2 Investing for the Future A debt security is a financial instrument that represents a creditor relationship with another company. Investments in debt securities include such items as U.S. treasury securities, municipal and corporate bonds, and convertible debt.An equity security is a financial instrument that represents an ownership interest in another company. Investments in equity securities include common stock, preferred stock, warrants, options, and rights.A portfolio of investments in debt and/or equity securities that have a readily determinable fair value is often referred to marketable securities (investment securities).
3 How Are Investments Classified And Valued? (Slide 1 of 4) An investment in another company that does not allow the investing company to control or exert significant influence over the other company is considered a minority passive investment.Generally, an investment is considered a passive investment when a company owns less than 20% of the voting common stock of the investee.At acquisition, a company classifies each passive investment in debt and equity securities into one of three categories based on the company’s intent to hold or sell the securities.
4 How Are Investments Classified And Valued? (Slide 2 of 4) The three categories are:Held-to-Maturity Securities. Investments in debt securities for which the company has the positive intent and ability to hold until maturity.Trading Securities. Investments in debt and equity securities that are purchased and held principally to sell in the near term.Available-for-Sale Securities. Investments in debt and equity securities that are not classified as held-to-maturity or trading.The accounting for each of the three categories of securities differs based on management intent.
5 How Are Investments Classified And Valued? (Slide 3 of 4) A company reports its investments in trading securities at fair value on the balance sheet with any changes in fair value reported on the income statement as part of net income.A company may invest in the debt or equity securities of other corporations to establish long-term relationships with suppliers or to obtain significant influence over the company.Significant influence generally occurs when the investor owns between 20% and 50% of the voting common stock of the investee.
6 How Are Investments Classified And Valued? (Slide 4 of 4) Minority active investments are investments in the debt or equity securities of other corporations to establish a long-term relationships with suppliers or to obtain significant influence over the companies’ activities. Significant influence generally occurs when the investor owns between 20% and 50% of the voting common stock of the investee.Consolidation occurs when the investor controls the investee through an investment in equity securities. The result of consolidation is the issuance of the combined financial statements of both companies.Legal control occurs when the investor owns more than 50% of the voting common stock of the investee.Majority active investment is where an investment in another company allows the investor to control the investee.
8 How Are Investments in Held-To-Maturity Securities Measured and Recorded? When a company has the positive ability and intent to hold a debt security to maturity, it can be reported as a held-to-maturity security.The investment is initially recorded at cost.The investment is subsequently reported at amortized cost on the ending balance sheet(s).Unrealized holding gains and losses are not recorded but are disclosed in the notes to the financial statements.Interest income is recognized in net income as it is earned, along with any realized gains and losses on sales.
9 Recording Initial Cost Debt securities, such as bonds, that carry a stated interest rate above the prevailing market interest rates are issued at a premium.Debt securities carrying a stated interest rate below the prevailing market are issued at a discount.
10 Recognition of Interest Income and Amortization of Bond Premiums and Discounts The amount of interest income recognized each accounting period is based on the effective interest rate determined at the time of acquisition using the following formula:Interest Income = Market Interest Rate × Book Value of the Investment at the Beginning of PeriodThe effective interest method (interest method) of amortizing bond discounts and premiums:Amortization ofDiscount/Premium= Interest Revenue ‒ Cash Interest Payment
11 How Are Investments in Trading Securities Measured and Recorded? Recall that when investments in debt and equity securities are actively bought and sold with the intention to profit on short- term changes in price, they are classified as trading securities.The accounting for trading securities applies the most complete fair value measurement approach, as follows:The investment is initially recorded at cost.The investment is subsequently reported at fair value on the balance sheet.Unrealized holding gains and losses resulting from changes in the fair value of the securities are included in the net income of the current period.Interest and dividend income, as well as realized gains and losses, are included in net income of the current period.
12 Recognition of Unrealized Holding Gains and Losses On its ending balance sheet, a company reports any investments in trading securities at fair value.An increase in the fair value of investment securities is an unrealized holding gain.A decrease in the fair value of investment securities is an unrealized holding loss.For investments in trading securities, the Unrealized holding Gain/Loss account is a temporary account that is closed to Retained Earnings.A debit balance in the account represents a net unrealized loss.A credit balance represents a net unrealized gain.
13 How Are Investments in Available-for-Sale Securities Measured and Recorded? The investment is initially recorded at cost.The investment is subsequently reported at fair value on the balance sheet.Unrealized holding gains and losses resulting from changes in the fair value of the securities are reported as a component of other comprehensive income of the current period.Interest and dividend income are included in net income for the current period.When a security is sold, realized gains and losses are included in net income for the current period, and any unrealized holding gains or losses must be reclassified from accumulated other comprehensive income into net income.
14 Recognition of Unrealized Holding Gains and Losses On its ending balance sheet, a company reports any investments in available-for-sale securities at fair value.The major difference in the accounting for investments in available-for-sale and trading securities is that in available-for-sale securities, a company reports its unrealized gains and losses in its other comprehensive income.A credit balance in the Unrealized Holding Gain/Loss account represents the cumulative net unrealized holding gains and is reported as a positive element in the accumulated other comprehensive income section of shareholders’ equity.A debit balance in the account represents the cumulative net unrealized holding losses and is reported as a negative element in the accumulated other comprehensive income section of stockholders’ equity.
15 Summary of Accounting for Investments Investment in held-to-maturity securities are reported at amortized cost while fair value is used to report investments in trading and available-for-sale investments.The major difference between the accounting for investments in trading and available-for-sale is the treatment of unrealized holding gains and losses.
16 Transfer of Investments between Categories (Slide 1 of 2) The transfer of a security between investment categories is accounted for at fair value at the time of the transfer.The accounting for any unrealized gain or loss depends on the type of transfer.A transfer from the trading category into any other category.No accounting for the unrealized holding gain or loss is needed because it has already been recognized in net income.A transfer into the trading category from any other category.The previous unrealized holding gain or loss is recognized immediately in net income and eliminated from accumulated other comprehensive income.
17 Transfer of Investments between Categories (Slide 2 of 2) A transfer into the available-for sale category from the held-to- maturity category.An unrealized holding gain or loss is established and included in other comprehensive income.A transfer of debt security into the held-to-maturity category.The unrealized holding gain or loss on the date of transfer will continue to be reported as a separate component of accumulated other comprehensive income and amortized over the remaining life of the security.Note that transfers into or out of the trading category should be rare, as should transfers from the held-to-maturity category.
18 ImpairmentsAt each reporting date, a company should evaluate each investment to determine if an impairment exists. This evaluation involves three steps:Step 1. Determine whether the investment is impaired.Step 2. Evaluate whether the impairment is other than temporary.Step 3. If the impairment is other than temporary, recognize a loss equal to the difference between the cost of the investment and its fair market value.
19 Minority Active Investments: The Equity Method When an investor company owns a sufficiently large percentage of the common stock of another company, it is able to exert significant influence over the financial and operating policies of the investee company.Significant influence is determined by factors such as representation on the board and participation in policy- making processes.In the absence of the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influence.The equity method of accounting is used to account for investments in which significant influence exists.
20 Impairment: Other Than Temporary Evidence of a decline in the value of an equity investment:Bankruptcy of the investeeLengthy declines in the fair value of the stockA number of years of operating lossesWhen the decline is determined to be other than temporary, the investor debits a Loss account and credits the Investment account for the difference between the carrying value of the investment and the fair value.If the fair value of the investment later increases, the investor does not recognize the recovery in value.
21 Change to Equity Method When an investor currently using the fair value method acquires enough additional common shares during a year to obtain significant influence over the investee, the investor is required to adopt the equity method of accounting.When the equity method is adopted, the investor restates its investments in the investee by debiting the Investment account and crediting Retained Earnings for the previous percentage of investee income (minus dividends) for the period from the original date of acquisition to the date that significant influence was obtained.Once the necessary adjustments have been made, the equity method is applied in the usual manner based on the current percentage ownership.
22 How are Investments Disclosed in the Financial Statements How are Investments Disclosed in the Financial Statements? (Slide 1 of 3)Trading Securities: A company should disclose:Aggregate fair valueChange in the net unrealized holding gain or loss that is included in each income statementAvailable-for-Sale Securities: For each balance sheet date, a company should disclose:Aggregate fair valueGross unrealized holding gains and lossesAmortized cost
23 How are Investments Disclosed in the Financial Statements? (Slide 2 of 3)For each income statement period, a company should disclose:Proceeds from sales and the gross realized gains and losses on those salesBasis on which cost was determinedGross gains and gross losses included in net income from transfers of securities from this category into the trading categoryChange in the net unrealized holding gain or loss included as a separate component of other comprehensive income
24 How are Investments Disclosed in the Financial Statements? (Slide 3 of 3)Held-to-Maturity Debt Securities: For each balance sheet date, a company should discloseAggregate fair valueGross unrecognized holding gains and lossesAmortized costThe related realized or unrealized gain or loss and the circumstances leading to the decision to sell or transfer the security
25 Long-Term Notes Receivable A note receivable is recorded at the fair value of the property, goods, or services or the fair value of the note, whichever is more clearly determinable.If neither of these values can be determined, the note is recorded at the present value by using the borrower’s incremental interest rate.
26 Loan Fees and Loan Origination Costs The nonrefundable fees charged to borrowers for lending activities that precede the payment of funds and generally include efforts to identify and attract potential borrowers and to obligate a loan or loan commitment are called loan origination fees (or commitment fees).Generally, any loan origination fees are deferred and recognized over the life of the loan as an increase in interest income.A loan (note receivable) is impaired if it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.
27 Cash Surrender Value of Life Insurance Many insurance policies allow a portion of accumulated premiums to build up as a savings plan.The cash surrender value is the portion of life insurance premiums that build up as a savings plan—it is returned to the purchaser if the policy is cancelled.
28 Investment in FundsCompanies may place assets in special funds for specific purposes. Special funds may be current, such as petty cash funds, or they may be long term. The most common long-term funds are as follows:Long-term funds used to accumulated cash to retire long-term liabilities (sinking funds)Long-term funds used to retire preferred stock (stock redemption funds)Long-term funds used to purchase long-term assets (plant expansion funds)
29 Derivatives of Financial Instruments (Slide 1 of 3) A financial instrument is cash, evidence of an ownership interest in an entity or a contract that both:Imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable terms with the second entityConveys to that second entity a contractual right to receive cash or another financial instrument from the first entity or to exchange other financial instruments on potentially favorable terms with the first entity
30 Derivatives of Financial Instruments (Slide 2 of 3) A derivative financial instrument (or simply derivative) is a financial instrument, such as a future, a forward, a swap, or an option contract, that derives it value from an underlying asset, market price, interest rate, foreign exchange rate, or index.A hedge is a means of protecting against a financial loss by mitigating exposure to changes in values of underlying assets, liabilities, or future cash flows.An interest-rate swap is an agreement in which two companies agree to exchange the interest payments on debt over a specific period.
31 Derivatives of Financial Instruments (Slide 3 of 3) A principal amount upon which interest payments of an interest-rate swap are based is referred to as a notional (i.e., imaginary) amount because the swap does not involve an actual exchange of principal at either the inception or maturity.A cash flow hedge protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain.