
Present
Amount
PV Factor
Value
Interest
$ ,000 × =
$573,496
Principal
1,000,000
311,805
Present value of bonds
$885,301
PV of ordinary annuity of $1, n = 20, i = 6%
On January 1, 2013, Matrix Inc. purchased as an investment $1,000,000 of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%. Let’s look at the calculation of the present value of the bond issue. The interest annuity is $50,000 ($1,000,000 times 10% equals $100,000, divide $100,000 by 2 for $50,000 cash interest). Look at the present value of an ordinary annuity of $1 table. Find the 20 periods row and move across to the 6% column to find the factor of Go to the present value of $1 table and follow the same procedures to arrive at the present value factor of The present value of the bonds at 12% return is $885,301.
PV of $1, n = 20, i = 6%

7. Securities to Be Held to Maturity
Partial Bond Amortization Table
January 1, 2013
Investment in bonds 1,000,000
Discount on bond investment ,699
Cash ,301
Here is a partial amortization table for the bonds purchased on January 1, 2013, with the intent of holding them to maturity. The bonds were priced as $885,301, to yield Matrix a 12% return with interest compounded semi-annually on June 30 and December 31. Let’s look at the journal entry to record the initial purchase of the bonds and the subsequent receipt of the first interest amount.
On January 1, Matrix will debit investment in bonds for the face amount of $1 million, credit discount on bond investment for $114,699, and credit cash for $885,301. On June 30, the first payment is due to Matrix. The journal entry is to debit cash for $50,000, debit discount on bonds payable for $3,118, and credit interest revenue for $53,118. The interest revenue is determined by taking 6% of the carrying value of the bonds, which is $885,301. The $50,000 cash received is determined by multiplying the face amount of the bonds, $1 million, by 5%, the stated rate. The difference between the calculated interest revenue and the cash interest received represents the amortization of the bond discount.
June 30, 2013
Cash (stated rate × face amount) ,000
Discount on bond investment ,118
Investment revenue ,118

8. Securities to Be Held to Maturity
This investment would appear on the June 30, 2013, balance sheet as follows:
$114,699 - $3,118 = $111,581 unamortized discount
As of June 30, discount on the bond investment account has been reduced to $111,581. The amortized amount of the investment is $888,419. If a balance sheet were prepared as of June 30, the investment in bonds would be shown at $888,419. We do not recognize unrealized holding gains and losses for HTM investments.
Unrealized holding gains and losses are not recognized for HTM investments.

9. Securities to Be Held to Maturity
On December 31, 2013, after interest is received by Matrix, all the bonds are sold for $900,000 cash.
December 31, 2013
Cash 50,000
Discount on bond investment 3,305
Investment revenue 53,305
On December 31, 2013, Matrix receives $50,000 cash interest. The journal entry to record the receipt is to debit cash for $50,000, debit discount on bonds payable of $3,305, and credit investment revenue for the total of $53,305.
Immediately after the receipt of interest, Matrix sells its investment in bonds for $900,000 cash. The entry to record the sale is to debit cash for the proceeds of $900,000, eliminate the unamortized discount with a debit to discount on bonds payable for $108,276, credit the investment in bonds for $1,000,000, and credit the realized gain on sale of investment for $8,276 (the difference between the cash received of $900,000 and the carrying value of the investment of $891,724).
December 31, 2013
Cash ,000
Discount on bond investment 108,276
Investment in bonds 1,000,000
Gain on sale of investment ,276

10. Trading Securities Income Statement Unrealized Gain Unrealized Loss
Investments in debt or equity securities acquired principally for the purpose of selling them in the near term. Adjustments to fair value are recorded
in a valuation account called fair value adjustment, or as a direct adjustment to the investment account.
as a net unrealized holding gain/loss on the income statement.
Unrealized Gain
Unrealized Loss
Trading securities are investments in debt or equity securities acquired principally for the purpose of selling them in the near term. The holding period for trading securities generally is measured in hours and days rather than months or years. These investments typically are reported among the investor’s current assets. Trading securities initially are recorded at cost including any brokerage fees. When a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value, or “marked to market.” These adjustments are typically made to a fair value adjustment account, but could also be made directly to the investment account.
Income Statement

11. Trading Securities
Matrix Inc. purchased securities classified as Trading Securities (TS) on December 22, The fair value amounts for these securities on December 31, 2013, are shown below. Prepare the journal entries for Matrix Inc. to show the purchase of the securities, and adjust the securities to fair value at 12/31/13.
On December 22, 2013, Matrix purchases 1,000 shares of Mining Inc. and 1,500 shares of Toys and Things to be held as trading securities. The cost of these securities are shown on the table at the bottom of your screen. On December 31, 2013, the fair value of the Mining Inc. shares is $41,000, and the fair value of Toys and Things shares is $20,000. Let’s see how we record the purchase of the shares and the unrealized holding loss on the securities.

12. Trading Securities
December 22, 2013
Investment in Mining Inc. stock ,000
Investment in Toys and Things stock 22,500
Cash ,500
On December 22, 2013, Matrix purchases shares of stock and classified these shares as trading securities. The journal entry to record the investments is to debit investment in Mining Inc. stock for $42,000 and debit investment in Toys and Things stock for $22,500, with a credit to cash for the total amount of $64,500.
At December 31, 2013, the journal entry required is to debit net unrealized holding gains and losses ― on the Income Statement (IS) for $3,500, and credit the fair value adjustment account for the same amount. The net unrealized holding loss will be reported in the current period income statement. The fair value adjustment account is an allowance account netted against the investment account on the balance sheet, so that the investment is carried at fair value. Also, any interest revenue is handled the same as with HTM investments, and any dividend revenue is handled similarly, with a debit to cash and a credit to investment revenue.
Reported on the balance sheet as a adjunct account to the investment.
December 31, 2013
Net unrealized holding gains and losses – I/S 3,500
Fair value adjustment ,500
The Net Unrealized Holding Loss is reported on the Income Statement.

13. Trading Securities
On January 3, 2014, Matrix sold all trading securities for $65,000 cash. Let’s record the entry for the sale and the adjustment to the fair value adjustment account.
January 3, 2014
Cash ,000
Investment in Mining, Inc. stock – T/S 42,000
Investment in Toys and Things stock – T/S 22,500
Gain on sale of investment
December 31, 2014
Fair value adjustment ,500
Net unrealized holding gains or losses – I/S 3,500
On January 3, 2014, Matrix sold all its trading securities for $65,000 cash. The entry to record the sale is to debit cash for $65,000, credit each trading security for its cost, and credit gain on sale of investments for $500.
In the period of sale, the fair value adjustment associated with the sold investment is eliminated, typically as part of the normal valuation process at the end of the period. This also has the effect of backing out of income any unrealized gains and losses that were recognized in prior periods, which avoids the double accounting that would result from including gains and losses both when unrealized (because fair value changes) and when realized (because the investment is sold). So, in our example, we eliminate the fair value adjustment with a debit of $3,500, and credit net unrealized gain or loss for the same amount.
Note that before-tax income is decreased by $3,500 in 2013 and increased by $4,000 (the $500 realized gain and the reversal of $3,500 of unrealized losses recorded previously) in So, over the life of the investment, the total effect on net income is ($3,500) + $4,000, or $500, equal to the realized gain on sale. The unrealized gains and losses show the effects of fair value changes in net income, but in the end the financial statements end up accumulating to equal the realized gain or loss associated with the investment.

14. Financial Statement Presentation
Trading securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income.
Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.
Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations.
Trading securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income
Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.
Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations. However, as discussed in more detail later, it may be appropriate to classify cash flows from buying and selling some trading securities as investing activities if they are not held for sale in the near term (which is particularly likely when an investment is classified as a trading security as a result of electing the fair value option).

15. Financial Statement Presentation
Presented below are the partial financial statements showing the accounting for TS owned by Matrix:
Presented below are the partial financial statements of the trading securities owned by Matrix for the years ended December 31, 2013 and Notice the reporting of realized and unrealized gains and losses on investments that are reported on the income statement. The interest and dividends were received from the investments. The purchase and sale of the securities are classified as operating activities in the statement of cash flows because they will be traded in the near term.

16. Securities Available-for-Sale
Investments in debt or equity securities that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS).
Adjustments to fair value are recorded
in a valuation account called fair value adjustment, or as a direct adjustment to the investment account.
as a net unrealized holding gain/loss in other comprehensive income (OCI), which accumulates in accumulated other comprehensive income (ACOI).
When an investment is not classified as an HTM or trading security, it is classified as an allowance as available-for-sale (AFS). Available-for-sale securities are recorded on the balance sheet at fair value subsequent to acquisition. Adjustments to fair value are recorded in account called fair value adjustment, or as a direct adjustment to the investment account. The net unrealized holding gains or losses is shown in the account other comprehensive income (OCI), which accumulates in accumulated other comprehensive income (ACOI).
The big concern is that including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than it really is. For example, many companies purchase AFS investments for the purpose of having the changes in fair value of those investments offset changes in the fair value of liabilities. This hedging insulates the company from risk and ensures that earnings are stable. However, if fair value changes for investments were to be recognized in income (as is the case with trading securities), but the offsetting fair value changes for liabilities were not recognized in income as well, we could end up with income appearing very volatile when in fact the underlying assets and liabilities are hedged effectively.
Unrealized Gain
Unrealized Loss
Other Comprehensive Income (OCI)

17. Other Comprehensive Income (OCI)
When we add other comprehensive income to net income we refer to the result as “comprehensive income.”
Other comprehensive income consists of the four elements shown and is reported net of aggregate income tax expense or benefit.

18. Accumulated Other Comprehensive Income
Unrealized holding gains and losses on available-for-sale securities are accumulated in the shareholders’ equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income (AOCI).
Shareholders’ Equity
Common stock
Paid-in capital in excess of par Accumulated other comprehensive income Retained earnings
Total shareholders’ equity
Net unrealized holding gains and losses.
Unrealized holding gains and losses on available-for-sale securities are reported in the shareholders’ equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income. The reason for this placement is that many in the business world believe that including unrealized holding gains and losses on available-for-sale securities would cause greater volatility in net income than was appropriate (or at least desired!).

19. Securities Available for Sale Example
Assume the same information for our T/S example for Matrix Inc., except that the investments are classified as available-for-sale securities rather than trading securities.
Assume the same information for our previous T/S example for Matrix Inc., except that the investments are classified as available-for-sale securities rather than trading securities. Recall that on December 31, 2013, we calculated a net unrealized holding loss of $3,500. Let’s see how we account for this net unrealized holding gain or loss on available-for-sale securities.
The adjusting entry on December 31, 2013, is to debit the net unrealized holding gains and losses for other comprehensive income for $3,500, and credit the fair value adjustment account for the same amount.
December 31, 2013
Net unrealized holding gains and losses – OCI 3,500
Fair value adjustment ,500

20. Financial Statement Presentation
AFS securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold.
Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.
Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.
AFS securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold.
Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.
Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

21. U. S. GAAP vs. IFRS
Until recently, IFRS did not allow transfers out of their “Fair Value through Profit and Loss” (FVTPL) classification.
U.S. GAAP also allows transfers out of the trading security category.
Reclassifications under U.S. GAAP are rare.
IAS No. 39 now allows transfer of debt investments out of the fair value category into AFS or HTM in “rare circumstances.”
The current financial crisis qualified as one of those circumstances.
Until recently, IFRS did not allow transfers out of their “Fair Value through Profit and Loss” (FVTPL) classification.
From the perspective of the IFRS,
IAS No. 39, now allows transfer of debt investments out of the fair value category into AFS or HTM in “rare circumstances.”
The current financial crisis qualified as one of those circumstances.
However,
IAS No. 39 increases convergence to U.S. GAAP, which also allows transfers out of the trading security category.
Reclassifications under U.S. GAAP are rare.

22. U. S. GAAP vs. IFRS
IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at “Fair Value Through Profit & Loss” (FVTPL), and thus having unrealized gains and losses included in net income.
U.S. GAAP permits classification as HTM, AFS, and TS.
No significant tests are required to classify a debt investment.
There is no comparable FVTPL or FVTOCI classification.
Investments in debt securities are classified as either “Amortized Cost” or FVTPL.
To be classified as a debt investment, two important tests must be met. The current financial crisis qualified as one of those circumstances.
Investments in equity securities are classified as either “FVTPL” or “FVTOCI” (“Fair Value through Other Comprehensive Income).
IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at “Fair Value Through Profit & Loss” (FVTPL), and thus having unrealized gains and losses included in net income.
Investments in debt securities are classified as either “Amortized Cost” or FVTPL. Like the previous HTM classification, debt in the amortized cost classification is accounted for at (you guessed it) amortized cost. However, to be included in the amortized cost category, a debt investment has to meet both (a) the “cash flow characteristics” test (which requires that the debt instrument consist of only principal and interest payments) and (b) the “business model test” (which requires that the objective of the company’s business model is to hold the investment to collect the contractual cash flows rather than to sell the investment at a gain). If debt isn’t classified in “amortized cost,” it is classified in FVTPL—there is no equivalent to AFS accounting for debt under IFRS No. 9.
Investments in equity securities are classified as either “FVTPL” or “FVTOCI” (Fair Value through Other Comprehensive Income). If the equity is held for trading, it must be classified as FVTPL, but otherwise the company can irrevocably elect to classify it as FVTOCI. Like the previous AFS classification, equity in the FVTOCI category has unrealized gains and losses included in OCI. However, unlike AFS, realized gains and losses are not reclassified out of OCI and into net income when they are later sold. Rather, the accumulated gain or loss associated with a sold investment is just transferred from AOCI to retained earnings (both shareholders’ equity accounts), without passing through the income statement.

23. Transfers Between Reporting Categories
Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Securities are transferred at fair market value on the date of transfer.
At each reporting date, the appropriateness of the classification is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. Reclassifications are quite unusual, so when they occur, disclosure notes should describe the circumstances that resulted in the transfers.
When a security is reclassified between two reporting categories, the security is transferred at its fair value on the date of transfer. This table illustrates reclassification of securities from one category to another. We will concentrate of the proper handling of any unrealized gain or loss from the transfer at fair market value.

24. Impairment of Investments
Occasionally, an investment’s value will decline for reasons that are other-than- temporary (OTT).
For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an “other than temporary” decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.
Sometimes an investment will incur an other-than-temporary or permanent decrease in value. We refer to this as an impairment in value.
For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an other-than-temporary decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

25. U. S. GAAP vs. IFRS
Until recently, IFRS did not allow transfers out of the “fair value through P&L” (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP).
U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified.
Under IAS No. 39 transfers of debt investments out of the FVTPL category into AFS or HTM in “rare circumstances.”
The 2008 financial crisis qualifies as one of those “rare circumstances.”
Until recently, IFRS did not allow transfers out of the “Fair Value through P&L” (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP).
From the perspective of the IFRS,
In recent changes, IAS No. 39 allows transfers of debt investments out of the FVTPL category into AFS or HTM in “rare circumstances.”
The 2008 financial crisis qualifies as one of those “rare circumstances.”
However, U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified.

26. Financial Statement Presentation and Disclosure
Aggregate Fair Value
Gross realized & unrealized holding gains & losses
Maturities of debt securities
Amortized cost basis by major security type
Listed on this slide are six disclosures required for investments in securities classified as held-to-maturity, available-for-sale, or trading. Additional disclosures are also required.
Change in net unrealized holding gains and losses
Inputs to fair value estimates

27. Investor Has Significant Influence
Now we are going to change the accounting for investments dramatically. We are going to assume a company has acquired enough equity securities in another company to exert significant influence over the operating policies of that company. The presumption is that if the investor owns between 20 and 50 percent of the voting stock of the investee company, the investor is able to exert significant influence over the policies of the investee. Under these circumstances, the equity method of accounting for the investment is required.

28. Investor Has Significant Influence
Extent of Investor Influence
Reporting Method
Lack of significant influence (usually < 20% equity ownership)
Varies depending on classification previously discussed
Significant influence (usually 20% - 50% equity ownership)
Equity method
Has control (usually > 50% equity ownership)
Consolidation
We use the equity method for investments in equity securities that are large enough to allow us to exert significant influence, typically assumed as occurring when we own between 20% and 50% of the voting common stock. If we own more than 50% of the voting common stock, we use consolidation. Consolidated financial statements combine the separate financial statements of the parent and the subsidiary each period into a single aggregate set of financial statements as if there were only one company. The investor is referred to as the parent; the investee is termed the subsidiary. In a consolidation, if the acquisition price is more than the sum of the separate fair values of the acquired net assets (assets less liabilities), that difference is recorded as an intangible asset — goodwill.

29. What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if
the investee challenges the investor’s ability to exercise significant influence through litigation or other methods.
the investor surrenders significant shareholder rights in a signed agreement.
the investor is unable to acquire sufficient information about the investee to apply the equity method.
the investor tries and fails to obtain representation on the board of directors of the investee.
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if:
The investee challenges the investor’s ability to exercise significant influence through litigation or other methods.
The investor surrenders significant shareholder rights in a signed agreement.
The investor is unable to acquire sufficient information about the investee to apply the equity method.
The investor tries and fails to obtain representation on the board of directors of the investee.

30. A Single Entity Concept
Under the equity method
The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.
Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is:
Increased by the investor’s percentage share of the investee’s net income (or decreased by its share of a loss).
Decreased by dividends paid.
Under the equity method
The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.
Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is:
Increased by the investor’s percentage share of the investee’s net income (or decreased by its share of a loss).
Decreased by dividends paid.

31. Equity Method
On January 1, 2013, Wilmer Inc. acquired 45% of the equity securities of Apex Inc. for $1,350,000. On the acquisition date, Apex’s net assets had a fair value of $3,000,000. During 2013, Apex paid cash dividends of $150,000 and reported net income of $1,750,000.
What amount will Wilmer Inc. report on the balance sheet as Investment in Apex Inc. on December 31, 2013?
Let’s look at a rather straightforward example of the equity method. In this case, the investor acquires 45% of the voting common stock of the investee. The investor pays $1,350,000, for its proportionate share of net assets with a fair value of $3 million. During 2013, the investee reports earnings of $1,750,000 and pays cash dividends of $150,000. Let’s look at the accounting for this investment under the equity method.

32. Equity Method January 1, 2013 Investment in Apex Inc. stock 1,350,000
Cash ,350,000
2013
Investment in Apex Inc. stock ,500
Investment revenue ,500
On January 1, 2013, we paid $1,350,000 cash for 45 percent of the stock of Apex Inc. The fair value of the net assets of Apex was $3,000,000, and we acquired 45 percent of these net assets. The journal entry at date of acquisition will be to debit investment in Apex Inc. for $1,350,000, and credit cash for the same amount.
During 2013, Apex reported net earning of $1,750,000. Our share of the reported earning is $787,500 ($1,750,000 × 45 percent). The journal entry to recognize our share of the earnings of the investee is to debit the investment in Apex Inc. stock for $787,500, and credit investment revenue for the same amount.
During 2013, Apex declared and paid dividends of $150,000. Our share of the dividends is $67,500 ($150,000 × 45 percent). The journal entry to record the dividend received is to debit cash for $67,500, and to credit investment in Apex Inc. stock for the same amount. Note that dividends are not considered revenue under the equity method. Instead, that payment of cash to the investor is considered a partial liquidation of the investment.
2013
Cash ,500
Investment in Apex Inc. stock ,500

33. Equity Method Investment in Apex Inc.
Investment ,350, , % Dividends
45% Earnings ,500
Reported amount 2,070,000
The investment in Apex Inc. account will be shown in the balance sheet of the investor at $2,070,000. Notice that the dividends received reduces the investment account, and recognition of the proportionate share of earnings increases the investment account.
If the investee company had reported a loss, the investment account would have been reduced by the investor’s proportionate share of that loss.
If the investee had a loss, the investment account would have been reduced with a credit.

34. Equity Method
On January 1, 2013, Wilmer Inc. purchased 25% of the common stock of Apex Inc. for $180,000. At the date of acquisition, the book value of the net assets of Apex was $400,000, and the fair value of these assets is $600,000. During 2013, Apex paid cash dividends of $40,000, and reported earnings of $100,000.
Now let’s complicate our discussion of the equity method. Please read this information carefully, noting that the price Wilmer paid for 25% of Apex stock ($180,000) is greater than 25% of the fair value of Apex’s net assets ($150,000). That difference of price paid over fair value of net assets is viewed as a goodwill component of the purchase price. Notice also that the fair value of Apex’s net assets is greater than 25% of the book value of those net assets on Apex’s balance sheet (25% times $400,000 equals $100,000).

35. Equity Method
The excess of the fair value of net assets over book value of those net assets is 75% attributable to depreciable assets with a remaining life of 20 years and is 25% attributable to land. Wilmer uses the straight-line depreciation.
Of the $50,000 excess of the fair value over book value of those net assets on Apex’s balance sheet, 75% is attributable to depreciable assets with a remaining useful life of 20 years. Wilmer, the investor, uses the straight-line method to depreciate similarly owned assets. Wilmer must depreciate its share of the fair value of the depreciable assets at the time it made it investment. This will cause Wilmer’s share of that additional depreciation expense would be $1,875 per year. To capture this income effect, Wilmer will record that depreciation expense as a deduction of investment revenue and a deduction of the investment. Note that, because neither goodwill nor land is depreciated, Wilmer makes no adjustment for those items.

36. Equity Method January 1, 2013 Investment in Apex stock 180,000
Cash ,000
2013
Cash ,000
Investment in Apex stock ,000
Investment in Apex stock ,000
Investment revenue ,000
December 31, 2013
Investment revenue ,875
Investment in Apex stock ,875
Wilmer will record the following journal entries on its books during We are familiar with the first three entries: purchase of the investment, recognition of dividends received, and recording of our proportionate share of earnings reported by Apex. The only new entry is the last one. This is the entry to recognize the additional depreciation that Wilmer must record. The journal entry is to debit investment revenue and credit investment in Apex stock for $1,875. The additional depreciation reduces the investment revenue Wilmer recognized.

37. Changing From the Equity Method to Another Method
When the investor’s level of influence changes, it may be necessary to change from the equity method to another method.
At the transfer date, the carrying value of the investment under the equity method is regarded as cost.
When we change from the equity method to another method (such as TS or AFS) the accounting is quite easy. The carrying value of the investment at the date of transfer becomes the cost basis under the new method.

38. Changing from Another Method to the Equity Method
When the investor’s ownership level increases to the point where they can exert significant influence, the investor should change to the equity method.
At the transfer date, the recorded value is the initial cost of the investment adjusted for the investor’s equity in the undistributed earnings of the investee since the original investment.
When we change from another method to the equity method, we adjust the investment to appear as if we had always used the equity method. Thus, we adjust the cost basis of the investment for the total undistributed earnings of the investee since the date of the original acquisition. Undistributed earnings is defined as reported earnings minus dividends paid.

39. Changing from Another Method to the Equity Method
The original cost, the unrealized holding gain or loss, and the valuation account are closed.
A retroactive change is recorded to recognize the investor’s share of the investee’s earnings since the original investment.
Any unrealized holding gains or losses included in a valuation allowance account are closed at the date of transition from cost to equity. A retroactive adjustment is required to restate the investment for the total undistributed earnings since the date of original acquisition.

40. Fair Value Option The investment is carried at fair value.
GAAP allows companies to use a “fair value option” for HTM, AFS, and equity method investments.
The investment is carried at fair value.
Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the investments as trading.
For equity method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.
The fair value option is determined for each individual investment, and is irrevocable.
GAAP allows companies to use a “fair value option” for HTM, AFS, and equity method investments as long as
The investment is carried at fair value and
Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the investments as trading.
For equity method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.
The fair value option is determined for each individual investment, and is irrevocable.

41. Financial Instruments and Investment Derivatives
Cash.
Evidence of an ownership interest in an entity.
Contracts meeting certain conditions.
Investment Derivatives:
Value is derived from other securities.
Derivatives are often used to “hedge” (offset) risks created by other investments or transactions
Financial instruments include cash, evidence of ownership interest in an entity, and contracts meeting certain conditions. To be treated as a financial instrument will require a contract that (a) imposes on one entity an obligation to deliber cash (say accounts payable) or another financial instrument and (b) conveys to the second entity a right to receive cash (say accounts receivable) or another financial instrument, or A contract that (a) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms (say the issuer of a stock option) and (b) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms (say the holder of a stock option).
These financial instruments often are called derivatives because they “derive” their values or contractually required cash flows from some other security or index. For instance, an option to buy an asset in the future at a preset price has a value that is dependent on, or derived from, the value of the underlying asset. Their rapid acceptance as indispensable components of the corporate capital structure has left the accounting profession scrambling to keep pace. Derivatives are often used to “hedge” (offset) risks created by other financial investments or transactions.

42. Appendix 12A – Other Investments
It is often convenient for companies to set aside money to be used for specific purposes. In the short-term, funds may be set aside for
Petty cash funds.
Payroll accounts.
In the long-run, funds are often set aside to:
Pay long-term debt when it comes due.
Acquire treasury stock.
Special purpose funds set aside for the long-term are classified as investments.
Appendix 12A—Other Investments
Petty cash is considered a special-purpose fund because it is monies that are set aside for the payment of small business expenditures that require cash. We might use the petty cash fund to pay for postage, cab fare for employees, or meals when employees work overtime. Most companies establish a payroll account as a special-purpose fund. The balance in the payroll account shortly after payday should be zero. The special-purpose funds serve as a control mechanism for the company.
Some companies set up special-purpose funds for long-term purposes. These funds might include a sinking fund used to reacquire long-term debt or treasury stock.

43. Appendix 12A – Other Investments
It is a common practice for companies to purchase life insurance policies on key officers. The company pays the premium and is the beneficiary of the policy. If the officer dies, the company receives the proceeds from the policy. Some types of policies build a portion of each premium as cash surrender value. The cash surrender value of such a policy is classified as an investment on the balance sheet of the company.
It is a common business practice for companies to purchase life insurance policies for key officers and employees. The company pays the premium and is the beneficiary of the policy. If the policy is a “whole life” policy, it develops a cash surrender value. The cash surrender value of the life insurance policy is treated as an investment on the company’s balance sheet.

44. Appendix 12B – Impairment of Investments
If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (“OTT”) impairment loss in earnings.
We use a three-step process to determine whether an OTT impairment loss must be recognized: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) determine where to report the OTT impairment.
Appendix 12B—Impairment of Investments
If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (“OTT”) impairment loss in earnings. We use a three-step process to determine whether an OTT impairment loss must be recognized: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements.

45. Appendix 12B – Impairment of Investments
On this screen and the one following we will look at the proper treatment of impairment to an investment. If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (OTT) impairment loss in earnings. We don’t need to worry about OTT impairments for trading securities or other investments for which a company has chosen the fair value option, because all changes in the fair values of those investments (whether temporary or OTT) always are recognized in earnings. However, that is not the case for HTM and AFS investments. Declines in fair value typically are ignored for HTM investments and recorded in OCI for AFS investments.
Therefore, companies need to evaluate HTM and AFS investments to determine whether an OTT impairment loss has occurred.
We use a three-step process to determine whether an OTT impairment loss must be recognized and how that loss is to be measured and recorded: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements. The graphic on this screen and the next summarizes these steps.

46. Appendix 12B – Impairment of Investments
A temporary impairment of an equity investment is simply accounted for as an unrealized loss in OCI, as demonstrated previously for fair value declines in AFS securities. However, if the impairment is viewed as OTT, the investor recognizes the loss in the income statement, just as if the loss had been realized by selling the investment. Also, because the equity investment is classified as AFS, recognizing an OTT impairment likely will involve reclassifying amounts out of OCI that were recorded previously as unrealized gains or losses.
Debt investments can be classified either as HTM or AFS. If the debt impairment is considered OTT, the investor always writes the investment down to fair value in the balance sheet, but the amount included in net income or other comprehensive income depends on the reason the impairment is considered OTT:
Record the impairment in net income, if the investor intends to sell the security or is “more likely than not” to be required to sell it before recovery of its amortized cost.
Otherwise, only the credit loss component is included in net income, as that amount of amortized cost is unlikely to be recovered. Any noncredit loss component reduces OCI, similar to how we normally account for unrealized gains and losses on AFS investments.
Also, if the debt investment is classified as AFS, recognizing an OTT impairment may involve reclassifying amounts out of OCI that were recorded previously as unrealized gains or losses.

47. Appendix 12B – Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2013 and 2014 pertain to the investment portfolio.
Purchase Investment: July 1, 2013, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value:
December 31, 2013: Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment.
December 31, 2014 : Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment
The journal entries to record the adjustments of the Bendac stock investment to fair value are:
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2013 and 2014 pertain to the investment portfolio. Purchase Investment: July 1, 2013, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value: December 31, 2013 valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment. December 31, 2014 valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment
The journal entries to record the adjustment at December 31, 2013, when the impairment in not to be treated as an OTT impairment is to debit net unrealized holding gains and losses in other comprehensive income for $10,000, and credit fair value adjustment for the same amount.
December 31, 2013
Net unrealized holding gains and losses – OCI 10,000
Fair value adjustment ,000

48. Appendix 12B – Impairment of Investments
December 31, 2014
Other-than-temporary impairment loss – I/S 15,000
Investment in Bendac 15,000
Fair value adjustment 10,000
Net unrealized holding gains and losses – OCI 10,000
The first 2014 journal entry reduces the Bendac investment to reflect the OTT impairment and recognizes the entire $15,000 in 2014 earnings. United adjusts the Bendac investment directly rather than using a fair value adjustment account because the OTT impairment cannot be recovered.
The second 2014 journal entry reclassifies any previously recognized unrealized losses associated with the investment, the same as if the investment had been sold. In 2013 United debited OCI and credited the fair value adjustment for $10,000 to reflect the decline in Bendac’s fair value to $990,000, so the second 2014 journal entry reverses the 2013 entry to remove those amounts.

49. Appendix 12B – Impairment of Investments
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. United’s fiscal year-end is December The following events occurred during 2014:
Purchase Investment: July 1, 2014, $1,000,000 of Bendac bonds, maturing on December 31, 2019.
Adjust Investment to Fair Value: December 31, 2014, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss.
Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers.
Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred.
United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. United’s fiscal year-end is December 31. The following events occurred during 2014, Purchase Investment: July 1, 2014, $1,000,000 of Bendac bonds, maturing on December 31, Adjust Investment to Fair Value: December 31, 2014, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss.
Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers.
Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred.
Let’s look at the necessary journal entries in these two cases.
Let’s look at the necessary journal entries in these two cases.

50. Appendix 12B – Impairment of Investments
Case 1
December 31, 2014
OTT impairment loss – I/S 50,000
Discount on bond investment 50,000
Case 2
December 31, 2014
OTT impairment loss – I/S 30,000
Discount on bond investment 30,000
OTT impairment loss - OCI 20,000
Fair value adjustment – Noncredit loss 20,000
In both Cases 1 and 2, the amortized cost of the investment is reduced by the total amount of OTT impairment. United achieves this by crediting a contra-asset, discount on bond investment, which United amortizes over the remaining life of the debt the same way it would if it had initially purchased the debt at that discounted amount. In Case 2, the noncredit-loss component of the impairment is recognized in OCI, the same way it would be if it were viewed as an unrealized loss under normal accounting for fair value declines of AFS investments. In both cases the carrying value of the debt becomes $950,000, reduced by the entire amount of the OTT impairment. In Case 1 this occurs via the $50,000 discount, and in Case 2 via the combination of the $30,000 discount and $20,000 fair value adjustment.
U.S. GAAP requires that the entire OTT impairment be shown in the income statement, and then the portion attributed to noncredit losses backed out, such that only the credit loss portion reduces net income.

51. U. S. GAAP vs. IFRS
Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset.
U.S. GAAP recognizes in OCI any non-credit losses on debt investments.
Calculation of the amount of impairment differs depending on the classification of an investment.
Under IFRS, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM.
Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset.
From the perspective of the IFRS,
Calculation of the amount of impairment differs depending on the classification of an investment.
Under IFRS, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM.
However, U.S. GAAP recognizes in OCI any non-credit losses on debt investments.

52. Investments: A Chapter Supplement
Supplement to Chapter 12
Chapter 12 Supplement: Investments: A Chapter Supplement
The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together. This Supplement discusses the FASB’s Exposure Draft of a proposed Accounting Standards Update (ASU) that addresses accounting for financial instruments and “tentative decisions” of the Board after receiving feedback.

53. GAAP vs. Proposed Accounting Standard Update
The proposed Accounting Standards Update (ASU) uses the same five basic categories to account for investments that you learned about in the main chapter, but with different names and minor differences, and the journal entries we use to account for the investments in each category are the same as they are under current GAAP.
The single asterisk at the end of the held-to-maturity description indicates that the investor may elect the fair value option. This type of investment also can be accounted for using the same approach that’s used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in net income.
The double asterisk notes that the proposed ASU eliminates the fair value option for almost all investments. The only exception occurs when the investor manages a group of financial assets and liabilities according to their net exposure to market risks and reports information on that basis to management. In that case, the investor can irrevocably elect the fair value option when the investments are acquired.

54. Accounting for Equity Investments
Determining how to account for equity investments in stock under the proposed ASU is easy. If the investor does not have “significant influence” over the investee, the equity investment is accounted for as FV-NI. If the investor has significant influence over the investee, but lacks control, the equity method is used. If the investor has control, the investment is consolidated.
Under current GAAP, the investor accounts for the equity investment as a trading or as an AFS security.
Under the ASU an equity investment always is treated as FV-NI (equivalent to being accounted for as a trading security).
Determining how to account for equity investments in stock under the proposal ASU is easy. If the investor does not have “significant influence” over the investee, the equity investment is accounted for as fair value in net income. If the investor has significant influence over the investee, but lacks control, the equity method is used. If the investor has control, the investment is consolidated.
Under current GAAP, the investor accounts for the equity investment as a trading or as an AFS security. Under the proposed ASU an equity investment always is treated as fair value in net income (FV-NI) (equivalent to being accounted for as a trading security).

55. Accounting for Debt Investments
Determining how to account for debt investments under the proposed ASU is more complicated than accounting for equity investments. Under the proposed ASU we base classification of debt investments on two criteria:
The characteristics of the debt instrument.
The business activity in which the instrument is used.
We discuss each of the criteria in turn.
Characteristics of a Simple Debt Instrument
 An amount is transferred to the borrower (debtor) when the debt instrument is issued that will be returned to the lender (creditor) when the debt matures or is settled. The amount is the principal or face amount of the debt adjusted for any discount or premium.
The debt cannot be prepaid or settled in such a way that the lender does not recover substantially all of its original investment, unless the lender chooses to allow it.
The debt instrument is not a derivative.
Determining how to account for debt investments under the proposed ASU is more complicated than accounting for equity investments. Under the proposed ASU we base classification of debt investments on two criteria:
The characteristics of the debt instrument.
The business activity in which the instrument is used.
We discuss each of the criteria in turn.
Characteristics of a simple debt instrument (an instrument that involves return of principal to the lender and can only be settled by the lender’s choice).
 An amount is transferred to the borrower (debtor) when the debt instrument is issued that will be returned to the lender (creditor) when the debt matures or is settled. The amount is the principal or face amount of the debt adjusted for any discount or premium.
The debt cannot be prepaid or settled in such a way that the lender does not recover substantially all of its original investment, unless the lender chooses to allow it.
The debt instrument is not a derivative.

56. Accounting for Debt Investments
Characteristics of a Complex Debt Instrument
Debt that lacks one or more of the characteristics of simple debt is considered complex. Under the proposed ASU, debt that is complex always is classified as fair value in net income.
A complex debt instrument is one that lacks one or more of the characteristics of simple debt is considered complex. Under the proposed ASU, debt that is complex is always classified as fair value in net income.

57. Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity that motivates the investor to hold the debt. The proposed ASU identifies three primary business activities as
lending,
long-term investing, or
held for sale.
The debt holder’s purpose is lending or customer financing with a focus on collecting cash flows (interest and principal). The debt holder must have the ability to renegotiate, sell, or settle the debt to minimize losses due to a borrower's deteriorating credit. The appropriate accounting approach is amortized cost.
For simple debt, we next must consider the business activity that motivates the investor to hold the debt. The proposed ASU identifies three primary business activities as
lending,
long-term investing, or
held for sale.
For the business purpose to be classified as lending, the debt holder’s purpose is a focus on collecting cash flows (interest and principal). The debt holder must have the ability to renegotiate, sell, or settle the debt to minimize losses due to a borrower's deteriorating credit. The appropriate accounting treatment is amortized cost.

58. Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity that motivates the investor to hold the debt. The ASU identifies three primary business activities as
lending,
long-term investing, or
held for sale.
The debt holder may choose to hold on to the debt investment or sell it as a way of either (a) maximizing its return on investment or (b) managing risk. The appropriate accounting approach is Fair Value – Other Comprehensive Income (FV-OCI)
For the business purpose to be long-term investing, the debt holder may choose to hold on to the debt investment or sell it as a way of either (a) maximizing its return on investment or (b) managing risk. The appropriate accounting approach is Fair Value – Other Comprehensive Income (FV-OCI)

59. Business Purpose of a Debt Instrument
For simple debt, we next must consider the business activity that motivates the investor to hold the debt. The ASU identifies three primary business activities as
lending,
long-term investing, or
held for sale.
For the business purpose to be classified as held for sale, the debt instrument is either (a) held for the purpose of being sold or (b) actively managed internally on a fair value basis. The appropriate accounting approach is Fair Value – Net Income.
For the business purpose to be classified as held for sale, the debt instrument is either (a) held for the purpose of being sold or (b) actively managed internally on a fair value basis but doesn’t qualify for FV-OCI, and should be treated as the fair value – net income approach.

60. Summary of Classification Criteria
Here is a summary of the proper classification and accounting procedures in the proposed ASU.
The proposed ASU does not allow transfers of debt from one category to another. After the debt is initially classified, reclassifications are not permitted.
The proposed ASU does not allow transfers of debt from one category to another. After the debt is initially classified, reclassifications are not permitted.

61. Impairments When the Investor Does Not Exercise Significant Influence
Because equity investments are reported at FV-NI, no impairment guidance is necessary. The same is true for debt investments recorded at FV-NI. Declines in fair value always are reported in net income. However, for debt investments reported at amortized cost or at FV-OCI, impairment losses are possible. Let’s look at the “three-bucket” approach currently under consideration.
Because equity investments are reported at FV-NI, no impairment guidance is necessary. The same is true for debt investments recorded at FV-NI. Declines in fair value always are reported in net income. However, for debt investments reported at amortized cost or at FV-OCI, impairment losses are possible. Let’s look at the “three-bucket” approach currently under consideration.
Bucket 1: Investments not affected by observed events. This bucket contains portfolios of debt investments that are evaluated individually or collectively for impairment in light of general risks of future default.
Bucket 2: Investments affected by observed events (but individual defaults have not been identified). This bucket contains portfolios of debt investments that have been affected by events that indicate potential for future default, but specific investments have not been identified as suffering default.
Bucket 3: Individual debt investments suffering credit losses. This bucket contains specific investments for which default has occurred or is expected to occur.
For bucket 1, expected losses would be estimated for the near term (say one or two years). For buckets 2 and 3, expected losses would be estimated for the life of the investment. Expected losses would include all expected losses of contractual cash flows (interest and principal), discounted for the time value of money. 1 2 3
Investments not affected by observed events.
Investments affected by observed events (but individual defaults have not been identified).
Individual debt investments suffering credit losses.

62. Debt Impairment (continued)
Objective: Use expected value (probability-weighted average) of losses of principal and interest on a discounted basis.
Time horizon of estimated losses:
Bucket 1: over near term (say, 1-2 years).
Buckets 2 and 3: over remaining life of investment.
No impairment upon acquisition of distressed debt (interest based on expected cash flows rather than contractual cash flows).
Under the proposed ASU, losses are measured as the expected value (probability- weighted average) of losses of principal and interest on a discounted basis. That differs from current GAAP, which focuses on only losses that are viewed as probable.
The time horizon used to estimate losses is tentatively planned on differing between buckets, with a near-term horizon (say, 1-2 years) for Bucket 1, and the entire remaining life of the investment for Buckets 2 and 3. 62 62

63. Equity Method
The criteria for applying the equity method are the same in the ASU as in current GAAP. If a company is holding an investment for sale that normally would qualify for the equity method, the investment is accounted for as FV-NI.
If facts indicate an impairment in value of an equity method investment, the investor recognizes an amount equal to the difference between the investment’s carrying value and its fair value. If fair value increases in the future, the impairment cannot be reversed.
The criteria for applying the equity method are the same in the proposed ASU as in current GAAP. If a company is holding an investment for sale that normally would qualify for the equity method, the investment is accounted for as FV-NI.
If facts indicate an impairment in value of an equity method investment, the investor recognizes an amount equal to the difference between the investment’s carrying value and its fair value. If fair value increases in the future, the impairment cannot be reversed.

64. End of Chapter 12
End of Chapter 12.