1. McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVESTMENTS Chapter 12

2. Slide 2 12-2 Nature of Investments Bonds and notes (Debt securities) Bonds and notes (Debt securities) Common and preferred stock (Equity securities) Common and preferred stock (Equity securities) Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

3. Slide 3 12-3 Reporting Categories for Investments

4. Slide 4 12-4 Securities to Be Held to Maturity On January 1, 2009, 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 calculation of the present value of the bond issue. Present Amount PV Factor Value Interest $ 50,000× 11.46992=$573,496 Principal 1,000,000× 0.31180= 311,805 Present value of bonds $885,301 PV of ordinary annuity of $1, n = 20, i = 6% PV of $1, n = 20, i = 6%

5. Slide 5 12-5 Securities to Be Held to Maturity Period Interest Payment Interest Revenue Discount Amortization Unamortized Discount Carrying Value 114,699 885,301 1 50,000 53,118 (3,118) 111,581 888,419 2 50,000 53,305 (3,305) 108,276 891,724 3 50,000 53,503 (3,503) 104,773 895,227 4 50,000 53,714 (3,714) 101,059 898,941 Partial Bond Amortization Table

6. Slide 6 12-6 Securities to Be Held to Maturity $114,699 - $3,118 = $111,581 unamortized discount How would this investment appear on the balance sheet after one period of discount amortization?

7. Slide 7 12-7 Securities to Be Held to Maturity On December 31, 2009 after interest is received by Matrix, all the bonds are sold for $900,000 cash. Period Interest Payment Interest Revenue Discount Amortization Unamortized Discount Carrying Value 114,699 885,301 1 50,000 53,118 (3,118) 111,581 888,419 2 50,000 53,305 (3,305) 108,276 891,724 3 50,000 53,503 (3,503) 104,773 895,227 4 50,000 53,714 (3,714) 101,059 898,941

8. Slide 8 12-8 Trading Securities Adjustments to fair value are recorded: 1.in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 2.as a net unrealized holding gain/loss on the Income Statement. Unrealized Gain Unrealized Loss Income Statement

9. Slide 9 12-9 Trading Securities Matrix, Inc. purchased additional securities classified as Trading Securities (TS) at the end of 2009. The fair value amounts for these securities on December 31, 2009, are shown below. Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at 12/31/09.

10. Slide 10 12-10 Trading Securities The Net Unrealized Holding Loss is reported on the Income Statement.

11. Slide 11 12-11 Trading Securities Unrealized holding gains and losses from trading securities are reported on the income statement.

12. Slide 12 12-12 Trading Securities On January 3, 2010, Matrix sold all trading securities for $65,000 cash.

13. Slide 13 12-13 Securities Available-for-Sale Adjustments to fair value are recorded: 1.in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 2.as a net unrealized holding gain/loss in Other Comprehensive Income (OCI), which accumulates in Accumulated Other Comprehensive Income (ACOI). Unrealized Gain Unrealized Loss Other Comprehensive Income

14. Slide 14 12-14 Other Comprehensive Income (OCI) When we add other comprehensive income to net income we refer to the result as “comprehensive income.”

15. Slide 15 12-15 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. 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.

16. Slide 16 12-16 Securities Available for Sale Example Now assume the same facts for our Matrix, Inc. example, except that the investment is for available-for-sale securities rather than trading securities.

17. Slide 17 12-17 Securities Available for Sale Example This net unrealized holding gain is reported in other comprehensive income.

18. Slide 18 12-18 Reclassification Adjustment When AFS Investments are Sold Event Effect on Comprehensive Income Effect on Shareholders' Equity Period 1: hold AFS investment and experience net unrealized loss.  OCI for unrealized holding loss.  AOCI Period 2: sell AFS investment and realize loss on sale  OCI to back out previously recognized unrealized  AOCI (so net effect on AOCI over time is zero) holding loss (so effect on OCI over time is zero)  Net income for realized loss  Retained earnings

19. Slide 19 12-19 On January 3, 2010, Matrix sold all available-for- sale for $65,000 cash. Securities Available for Sale Example

20. Slide 20 12-20 Other Than Temporary Impairments This is called an... Occasionally, an investment’s value will decline for reasons that are “other than temporary.” Impairment in Value

21. Slide 21 12-21 Transfers Between Reporting Categories Unrealized holding gains or losses at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. fair value Transfers are accounted for at fair value on the transfer date.

22. Slide 22 12-22 Transfers Between Reporting Categories Transfer from:To:Unrealized Gain or Loss from Transfer at FMV Either of the otherTradingInclude in current net income TradingEither of the otherThere is none (already recognized in net income) Held-to-maturityAvailable-for-sale Report as a separate component of shareholders' in OCI. Available-for-saleHeld-to-maturity Don't write-off existing unrealized holding gain or loss. Amortize it to net income over the remaining life of the security.

23. Slide 23 12-23 Disclosures Aggregate Fair Value Maturities of debt securities Change in net unrealized holding gains and losses Gross realized & unrealized holding gains & losses Amortized cost basis by major security type Inputs to fair value estimates

24. Slide 24 12-24 Investor Has Significant Influence

25. Slide 25 12-25 Investor Has Significant Influence Extent of Investor InfluenceReporting 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

26. Slide 26 12-26 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 : 1. the investee challenges the investor’s ability to exercise significant influence through litigation or other methods. 2. the investor surrenders significant shareholder rights in a signed agreement. 3. the investor is unable to acquire sufficient information about the investee to apply the equity method. 4. 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 : 1. the investee challenges the investor’s ability to exercise significant influence through litigation or other methods. 2. the investor surrenders significant shareholder rights in a signed agreement. 3. the investor is unable to acquire sufficient information about the investee to apply the equity method. 4. the investor tries and fails to obtain representation on the board of directors of the investee.

27. Slide 27 12-27 Equity Method and Consolidation If a company acquires more than 50% of the voting stock of another company: 1. it controls the company acquired (cannot be outvoted). The “parent” controls the “subsidiary.” 2. for accounting purposes, the parent and subsidiary are considered a single reporting entity. Consolidated financial statements combine the separate financial statements of the parent and subsidiary each period into a single aggregate set of financial statements. 3. the equity method is sometimes referred to as a “one line consolidation,” because it shows the investor’s income and investment as increasing by their portion of the investee’s income. If a company acquires more than 50% of the voting stock of another company: 1. it controls the company acquired (cannot be outvoted). The “parent” controls the “subsidiary.” 2. for accounting purposes, the parent and subsidiary are considered a single reporting entity. Consolidated financial statements combine the separate financial statements of the parent and subsidiary each period into a single aggregate set of financial statements. 3. the equity method is sometimes referred to as a “one line consolidation,” because it shows the investor’s income and investment as increasing by their portion of the investee’s income.

28. Slide 28 12-28 Equity Method increased 1. The investment account is increased by: Original investment cost. Proportionate share of investee's earnings. decreased 2. The investment account is decreased by: Dividends received.

29. Slide 29 12-29 Equity Method On January 1, 2009, Matrix, 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 2009, Apex paid cash dividends of $150,000 and reported net income of $1,750,000. What amount will Matrix, Inc. report on the balance sheet as Investment in Apex, Inc.?

30. Slide 30 12-30 Equity Method

31. Slide 31 12-31 Equity Method

32. Slide 32 12-32 Equity Method Investment in Apex, Inc. Investment 1,350,000 67,500 45% Dividends 45% Earnings 787,500 Reported amount 2,070,000 If the investee had a loss, the investment account would have been reduced.

33. Slide 33 12-33 Equity Method On January 1, 2009, Matrix, Inc. purchase 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 net fair value of these assets is $600,000. During 2009, Apex paid cash dividends of $40,000, and reported earnings of $100,000.

34. Slide 34 12-34 Equity Method Assume that of the $50,000 excess of the fair value of net assets acquired ($600,000 × 25% = $150,000) over the book value of those net assets on Apex’s balance sheet ($400,000 × 25% = $100,000), 75% is attributable to depreciable assets with a remaining life of 20 years and the remainder is attributable to land. Matrix uses the straight-line method of depreciation on similar owned assets.

35. Slide 35 12-35 Equity Method Remember, goodwill is not amortized.

36. Slide 36 12-36 Changing 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 the investor’s level of influence changes, it may be necessary to change from the equity method to another method.

37. Slide 37 12-37 Changing From the Equity Method to Another Method Any difference between carrying value and fair value is recorded in a valuation account and is recognized as an unrealized holding gain or loss. After the transfer, the investment is treated as a trading security or a security available for sale, depending on management’s intent.

38. Slide 38 12-38 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.

39. Slide 39 12-39 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. 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.

40. Slide 40 12-40 Fair Value Option SFAS No. 159 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 just 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. SFAS No. 159 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 just 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. Slide 41 12-41 Financial Instruments & Derivatives Financial Instruments: 1. Cash. 2. Evidence of an ownership interest in an entity. 3. Contracts meeting certain conditions. Financial Instruments: 1. Cash. 2. Evidence of an ownership interest in an entity. 3. Contracts meeting certain conditions. Derivatives: 1. Value is derived from other securities. 2. Derivatives are often used to “hedge” (offset) risks created by other investments or transactions Derivatives: 1. Value is derived from other securities. 2. Derivatives are often used to “hedge” (offset) risks created by other investments or transactions

42. Slide 42 12-42 Other Investments – Appendix A 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 1.Petty cash funds. 2.Payroll accounts. In the long-run, funds are often set aside to: 1.Pay long-term debt when it comes due. 2.Acquire treasury stock. Special purpose funds set aside for the long-term are classified as investments.

43. Slide 43 12-43 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.

44. Slide 44 12-44 Appendix 12B – Impairment of a Receivable Due to a Troubled Debt Restructuring troubled debt restructuring When the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor, the new arrangement is referred to as a troubled debt restructuring. Sometimes a troubled debt is settled in full when the debtor transfers assets or equities to the creditor. The creditor usually recognizes a loss on the settlement. Such a settlement is not considered unusual or infrequent and is not an extraordinary item.

45. McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 12