2. Chapter 12 Investments

3. 2 Objectives of the Chapter 1.Classification and reporting of Investments: trading securities, available-for-sale securities and held- to-maturity securities. 2.Investments recorded and reported using the equity method. 3. The fair value option reporting for investments.

4. Investments3 Securities for Investments n Investment in debt securities: include U.S. treasury securities, municipal securities, corporate bonds, commercial papers, pf stock with a mandatory redemption feature or redeemable at the option of the holder. n Investment in equity securities: include common stock, preferred stock, stock warrants, stock rights, call and put options.

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

6. 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: Including debt and equity securities that are not classified as trading securities and not classified as held-to-maturity securities.

7. 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. 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. Investments8 Investments - initial recording and end of period reporting (valuation) 1.Initial Recording of all investments: at cost. 2. End of Period Reporting (Valuation): a. Trading securities: reported at their fair market values on the B/S. The unrealized gains or losses are included in income of the current period.

10. Investments9 Investments - initial recording and valuation (cont.) b. Available-for-sale securities: reported at their fair values on the B/S. The unrealized gains or losses are reported as a separate component of stockholders’ equity until realized. c. Held-to-maturity securities: reported at their amortized cos t.

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

12. Investments11 Investments - other valuation methods n Other Valuation Methods: n a. 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. n Results in a partial consolidation statements for the inves tor.

13. Investments12 Investments - other valuation methods (cont.) b. Consolidated financial statements Applied when the investor(the parent) controls the investee (the subsidiary) through an investment in equity securities (i.e., the investor owing over 50% of the voting common stock).

14. Investments13 Investments - other valuation methods (cont.) n The investor has to issue the consolidated financial statements. No recognition of unrealized gains or losses.

15. Investments14 Summary of Accounting for Investments

16. Investments15 Example A:investments classified as available-for- sale securities (SAS) 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 as a separate component of stockholders’ equity on B/S; (d) interests, dividends, realized gains or losses reported on the I/S

17. Investments16 Example A:(cont.): n Assume that Green Company acquires the following securities on 5/1/x5: Shares # per share A Company common stock100$50 B Company common stock300$80 C Company preferred stock200$120 D Company 10% bonds with a face value of $15,000 at par plus accrued interest (interests are paid on 5/31 & 11/30)

18. Investments17 Example A:(cont.) 1. Initial recording on 5/1/x5: Investments in SAS 68,000* Invest. Rev. 625** Cash68,625 n Cost = 100 x 50 + 300 x 80 + 200 x 120 + 15,000 = 68,000 ** Accrued interests = 15,000 x 10% x 5/12 = $625

19. Investments18 Example A: cont. n 5/31/x5 Cash750 Invest. Revenue750 (the net interest revenue = $750 -625= $125; the interest revenue for 5/1/95 ~ 5/31/95) n 11/30/x5 Cash750 Invest. Revenue750 Note: If the bonds were purchased at a discount or premium, the discount or premium needs to be amortized when interest revenue is recongized.

20. Investments19 Example A: cont. n 12/31/x5 Invest. Receivable125 Invest. Revenue125 n Assuming Green received $3,000 for dividends in 20x5 Cash3,000 Invest. Revenue3,000

21. Investments20 Example A:(contd.) n The following info. is available on 12/31/x5: (Note: for investment in bonds, the cost is the amortized cost.)

22. Investments21 Example A:(contd.):SAS n 12/31/x5 Adjusting entry (for valuation): n Fair Value Adjustment 3,000 Unrealized holding Gains** on investments-OCI 3,000 ** Reported in B/S as other comprehensive income of x5

23. Investments22 Balance Sheet Presentation :SAS Balance Sheet 12/31/x5 AssetsLiabilities Inv. Sec. (at cost) $68,000 Fair Value Adjust. $3,000Stockholders’ Equity: Inv. Sec. ( at fair Value) $71,000 Accu. Other Comp. Income Unrealized holding gains (losses) on investment 3,000

24. Investments23 Example A: SAS(contd.) n The following info. is available on 12/31/x6:

25. Investments24 Example A: (cont.):SAS n 12/31/x6 Adjusting entry (for valuation): Unrealized holding Gains (losses) on investment**-OCI5,000 Fair Value Adjustment 5,000 ** Other comprehensive income of x6

26. Investments25 Balance Sheet Presentation:SAS Balance Sheet 12/31/x6 AssetsLiabilities Inv. Sec. (at cost) $68,000 Fair Value Adj. (2,000) Inv. Sec. (at fair value) $66,000 Stockholders’ Equity: Accu. Other Comp. Income Unrealized holding gains (losses) on investment(2,000)

27. Investments26 Realized Gains and Losses from Sale of investments n Realized gains and losses are calculated as the difference between the selling price and the cost and is reported in the income statement. n This is due to the unrealized gain/loss of SAS is never recognized in the income statement.

28. Investments27 Example B: SAS n In 20x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction n Cash6,000 Investments in SAS (at cost) 5,000 Gain on sale of investments 1,000

29. Investments28 Example B (cont.): SAS n Also in 20x7, Green sold 300 share of B for $22,000 J.E. to record this transaction Cash 22,000 Loss on sale of investments 2,000 Investments (at cost) 24,000

30. Investments29 Example B:(cont.) (with a fair value adjustment account) :SAS n Before the adjusting entry on 12/31/x7: Fair Value adjustment Investment (at cost) 1/1/x7 3,000 5,000 68,000 5,000 a 24,000 b 2,000 39,000 a. from sale of Stock A b. From sale of Stock B

31. Investments30 Example B:(contd.):SAS n The following info. is available on 12/31/x7:

32. Investments31 Example B:SAS n The Adjusting entry on 12/31/x7 Fair Value Adjustment 1,000 Unrealized Gains (Losses) on Investment** 1,000 Note: before the adjustment, the ending bal. of fair value adjustment and unrealized holding gain/loss equal $2,000 (credit) and $2,000 (debit), respectively. After the adjustment, the bal. of fair value adj. And unrealized holding G/L equal $1,000 (credit) and $1,000 (debit), respectively.

33. Investments32 Balance Sheet Presentation:SAS Balance Sheet 12/31/x7 AssetsLiabilities Investment Securities at Cost $39,000 Fair Value Adjus. (1,000) Stockholders’ Equity: Invest. Sec. (at fair) $38,000 Accu. Other Comp. Income Unrealized holding gains (losses) on investment(1,000)

34. Investments33 Impairment of Securities Available- for-Sale n If the decline in the fair value of securities available-for-sale 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.

35. Investments34 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 in the income statement; (d) interests, dividends, realized gains or losses reported in the income statement

36. Investments Classified as Trading Securities (contd.) n Trading securities are held primarily by banks and stock brokers. FASB 115 applies to all specialized industries. n For trading securities, the realized gains and losses are computed as the difference of the selling price and the fair value (NOT the cost) recorded in the most recent balance sheet date. n This is due to the unrealized holding gain/loss for trading sec. is recognized in the previous income statement. Investments35

37. Example C: same infor. as in Example A on p20 but for Trading Securities Valuation on 12/31/x5 n 12/31/x5 Adjusting entry for valuation (a direct adjustment to the investment account): n Investment Securities* 3,000 Unrealized holding Gains** on investments-I/S 3,000 *the bal. of the investment securities account equals $71,000, the fair value, after the adjustment. ** Reported in the income statement of x5 and will be closed to income summary at the end of x5. Investments36

38. Example C(contd.): same as in Example A on p23 Except for Trading Securities Valuation on 12/31/x6 n 12/31/x6 Valuation adjusting entry (a direct adjustment): Unrealized holding Gains on investment * - I/S 5,000 Investment Securities** 5,000 *Reported in the income statement of x6. **The bal. of investment securities equals $66,000, the fair value, after the adjustment. Investments37

39. Example D: same as in Example B on p27 Except for Sale of Trading Securities n In 20x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction n Cash6,000 n Loss on Sale of Investment 100 Investments in Trading Sec. 6,100* *The investment account is at the fair value. Unlike the SAS, the unrealized Gains (Losses) of trading securities have been closed to the Income Summary at the end of 20x6. Investments38

40. Example D (contd.): same as in Example B on p28 Except for Sale of Trading Securities n Also in 20x7, Green sold 300 share of B for $22,000 J.E. to record this transaction Cash22,000 Loss on sale of investments 700 Investments (at fair value) 22,700 * The investment account is at the fair value. Investments39

41. Example D (contd.): same as in Example B on p30 The following info. is available on 12/31/x7: 12/31/x6 12/31/x7 Change cost Fair Value Fair Value in F.V C $24,000 $23,200 $26,000 $2,800 ↑ D$15,000 $14,000 $12,000 (2,000)↓ $39,000 $37,200 $38,000 ($800)↓ Investments40

42. Example D (contd.) The information on p40 indicates that the fair value of securities C and D equals $37,200 and $38,000 on 12/31/x6 and 12/31/x7, respectively. Since the trading securities account balance is at the fair value (under the direct adjustment), the end of period valuation adjustment is to increase the trading securities investment account by $800. Investments41

43. Example D (Contd.) n The Adjusting entry on 12/31/x7 Investment in Trading Securities* 800 Unrealized Holding Gain**-I/S 800 *The investment bal. equals $38,000, the fair value, after the adjustment. **Reported in the income statement Investments42

44. Investments43 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

45. Investments44 Investments in Held-to-Maturity (HTM) Securities 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.

46. Investments45 Example E: 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 ?%

47. Investments46 Example E:(contd.) J.E n 1/1/x5 Investment in Bonds - held-to-maturity102,458.71 Cash 102,456.71 n 6/10/x5 Cash 6,500 Interest Revenue* 6,147.52 Inv. in Bonds 352.48

48. Example E: record the premium in a separate account (An alternative) J.E n 1/1/x5 Investment in Bonds 100,000 Prem. on Bond Inv. 2,458.71 Cash 102,456.71 n 6/10/x5 Cash 6,500 Interest Revenue* 6,147.52 Prem. on Bond Inv. 352.48 Investments47

49. Investments48 Example E:(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.

50. Investments49 Bond Investment Interest revenue and Premium Amortization Schedule n Effective Interest Method

51. Investments50 Bond Investment Interest revenue and Premium Amortization Schedule:(contd.) n Straight-Line Method

52. Investments51 Example F: Investment in HTM at a Discount n Assume that HTM investments on p45 were acquired at a discount for $97,616.71. The effective interest rate is 14%. 1/1/x5 Invest. in Bonds- held to maturity 97,616.71 Cash 97,616.71 6/30 Cash 6,500 Invest. in Bonds 333.17 Interest Revenue* 6833.17 * Interest Revenue = Present value x 14% x 6/12 = 97,616.71 x 14% x 6/12

53. HTM Example F (contd.): Discount Recorded in a Separate Account 1/1/x5 Invest. In Bonds 100,000 Cash 97,616.71 Discount on Bond Inv. 2,383.29 6/30 Cash 6,500 Discount on Bond Inv. 333.17 Interest Revenue* 6833.17 Investments52

54. Investments53 Bond Investment Interest Revenue and Discount Amortization Schedule n Effective Interest Method

55. Investments54 Amortization for Bonds Acquired Between InterestDates Example G n 13% bonds with a face value of $200,000 were purchased for $204,568.5 plus the accrued interest of $6,500 on 4/3/x5. n Interests were paid on 6/30 and 12/31 and the bonds mature on 12/31/x7. The effective rate is 12%

56. Investments55 Amortization for Bonds Acquired Between InterestDates Example G(cont.) n Bond Investment Interest Revenue and Premium Amortization Schedule (Effective Interest Method)

57. Investments56 Amortization for Bonds Acquired Between InterestDates Example G(cont.) a. 200,00 x 13% x6/12. b Previous investment carrying value x 0.12 x 6/12. c. a - b. d. Previous investment carrying value - c. e. Difference $4.87 due to rounding error.

58. Investments57 Amortization for Bonds Acquired Between InterestDates Example G(cont.) n Verifying the purchase price of example G : Present value of the bond on 1/1/x5 => 200,000 x 0.705 + 13,000 x 4.917 = $204,921 n Interest Revenue for 1/1/95 - 6/30/x5 $204,921 x 12% x 6/12 = 12,295 n Cash Received for interest (1/1/x5 - 6/30/x5) $200,000 x 13% x 6/12 = 13,000 n Premium amortized for the period of 1/1/x5 - 6/30/x5 =>13,000 -12,295 = 705 (for 6 months) n Premium amortized for the period of 1/1/x5 - 4/1/x5 =>705 x 3/6 = 352.5 (for 3 months of the first period) n Therefore, the P.V. of the bond on 4/1/x5 => $204,921 -352.5 = $204,568.5

59. Investments58 Amortization for Bonds Acquired Between InterestDates Example G(cont.) 4/3/x5 Investment in bonds- HTM204,568.5 Interest Receivable 6,500 Cash 211,068.5 6/30/x5 Cash 13,000 Interest Receivable 6,500 Interest Revenue6,147.5 Investment in bondds- HTM 352.6

60. Investments59 Amortization for Bonds Acquired Between InterestDates Example G(cont.) 12/31/x5 Cash13,000 Interest Revenue*12,252.96 Inv. In Bonds- HTM** 747.04 * P.V. of bond on 7/1/x5 => P.V. of Bond on 1/1/x5 minus premium amortized for the period of 1/1/x5 - 6/30/x5 => $204,921 - 352.5 -352.5 = $204,216 Interest revenue of the 2nd. Period (7/1/x5 -12/31/x5) =>$204,216 x 0.12 x 6/12 = 12,252.96 ** Amortization of Premium for 7/1/x5 - 12/31/x5 period.

61. Investments60 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.

62. Investments61 Sale of Investment in Securities Held to Maturity Before Maturity Example H: n 13% bonds with a face value of $100,000 were purchased on 1/1/x5 for $97,616.71 as in example F. The bonds were sold on 3/31/x6 for $102,000 plus accrued interest effective interest rate is 14%.

63. Investments62 Sale of Investment in Securities Held to Maturity Before Maturity Example H:(contd.) (1) = (4) * 0.07 (2) = face amount * 0.065 (3) = (1) - (2) (4) = P.V. at beginning + (3) * Interest Revenue for 1/1/96 - 3/31/96 => 6881.45 * 3/6 = 3440.72 Dis. Amortized for 1/1/96 - 3/31/96 => 381.45 * 3/6 = 190.73

64. Investments63 Sale of Investment in Securities Held to Maturity Before Maturity Example H:(contd.) Investment in Debt Securities Held to Maturity 97,616.71 6/30/x5 333.17 12/31/x5 356.49 3/31/x6 190.17 * *Interest Revenue = (P.V. on 1/1/x6) x 14% x 3/12 = (98,306.39) x 14% x 3/12 = 3,440.72 97616.71 + 333.17 + 356.49 = 98,306.37 98,496.54

65. Investments64 Sale of Investment in Securities Held to Maturity Before Maturity Example H:(contd.) n J.E n 3/31/x6 Interest Receivable3,250 Investment in Debt Sector190.73 Interest Revenue3440.72 n Cash (102,000 + 3,250)105,250 Investment in Debt 98,496.54 Interest receivable3,250 Gain on Sale of Invest. in Debt3,503.46

66. Investments65 Sale of Investment in Securities Held to Maturity Before Maturity Example H:(contd.) Gains= Selling pirce (excluding accrued interest)- Carrying value (updated with amort. of pemium) =102,000-98,496.54 =3,503.46

67. Investments66 The Fair Value Option for Financial Assets (SFAS 159)  SFAS159 allows companies to choose reporting most financial assets at fair value including security investments classified as available-for-sale (SAS) and held-to-maturity (HTM).  This decision of reporting these investments at fair value is irrevocable.  Once the decision is made for a SAS or a HTM security, the company would report that security as a trading security.

68. Investments67 The Fair Value Option (contd.)  When electing the fair value option to account for SAS or HTM, the fair value adjustment for these securities should be made indirectly using a valuation account (i.e., the fair value adjustment account).  The fair value adjustment should not be made directly to the trading security account.  The unrealized gain or loss would be reported in the income statement.

69. Example I: Same infor. as in Example A on p20, Investment in SAS-Fair Value Option Reporting The fair value option reporting was elected for all investments in SAS a. The following entry would be recorded on 12/31/x5: Fair Value Adjustment b 3,000 Unrealized Holding Gain/Loss c 3,000 a The fair value option can be applied on an instrument-by-instrument basis. b The adjustment to fair value is made indirectly and the SAS investment is reported as trading securities on the B/S at the fair value. C Reported in the income statement Investments68

70. Example I: Same infor. as in Example A on p23, Investment in SAS-Fair Value Option Reporting The following entry would be recorded on 12/31/x6: Unrealized holding Gain/Loss a 5,000 Fair Value Adjustment b 5,000 a Reported in the income statement B An indirect adjustment; the SAS is reported as trading securities on the B/S at fair value. Investments69

71. Example J: Same infor. as in Example B on p27, Investment in SAS-Fair Value Option Reporting n In 20x7, Green sold 100 shares of A stock for $6,000. J.E. to record this transaction Cash6,000 Loss on sale of invest. 100 Investments (at cost) 5,000 Fair Value Adjustment * 1,100 *For stock A, the cost is $5000 while the fair value on 12/31/x6 is $6,100 (see P23). Investments70

72. Investments71 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

73. Investments72 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.

74. Investments73 Transfers :(contd.) n The accounting Treatments for Transfers: From SAS,HTM To Trading Treatment The unrealized gain or loss included in current earnings.

75. Investments74 Transfers :(contd.) n The accounting Treatments for Transfers: From Trading To Available Held to Maturity Treatment No accounting for the unrealized gain or loss (it has been recognized in income)

76. Investments75 Transfers :(contd.) From Held to Maturity To SAS Treatment The unrealized gain or loss reported in the balance sheet as a separate component of stockholders’ equity

77. Investments76 Transfers :(contd.) n The accounting Treatments for Transfers: From SAS To HTM Treatment Fair value of SAS became the amortized cost of HTM. (amortized the unrealized gain or loss to earnings over the remaining life of the securities.)

78. Investments77 Transfers :(contd.) n Example 1: Transfer from SAS to Trading: Using the example of Green Company and instead of selling security A (cost is $5,000) in 20x7, Green decided to transfer security A from SAS security category to trading security category when security A’s fair value is $6,300 on 12/31/20x7. The transfer is recorded as follows:

79. Investments78 Transfers :from SAS to Trading * (Fair value of security A on 12/31/x6 is $6,100) 1. Fair Value Adjustment 200 Unrealized gain or loss 200 2. Investment in Trading 6,300 Unrealized gain/ loss 1,300 Investment in SAS (at cost) 5,000 Fair Value Adjustment (for A) 1,300 Gain on Transfer of Securities 1,300

80. Investments79 Transfers : from Trading to SAS Example 2: From Trading to SAS Assume the same facts as example 1 expect security A is being transferred from Trading to SAS. The transfer is recorded as: Investment in Trading 200 Unrealized Gain / Loss 200 Investment in SAS 6,300 nvestment in Trading 6,300

81. Investments80 Transfers:(contd.) 3.From held-to-maturity to Available (or Trading): Bonds with a face amount of $10,000 was purchased at par and was included in the held-to-maturity category. When the fair value is $9,500, the company transfers the bonds into the available-for- sale category.

82. Investments81 Transfers:(contd.) The transfer is recorded as follows: Investment in SAS 9,500* Unrealized Gain or Loss in Value of Investment in SAS 500 Investment in HTM 10,000* Note: the new carry value is $9,500. The unrealized gain or loss is reported in the stockholder’s equity section of the Balance Sheet.

83. Investments82 Transfers :(contd.) * or any amortized cost if the bonds were purchased at discount or premium. The unrealized account will be adjusted accordingly. ** If the transfer is to Trading category, the gain or loss will be included in income. Alternative J.E. for the transfer: Investment in T. S. 9,500 Loss 500 Investment in HTM10,000

84. Investments83 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.

85. Investments84 Financial Statement Classification n T rading securities related cash flows are classified as cash flows of operating activities while cash flows from all other types of securities are reported as cash flows of investing activities.

86. Investments85 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.

87. Investments86 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.

88. Investments87 Impairment of Value (in Debt Investment) n Impairment occurs for debt securities when company cannot collect all the amount due from debt securities investments.

89. Investments88 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.

90. Investments89 Impairment:(contd.) Example a: Tr acy company had an investment categorized as held to maturity with an amortized cost of $21,500 and a fair value of $6,500. If the decline is Not temporary, the accounting treatment is: Loss on Impairment 15,000 Investment in Debt Securities Held to Maturity 15,000

91. Investments90 Impairment:(contd.) Example a(contd.): n The $6,500 became the “new” cost. Interest revenue is computed using the effective interest needed based on the new effective rate.

92. Investments91 Impairment of Value (contd.): n For investment in debt securities classified as SAS experienced a decline in value other than temporary, the accounting treatments are: 1.Eliminate the unrealized gain or loss related to the securities. 2.Write down to the fair value and recognize the write down as a realized Loss. n Therefore, the fair value becomes the new cost basis.

93. Investments92 Impairments:(contd.) Example b: (debt investment classified as SAS) n In 20x7, Hinges' investment in D company had a fair value of $5,000. The cost of this investment is $15,000 and the fair value of D company investment is 13,000 on 12/31/x6. This investment was classified as SAS. The J.E. to record the impairment are :

94. Impairments:(contd.) Example b: (debt investment classified as SAS) Fair Value Adjustment 2,000 Unrealized Holding Gain/Loss 2,000 Eliminate the unrealized gain/loss Loss on Impairment 10,000 Investment in SAS 10,000 Write down to the fair value Investments93

95. Investments94 Impairments:(contd.) Example c: n If the debt investment is classified as trading securities, the following entry will be recorded for the write-down: Loss on Impairment 8,000 Investment in Trading 8,000 Securities

96. Investments95 Impairment of Value ( in equity securities) n SFAS No. 115 does not provide precise guideline to determine the impairment for equity securities. n Whenever the realizable value is lower than the carrying amount of the investment, an impairment should be considered. n Accounting treatment for the write down is similar to that of the debt securities as in examples b and c.

97. Investments96 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 of an investee. n In the absence to the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influence.

98. Investments97 Equity Method n Exceptions: there are cases that investors hold 20% or more of the outstanding common stock of an investee but do not have significant influence. In these cases, the equity method should not be used. n FASB Interpretation No. 35 provides examples of these cases:

99. Investments98 Equity Method:(contd.) 1.The investee challenges the investor's ability to exercise significant influence (through litigation or complaints to regulators). 2.Majority of investee’s ownership is concentrated among a small group of shareholders who operate the investee without regards the views of the investor;

100. Investments99 Equity Method:(contd.) 3.The investor tries and fails to obtain representation on the investees board of directors; 4.The investor signs an agreement to give up significant shareholder rights. 5.The investor could not acquire financial information needed to apply the equity method (i.e., fair market value of depreciable assets).

101. Investments100 Equity Method:(contd.) n On the other hand, the investor may own less than 20% of the voting shares but is able to exercise significant influence over the investee. n The equity method should be applied in this case.

102. Investments101 Consolidated Financial Statements and the Equity Method n When a company acquires 51% or more of the voting stock of another company, the acquiring firm has the controlling interest and is called the parent while the investee company is called the subsidiary. n Both companies continue to operate as separate legal entities and report separate financial statements. n The parent company also reports consolidated financial statements (F/S).

103. Investments102 Consolidated Financial Statements and the Equity Method (contd.) n Consolidated F/S combine the parent and subsidiary F/S into a single aggregate set of F/S. n When a purchase method is used to account for the acquisition, the acquired company's assets are reported on the consolidated F/S at their fair values, not their book values.

104. Investments103 Consolidated Financial Statements and the Equity Method (contd.) n If the purchase price is greater than the fair value of the acquired net assets (fair value of assets - fair value of liabilities), the excess amount is recorded as goodwill. n The depreciation of the acquired company's assets is based on the fair value on the consolidated F/S. n This depreciation expense is greater than that of using the book value as the deprecation base.

105. Investments104 Consolidated Financial Statements and the Equity Method (contd.) n The goodwill is NOT subject to amortization on the consolidated F/S (SFAS No.142). a n The incremental depreciation expense will reduce the net income reported on the consolidated F/S. n The investment account of the equity method is to approximate the net outcome of the consolidated F/S for the investor. n a. Effective date for SFAS 142 is for fiscal years beginning after 12/15/2001. SFAS 142 is to apply to all goodwill. Goodwill acquired after 6/30/2001 is subject immediately to nonamortization of SFAS 142.

106. Investments105 The Accounting Procedures of the Equity Method n The investment is originally recorded at cost but is subsequently adjusted each period for the changes in the net assets of the investee. n The investment is increased (decreased) by the investor's proportionate shares of investee’s net income (loss) and decreased by the dividends received.

107. Investments106 The Accounting Procedures of the Equity Method n The Investee’s net income is further adjusted by the following: 1. Elimination of intercompany transaction impact; 2. the depreciation of investee’s assets step-up a (if there is any) a. fair value of investee’s depreciable assets - book value of these assets

108. Investments107 The Accounting Procedures of the Equity Method:(contd.) n Treat the proportionate share of investee extraordinary items as investor's extraordinary items. n Similar principle applies to investee’s discontinued operation results and cumulative effect from accounting method change).

109. Investments108 Summary of the Equity Method Procedures: Investment = Acquisition Cost + Investor’s Share of Investee's Net Income (N/I) - Dividends Received Where: Investor’s Share of Investee's Income = (Investee’s N/I x owner. %) - Adjustments Dividends Received = Total Div. Paid by Investee x ownership %

110. Investments109 Summary of the Equity Method Procedures (contd.): Adjustments include: a.elimination of intercompany transaction impact b.the depreciation of investee’s depreciable assets step-up

111. Investments110 Summary of the Equity Method Procedures (contd.): Investment Cost Share of Income Share of dividends Share of depre. on assets step-up

112. Investments111 Example: Equity Method Investments n On 1/1/x5, 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/x5. n Thus, Cliborn has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000. n The following information concerning Sam Corporation is also available on 1/1/x5:

113. Investments112 Example:(contd.) B/S Book Value Fair Market Value Depreciable assets (remaining life, 10 year) $400,000 $ 450,000 Other nondepreciatble assets (e.g., land) $190,000 $ 226,000 Total $ 590,000 $ 676,000 Liabilities $ 200,000 $ 200,000 Common Stock $ 250,000 Retained Earnings $ 140,000 $ 590,000

114. Investments113 Example:(contd.) n Also, no intercompany transactions occur during the year. n Sam Corp. paid $20,000 dividends on 8/28/x5, and reported net income for 20x5 of $81,000 consisting of ordinary income of $75,000 and an extraordinary gain of $6,000. n These events are recorded on Cliborn Company’s book as follows:

115. Investments114 Example:(contd.) 1.To record the investment on 1/1/x5: Investment in Stock 125,000 Cash 125,000 2.To record the receipt of dividends on 8/28/x5: Cash (20,000 x 25%) 5,000 Investment in Stock 5,000

116. Investments115 Example:(contd.) 3.To record Cliborn Company’s 25% share in the year’s net income: 12/31/x5 Investment in Stock 20,250 a Investment Income: ordinary 18,750 b Investment Income: extra 1,500 c a. $81,000 x 25% b. $75,000 x 25% c. 6,000 x 25%

117. Investments116 Example:(contd.) 4. Adjustments: To reduce the investment by the proportionate depreciation of invstee’s depreciable assets step-up: Investment Income: ordinary1,250 a Investment in Stock1,250 a.[(450,000 - 4000,000) x 25%] / 10

118. Investments117 Example:(contd.) Goodwill: Purchase price - fair value of net assets acquired n Fair value of net assets (assets –liabilities) =$676,000 - $200,000= $476,000 n Investor's share of the fair value of net assets = $476,000*25% = $119,000 n Goodwill = $125,000 - 119,000 = $6,000

119. Investments118 Summary of the Equity Method Procedures (contd.): Investment (12/31/x5) Cost 125,000 Share of Income 20,250 5,000 Dividends 1,250 Incremental Depr. Balance 139,000

120. Investments119 Financial Statement Disclosures The Investment in stock account is disclosed in the long-term investment section of the 12/31/x5 Balance Sheet of Cliborn Company as follows: Investment in Sam Corp. Acquisition Price (1/1/x5) $125,000 Add: Shares of 20x5 reported ordinary Income $18,750 Shares of 20x5 reported extraordinary Income 1,500 20,250 145,000 Less: Dividends Paid (8/28/x5) $5,000 Depreciation on Excess Market Value of Acquired Assets 1,250 ($6,250) Carrying Value$139,000

121. Investments120 Financial Statement Disclosures :(contd.) n The total amount of Investee income disclosed on Cliborn income statement for 20x5 is $18,700, which consists of $17,200 income from continuing operations and $1,500 of an extraordinary income. The supporting schedule is as follows: Shares of 20x5 Ordinary Income $18,750 Less: Depreciation on Excess M.V. of Acquired Assets ($1,250) Ordinary Investment Income$17,500 Plus: Share of extraordinary Income $1,500 Net Investment Income $19,000

122. Fair Value Option for Investments Accounted for Under the Equity Method When the fair value option is elected to report investments accounted for under the equity method, the investments are reported at the fair value. The investments are not reclassified as trading securities as in the case of fair value option reporting for SAS or HTM. Investments121

123. Fair Value Option for Equity Method Investments (Contd.) The investments are reported on a separate line in the balance sheet or with other equity method investments with the fair value in a parenthesis. The unrealized holding gain/loss is reported in the income statement. Investments122

124. Example: Fair Value Option for Equity Method Investments  Using the example on p111-120, Clibron Corporation has been applying the equity method to account for its investment in Sam Corporation, the investment account balance under the equity method is $139,000 on 12/31/20x5(see the t-account on p118).  Assuming the fair value of Sam Corporation on 20x5 is $700,000, the fair value of Clibrone’s 25% share of Sam Corp. would be $175,000. Investments123

125. Example: Fair Value Option for Equity Method Investments (Contd.) If Clibron had been using the equity method to account for its investments in Sam Corp. but elected the fair value option reporting for this investment on 12/31/x5, the following adjustment would be made by Clibron Corp. on 12/31/x5: Fair Value Adjustment* 36,000 Unrealized Holding Gain** 36,000 *to adjust the investment account to fair value of $175,000 ** reported in the income statement Investments124

126. Example: Fair Value Option for Equity Method Investments (Contd.) The contribution to the earnings from investment in Sam Corp equals: $19,000 (net investment income recognized under the equity method, see p 120) +$36,000 (fair value adjust.) = $55,000 Investments125

127. Example: Fair Value Option for Equity Method Investments (Contd): An Alternative If Clibron has been using the fair value reporting for its investment in Sam and made its fair value adjusting on 12/31/x5, the following entries would have been recorded in 20x5 for this invement: 1/1 Investment 125,000 Cash 125,000 8/28 Cash 5,000 Investment Revenue 5,000 Investments126

128. Example: Fair Value Option for Equity Method Investments (Contd): An Alternative 12/31/x5 Fair Value Adjustment * 50,000 Unrealized Holding Gain** 50,000 * to adjust the investment to the fair value of $175,000 ** reported in the income statement The contribution to the earnings from investment in Sam equals: $55,000 (i.e., $5,000+50,000). Investments127

129. Investments128 Change from Equity method: n When the ownership falls below 20%, the investor may lose significant influence over the investee and the use of the equity method is no longerappropriate. n The investment should be accounted for under the fair value method.

130. Investments129 Change from Equity method (contd.): n No adjustment is made to the carrying amount of the investment account. n The carrying amount of the investment on the date of change becomes the new cost basis. n The equity method is simply discontinued and the appropriate new method is applied from then on.

131. Investments130 Change to Equity method: n Change to Equity method: The investment account is retroactively adjusted to the balance as if the equity method always had been used. n An example of changing from accounting the investment as SAS to the equity method: Procedures:

132. Investments131 Change to Equity method: 1. Eliminate the unrealized gain or loss (i.e., adjust the investment account to the cost) 2. Adjust the investment account retroactively: Investment in Stock$$ Retained Earnings $$ $$ = its previous percentage of( investee's adjusted income - Dividends) prior to the change.

133. Investments132 Change to Equity method (contd.): n Prior financial statements should be restated using the equity method for comparative purposes. n The income effect for years prior to those shown in the comparative statements is reported as an adjustment to the beginning retained earnings of the earliest year reported on the R/E statement.

134. Investments133 Sale of Equity Method Investment n A gain or loss is recognized as the difference between the selling price and the carrying amount of the investment account.

135. Investments134 Conclusion n Different methods in accounting for investments will not affect the cash flows, but only the income number. n Equity method is to prevent income manipulation by investees who have significant influence on dividend policy.

136. Investments135 Additional Issues n A. Reporting for non marketable securities: non marketable securities are stock or bonds issued by a privately-held company whose securities are not traded in a “qualifying” market. n Reporting for these securities does not follow the guidance of SFAS 115. These securities are typically reported at their historical cost and the unrealized gains and losses are ignored.

137. Investments136 Additional Issues (contd.) B.Stock Dividends and Splits No journal entry is needed to account for either the stock dividends or the splits. However, a memo is required to indicate that the cost of shares is reduced.

138. Investments137 Additional Issues:(contd.) Example of stock dividends: n 2,000 shares of Kell Co. common stock were originally purchased for $30 per share by the Smith Co. n Two months later, Kell issued a 50% stock dividend. Therefore, Smith received another 1,000 shares. The following memo is to reflect the stock dividend received by Smith:

139. Investments138 Additional Issues:(contd.) Example of stock dividends: n memo: Received 1,000 shares of Kell Companycommon stock as a stock dividend. The cost of the shares is now $20 per share, computed as follows: $60,000 / (2,000 + 1,000) = $20. n Subsequently, 500 shares of investment were sold for $25 per share. The fair value at the most recent B/S data was $23 per share. The journal entry to record this transaction is:

140. Investments139 Additional Issues:(contd.) Example:(contd.) Cash 12,500 Unrealized Gain and Loss in Value of SAS 1,500 Investment in SAS 11,500 Gain on Sale of Investments ** 2,500 * Cost per share has been reduced from $30 to $20 per share due to stock dividends. ** ($25 - 20) * 500 = 2,500

141. Investments140 Additional Issues:(contd.) C.Stock Warrants n Stock warrants are certificates that enable their holders to purchase a specific number of shares at a predetermined price. n No additional cost is incurred when the warrants are received by the corporation holding the investment in common stock. n It is necessary to assign a portion of the cost of the stock (investment) to the warrants upon their receipt of warrants.

142. Investments141 Additional Issues:(contd.) C.Stock Warrants (contd.) n The amount is determined by use of a weighted average based on the market value of the stock ex right and the market value of the warrants. n The accounting for any subsequent purchases of shares (or any sale of warrants) would use the amount assigned to the warrants.

143. Investments142 Additional Issues:(contd.) D.Convertible Bonds n Investments in convertible bonds would be included in the available for sale (or trading) category and valued at fair value. n When these convertible bonds are converted into stocks,memo is required to specify the number of shares that are now owned instead of bonds.

144. Investments143 Additional Issues:(contd.) E.Cash Surrender Value of Life Insurance n Portion of insurance premiums paid for executives may be returned to the company upon the cancellation of the policy. n This guaranteed cash returned upon the cancellation of an insurance is called “ Cash Surrender Value” of an insurance plan.

145. Investments144 Additional Issues:(contd.) E. (contd.) n This portion of the insurance premiums (equal to the cash surrender value) should be reported as a long- term investment on the balance sheet, rather than an insurance expense. n Example: At the beginning of the year, the Mele Co. pays an annual insurance premium of $5,500 to cover the lives of its officers. The following entry is recorded:

146. Investments145 Additional Issues:(contd.) Example: Prepaid Insurance5,500 Cash5,500 n According to the terms of the insurance contract the cash surrender value of the policy increases from $7,200 to 8,300 during that year. n The adjusting entry at the end of year to record the insurance expense and the increase in cash surrender value is as follows:

147. Investments146 Additional Issues:(contd.) Example:(contd.) Insurance Expense 4,400 Cash Surr. Value of Life Ins. 1,100 Prepaid Insurance5,500 n Upon the death of any of insurance officer, Mele would debit cash for the proceeds received from the insurance company, credit cash surrender value and any difference will be reported as an ordinary gain. n For tax purchases, the premiums are Not tax deductible and the gain is not taxable.

148. Investments147 Additional Issues:(contd.) F.Investments in Funds n Assets (i.e., securities, cash,..) could be placed in special funds for specific purposes (i.e. for the retirement of long-term liabilities (bond sinking fund), etc). n Assets placed in the funds are not available for normal operations because of the contractual arrangement. Therefore, long- term funds are reported as investments on the balance sheet.

149. Investments148 Additional Issues:(contd.) F.Investments in Funds (contd.) n The accounts used in connection with a bond sinking fund are: Sinking Fund Cash, Sinking Fund Securities, Sinking Fund Revenues, Sinking Fund Expenses, Allowance for Change in Value of Sinking Fund Securities, Unrealized Gain/Loss in Value of Sinking Fund Securities, and loss on Sale of Sinking Fund Securities and Loss on Sale of Sinking Fund Securities.

150. Investments149 Impairment of Receivable due to Troubled Debt Restructuring n The receivable is settled outright (example is from p589 of Spiceland, etc. textbook) n First Prudent is owed $30 million by Brillard Properties under a 10% note with two years remaining. n The previous year’s interest was not received due to financial difficulties of Brillard. n First Prudent agrees to settle the receivable and the accrued interest in exchange for property with a fair value of $20 million on 1/1/x3.

151. Impairment of Receivable due to Troubled Debt Restructuring (contd.) n J.E. ($ in millions) Land 20 Loss on T/D restructuring 13 Interest receivable 3 Note receivable 30 Investments150

152. Impairment of Receivable due to Troubled Debt Restructuring (contd.) The receivable is continued but with modified terms: (p589 of Spiceland, etc.) Same information as on p148, except First Prudent agrees to forgive the interest accrued, reduce the remaining two interest payments to $2 million each and reduce the principal to $25 million. Investments151

153. Investments152 Impairment of Receivable due to Troubled Debt Restructuring (contd.) n Carrying value of the loan: $33 million n Present value of future cash flows of receivable (24,132,330) n Loss from the settlement $8,867,670 n PV=$2 millionx1.73554+$25 millionx0.82645

154. Investments153 Impairment of Receivable due to Troubled Debt Restructuring (contd.) n J.E.(1/1/x3) n Loss on T/B restructuring 8,867,670 n Interest receivable 3,000,000 n Note receivable 5,867,670* n * $30 million-24,132,330 (PV of future cash flows from the settlement) n 1/1/x4 n Cash 2,000,000 n Note Receivable 413,233 n Interest Revenue* 2,413,233 n *10% interest on the balance of N/R on 1/1/x3

155. Impairment of Receivable due to Troubled Debt Restructuring (contd.) The balance of Note Receivable on 1/1/x4 = 24,132,330 +413,233 = 24,545,563 = present value of Note receivable on 1/1/x4 = $2 million x0.9091+25,000,000x0.9091 Investments154

156. Impairment of Receivable due to Troubled Debt Restructuring (contd.) 1/1/x5 (receipt of $2 million interest and $25 million of principal) Cash 2,000,000 Note Receivable 454,570 Interest Revenue 2,454,570* *10% interest on the bal. of N/R on 1/1/x4 Cash 25,000,000 Note Receivable 25,000,000 Investments155