2. BUS780 Chapter 11 Marketable Securities, Derivatives and Investments

3. Marketable Securities, Derivatives, and Investments2 Objectives of the Chapter 1.Classifications of Investments for financial reporting purposes. 2. Using market value method to account for minority, passive investments. 3. Using equity method to account for minority, active investments (i.e., holding 20% or more of investee’s voting shares). 4. To learn the accounting for consolidated financial statements for majority, active investments (i.e., holding more than 50% investee’s voting shares).

4. Marketable Securities, Derivatives, and Investments3 1. Securities for Investments n Investments in debt securities: include U.S. treasury securities, municipal securities, corporate bonds, commercial papers, etc. n Investments in equity securities: include common stock, preferred stock, stock warrants, stock rights, call and put stock options.

5. Marketable Securities, Derivatives, and Investments4 Securities for Investments(cont.) n For reporting purposes, all investments in securities must be classified into one of the following three categories at the reporting date: 1. Trading securities; 2. Available-for-sale securities (SAS); or 3. Held-to-maturity (HTM) securities.

6. Marketable Securities, Derivatives, and Investments5 Classification of Investments 1.Trading securities: investments in debt and equity securities held for the purpose of selling them in the near future. 2. Available-for-sale securities: Investments in debt and equity securities that are not classified as trading securities and not classified as held-to-maturity securities.

7. Marketable Securities, Derivatives, and Investments6 Classification of Investments (cont.) 3.Held-to-maturity securities: investments in debt securities with positive intent and ability to hold these securities to maturity.

8. Marketable Securities, Derivatives, and Investments7 Classification of Investments (cont.) n Classifications of investments in securities into these three categories and the subsequent reclassification are based on management’s intent and judgment.

9. Marketable Securities, Derivatives, and Investments8 2. Investments - initial recording and end of period reporting (valuation) 1.Initial Recording of all investments: at cost (including commissions). 2. End of Period Reporting: Trading securities: n Reported at their market values on the balance sheet statement (B/S). n The unrealized gains or losses are included in income statement (I/S) of the current period.

10. Marketable Securities, Derivatives, and Investments9 Investments – End of Period Valuation (cont.) Available-for-sale securities: n Reported at their market values on the B/S. n The unrealized gains or losses are reported as a separate component of stockholders’ equity until realized. Held-to-maturity securities: n Reported at their amortized cost.

11. Marketable Securities, Derivatives, and Investments10 Investments - Dividends and Interest revenue n Realized dividends, interest revenues of investments in securities and realized gains or losses from sale of investments are reported on the income statement.

12. Marketable Securities, Derivatives, and Investments11 Investments -other valuation methods for equity investments Other Valuation Methods: 1. Equity method: applied when investments in equity securities with significant influence over the investee (usually owing 20% - 50% of the voting stock). No recognition of unrealized gains or losses. Equity method results in a partial consolidation statements for the investor.

13. Marketable Securities, Derivatives, and Investments12 Investments - other valuation methods for equity investments 2. Consolidated financial statements: applied when the investor(the parent) controls the investee (the subsidiary) through owning over 50% of the investee’s voting stock. The investor has to issue the consolidated financial statements. No recognition of unrealized gains or losses

14. Marketable Securities, Derivatives, and Investments13 Summary of Accounting for Investments (by types of securities)

15. Marketable Securities, Derivatives, and Investments14 Accounting for Investments Classified as Trading Securities n The accounting treatment (SFAS 115) (a) initial recording: at cost; (b) end of period reported: at fair value; (c) unrealized holding gains or losses: reported on the income statement; (d) interests, dividends, realized gains or losses reported on the income statement

16. Marketable Securities, Derivatives, and Investments15 Trading Securities (contd.) n Trading securities are held primarily by banks and stock brokers. n SFAS 115 applies to all industries including specialized industries..

17. Marketable Securities, Derivatives, and Investments16 Example A: Trading Securities n Green Company acquired the following securities on 5/1/x5 and reported the investments as trading securities: Shares $per share A Company common stock100$50

18. Marketable Securities, Derivatives, and Investments17 Example A: Trading Securities (contd.) n Initial recording on 5/1/x5: Marketable Securities 5,000 Cash 5,000 n Green received $300 for dividends from investment in A during 20x5: Cash 300 Invest. Revenue 300

19. Marketable Securities, Derivatives, and Investments18 Example A: Trading Securities (contd.) n The following info. is available on 12/31/x5 :

20. Marketable Securities, Derivatives, and Investments19 Example A: trading Securities (Contd.) n 12/31/x5 Adjusting entry (for valuation): n Marketable Securities 1,500 Unrealized Gains** (losses) on investments 1,500 ** reported on the income statement

21. Marketable Securities, Derivatives, and Investments20 Example A: trading Securities n After the adjusting entry on 12/31/x5: Marketable Securities Unrealized Gains/Losses 1/1/x5 5,000 1,500 a 12/31/x6 1,500 12/31/x6 6,500 a. The unrealized gains of trading securities would be reported on the income statement of 20x5 and closed to income summary on 12/31/20x5

22. Marketable Securities, Derivatives, and Investments21 Example A: Trading Securities (contd.) n The following info. is available on 12/31/x6:

23. Marketable Securities, Derivatives, and Investments22 Example A: trading securities (cont.) n 12/31/x6 Adjusting entry (for valuation): Unrealized holding Gains (losses) on investment**400 Marketable Securities* 400 ** reported on income statement of x6 and will be closed to income summary on 12/31/x6. * To adjust the balance of marketable securities to $6,100, the market value of A on 12/31/x6.

24. Marketable Securities, Derivatives, and Investments23 Example A: trading Securities (contd.) n After the adjusting entry on 12/31/x6: Marketable Securities Unrealized Gains/Losses 1/1/x6 6,500 400 12/31/x6 400 a 12/31/x6 6,100 a. The unrealized losses $400 of trading securities would be reported on the income statement of 20x6 and will be closed to income summary on 12/31/20x6

25. Marketable Securities, Derivatives, and Investments24 Example A: trading securities (contd.) n On 2/10/x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction n Cash6,000 Loss on sale of investments 100** Marketable Securities 6,100* *The marketable securities account is at the fair value as of 12/31/x6. ** for trading securities, the realized loss is the difference between the sales price and the most recent fair value (i.e., $6,100).

26. Marketable Securities, Derivatives, and Investments25 Example B: investments classified as available-for-sale securities (SAS) The accounting treatment of SAS (SFAS 115) (a) initial recording: at cost; (b) end of period reported: at fair value; (c) unrealized holding gains or losses: reported as a separate component of stockholders’ equity on B/S; (d) interests, dividends, realized gains or losses reported on the I/S

27. Marketable Securities, Derivatives, and Investments26 Example B: Accounting for Securities- Available-for-Sale (SAS) n Green Company acquired the following securities and reported them as SAS on 5/1/x5: Shares $ per share A Company common stock100 $50

28. Marketable Securities, Derivatives, and Investments27 Example B: SAS (contd.) n Initial recording on 5/1/x5: Marketable Securities 5,000 Cash 5,000 n Green received $300 for dividends from investment in A during 20x5: Cash 300 Invest. Revenue 300

29. Marketable Securities, Derivatives, and Investments28 Example B: SAS (contd.) n The following info. is available on 12/31/x5 :

30. Marketable Securities, Derivatives, and Investments29 Example B: SAS (Contd.) n 12/31/x5 Adjusting entry (for valuation): n Marketable Securities 1,500 Unrealized Gains* (losses) on investments 1,500 * Unlike the reporting for trading securities, this account is to be reported on the balance sheet.

31. Marketable Securities, Derivatives, and Investments30 Example B: SAS n After the adjusting entry on 12/31/x5: Marketable Securities Unrealized Gains/Losses 1/1/x5 5,000 1,500 12/31/x6 1,500 12/31/x6 6,500 a. The unrealized gains of SAS would be reported on the B/S of 20x5 and will be carried over to 20x6.

32. Marketable Securities, Derivatives, and Investments31 Balance Sheet Presentation Balance Sheet 12/31/x5 AssetsLiabilities Investment Securities at fair value (cost 5,000) $6,500 Stockholders’ Equity: Accu. Other Comp. Income Unrealized gains (losses) on investment 1,500

33. Marketable Securities, Derivatives, and Investments32 Example B: SAS (contd.) n The following info. is available on 12/31/x6:

34. Marketable Securities, Derivatives, and Investments33 Example B: SAS (cont.) n 12/31/x6 Adjusting entry (for valuation): Unrealized holding Gains (losses) on investment**400 Marketable Securities* 400 * To adjust the balance of marketable securities to $6,100, the market value of A on 12/31/x6.

35. Marketable Securities, Derivatives, and Investments34 Example B: SAS (contd.) n After the adjusting entry on 12/31/x6: Marketable Securities Unrealized Gains/Losses 1/1/x6 6,500 400 12/31/x6 400 b 1,500 a 12/31/x6 6,100 1,100 c a. The balance on 1/1/x6, carried over from 12/31/x5. b. The adjustment of 12/31/20x6. c. The ending balance on 12/31/06 and is reported on the B/S of 2006.

36. Marketable Securities, Derivatives, and Investments35 Balance Sheet Presentation Balance Sheet 12/31/x6 AssetsLiabilities Investment Securities at fair value (cost 5,000) $6,100 Stockholders’ Equity: Accu. Other Comp. Income Unrealized holding gains (losses) on investment(1,100)

37. Marketable Securities, Derivatives, and Investments36 Example B: SAS (contd.) n On 2/10/x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction n Cash6,000 Unrealized holding gains and losses on investments1,100* Marketable Securities 6,100* Gain on sale of investments 1,000** * the balance of unrealized gains and losses on SAS on 2/10/x7. ** The realized gain for SAS is the difference between the sales price and the cost (i.e., $5,000).

38. Marketable Securities, Derivatives, and Investments37 Investments in Held to Maturity Securities (debt securities only) n The account treatment (SFAS No. 115): (a) Initial Recording: at cost*(not using a discount or a premium account); (b)End of Period Reporting: at amortized cost; (c)Unrealized Holding Gains or Losses:not recognized. (d)Interests and realized gains (Losses) on Sale : all included in income. * the present value

39. Marketable Securities, Derivatives, and Investments38 Investments in Held-to-Maturity Securities (HTM) n APB opinion No.21 recommends separate disclosure of face amount ($100,000) and the discount ($1,000). n However, most investors do not use separate accounts for face value and the unamortized discount (or premium). n The discount ($1,000) will be amortized to increase the interest revenue using the effective interest method.

40. Marketable Securities, Derivatives, and Investments39 Example C: amortization of discount or premium of investments in held-to-maturity n Assume that Green acquires an investment in bonds that will be held to maturity with a face value of $100,000 for $102,458.71 on 1/1/x5. The stated interest rate is 13% and interests are paid on 6/30 and 12/31. The bonds mature on 12/31/x7. The effective interest rate is 12%* * 102,458.71 = 100,000 x 0.70496 + 6,500 x 4.91732 semiannual effective interest rate = 6% 6 period 6 period ?%

41. Marketable Securities, Derivatives, and Investments40 Example C: (contd.) J.E n 1/1/x5 Investment in debt securities- HTM 102,458.71 Cash 102,456.71 n 6/10/x5 Cash 6,500 Interest Revenue* 6,147.52 Inv. in HTM 352.48

42. Marketable Securities, Derivatives, and Investments41 Example C: (contd.) * Interest Rev. = Present Value x Effective Rate = 102,458.71 x 6% = 6,147.52 n Amortization of Premiums(discounts) on investments decreases (increases) interest revenue.

43. Marketable Securities, Derivatives, and Investments42 Bond Investment Interest revenue and Premium Amortization Schedule n Effective Interest Method

44. Marketable Securities, Derivatives, and Investments43 Sale of Investment in Securities Held to Maturity Before Maturity n This should not occur unless circumstances changed. n If it does occur, update the interest revenue and the amortization of premium or discount from last interest payment date to the sale date. n To determine the gains or losses, compare selling price (excluding accrued interests) with the updated carrying value.

45. Marketable Securities, Derivatives, and Investments44 Transfers Between Reporting Categories n Investment classification is reassessed at each reporting date. n Securities investments can be reclassified* at the reporting date if a different reporting category is more appropriate. n *an unusual event, disclosures of reasons are required

46. Marketable Securities, Derivatives, and Investments45 Transfers (contd.) n At reclassification: 1) The security is updated to its fair value. 2) The security is transferred at its fair value. 3) Any unrealized holding gain or loss should be accounted for in a manner consistent with the new reporting category.

47. Marketable Securities, Derivatives, and Investments46 Financial Statement Classification a.Trading securities: current assets. b.Securities-available-for-sale (SAS): Current or noncurrent depends on whether the securities will be sold in one year or one operating cycle, whichever is longer. c.Securities-held-to-maturity:current or noncurrent assets.

48. Marketable Securities, Derivatives, and Investments47 Financial Statement Disclosure Disclosure notes for investments should include: a. Amortized cost (cost basis). b.Gross unrealized gains. c. Gross unrealized losses. d. Estimated fair value.

49. Marketable Securities, Derivatives, and Investments48 Impairment of Value n If the decline in the fair value of investment is NOT temporary (i.e., a bankruptcy filing), the value of the securities should be written down to the fair value. n The amount of the write-down should be treated as a realized loss and is included in the income of the year.

50. Marketable Securities, Derivatives, and Investments49 Impairment of Value (in Debt Investment) (cont.) n The amount of write down is included in the Income statement as a realized loss. n The fair value becomes the “New” cost and is not changed for the subsequent recovery in the fair value.

51. Marketable Securities, Derivatives, and Investments50 3. Equity Method n APB Opinion No.18 requires the use of equity method by an investor who is able to exercise significant influence over the operating and financial policies (i.e., dividends distribution) of an investee. n In the absence to the contrary, an investment of 20% to 50% in the outstanding common stock of the investee leads to the presumption of significant influence.

52. Marketable Securities, Derivatives, and Investments51 Equity Method (contd.) n In some cases, the investors hold more than 20% of the outstanding common stock of an investee and do not have significant influence. The equity method should not be used to account for the investment in those cases.

53. Marketable Securities, Derivatives, and Investments52 Equity Method (contd.) n A survey of 600 companies conducted by Accounting Trends & Techniques indicated 252 (42%) of the corporations surveyed used the equity method to account for their investments. n The investee companies are referred to as affiliates.

54. Marketable Securities, Derivatives, and Investments53 The Accounting Procedures of the Equity Method n The investment is originally recorded at cost of the shares acquired. n The investment is subsequently adjusted each period for the changes in the net assets (equity) of the investee.

55. Marketable Securities, Derivatives, and Investments54 The Accounting Procedures of the Equity Method n For example, increased (decreased) by the investors’ proportionate shares of earnings (losses) of the investee and decreased by the dividends received.* * This is due to investee’s net income will increase investee’s equity while dividends will decrease investee’s equity.

56. Marketable Securities, Derivatives, and Investments55 The Accounting Procedures of the Equity Method (contd.) In Summary: Investment = Acquisition Cost + Investor’s Share of Investee’s Income - Dividends Received

57. Marketable Securities, Derivatives, and Investments56 Example D n On 1/1/x9, Clibron Company purchases 4,200 shares of common stock of the Sam Corporation which has 16,800 shares of common stock outstanding on 1/1/x9. Thus, Clibron has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000. n Also, Sam Corp. paid $20,000 dividends on 8/28/x9, and reported net income of 81,000 for 20x9. These events are recorded on Clibron Company’s book as follows:

58. Marketable Securities, Derivatives, and Investments57 Example D (contd.) 1. To record the investment on 1/1/x9: Long-Term Investment125,000 Cash125,000 2. To record the receipt of dividends on 3/28/x9: Cash (20,000 x 25%)5,000 Long-Term Investment (Sam Corp.)5,000

59. Marketable Securities, Derivatives, and Investments58 Example D (contd.) 3. To record Clibron Company’s 25% share in the year’s net income: 12/31/x9 Long-Term Investment ($81,000 x 25%)20,250 Investment Revenue20,250

60. Marketable Securities, Derivatives, and Investments59 Presentation on the B/S and I/S: Balance Sheet 12/31/x9 Assets Long-Term Investments, at equity140,250 Income Statement for the year ended 12/31/x9 Other Revenue: Investment Revenue20,250

61. Marketable Securities, Derivatives, and Investments60 Gain or Loss on Sales of an Equity- Method Investment n Gain or loss on sales of an equity- method investment is measured as the difference between the sale proceeds and the carrying amount of the investment.

62. Marketable Securities, Derivatives, and Investments61 Example D (contd.) n On 1/3/00, Clibron Sells 20% of its holding of Sam Corp. for $30,000. Cash30,000 Long-Term Investment28,050* Gain on Sale of Investment1,950 * 140,250 x 20% = 28,050

63. Marketable Securities, Derivatives, and Investments62 Joint Venture n A joint venture is a separate entity or business project owned by a small group of investors. n Investors of a joint venture usually account for their investments using the equity method even if its share is less than 20%. n This is because these investors usually have significant influence on the joint venture.

64. Marketable Securities, Derivatives, and Investments63 Comments Regarding Different Accounting Treatment for Investments n Different methods in accounting for investments will not affect the cash flows, but will affect the earnings. n Reporting investments as SAS can reduce earnings volatility comparing reporting investments as trading securities.

65. Marketable Securities, Derivatives, and Investments64 Comments Regarding Different Accounting Treatment for Investments n Firms reporting investments as SAS can cherry pick investments to be sold (i.e., sell the SAS with unrealized gain to report the gain on income statement). n Equity method is to prevent income manipulation by investees who have significant influence on dividends policy.

66. Marketable Securities, Derivatives, and Investments65 4. Accounting for Consolidated Subsidiaries n When a parent company purchased all or more than 50% of the outstanding common stock of subsidiary corporations, consolidated financial statements need to be prepared.

67. Marketable Securities, Derivatives, and Investments66 4. Accounting for Consolidated Subsidiaries n The consolidated statements combine the balance sheets, income statements and other financial statements of the parent company with those of majority-owned subsidiaries into an overall set of statements as if the parent and its subsidiaries were a single business entity.

68. Marketable Securities, Derivatives, and Investments67 Accounting for Consolidated Subsidiaries (contd.) n A work sheet is used to combine financial statements of the parent company and the subsidiaries. A. Parent corporation owns all of subsidiary’s stock. B. Parent company owns less than 100% of subsidiary’s stock.

69. Marketable Securities, Derivatives, and Investments68 A. Parent Corporation Owns All of Subsidiary’s Stock n Some accounts are eliminated (i.e., the parent company’s investment in subsidiary account and the subsidiary’s equity accounts because the two accounts represent the same thing -- subsidiary equity which is also represented by assets and liabilities of the subsidiary in the combined financial statements).

70. Marketable Securities, Derivatives, and Investments69 B. Parent Company Owns Less Than 100% of Subsidiary’s Stock n A minority interest account (on the credit side as a liability) is used to account for the subsidiary’s equity which is held by stockholders other than the parent company.

71. Marketable Securities, Derivatives, and Investments70 Exhibit ( source: Harrison and Horngren, Exhibit 10-8)

72. Marketable Securities, Derivatives, and Investments71 Income of A Consolidated Entity n The income of a consolidated entity is the net income of the parent plus the parent’s share (proportion) of the subsidiary’s net income.