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Understanding Investment Accounting: Debt and Equity Securities Treatment

Learn about the accounting and reporting treatment of different categories of debt and equity securities in investments. Understand methods for discount and premium amortization on bond investments and compare the equity method with the fair value method for equity securities.

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Understanding Investment Accounting: Debt and Equity Securities Treatment

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  1. C H A P T E R 17 • INVESTMENTS • Intermediate Accounting • 13th Edition • Kieso, Weygandt, and Warfield

  2. Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. Understand the procedures for discount and premium amortization on bond investments. Identify the categories of equity securities and describe the accounting and reporting treatment for each category. Explain the equity method of accounting and compare it to the fair value method for equity securities. Learning Objectives

  3. Investments • Investments in Debt Securities • Investments in Equity Securities • Held-to-maturity securities • Available-for-sale securities • Trading securities • Holdings of less than 20% • Holdings between 20% and 50% • Holdings of more than 50% • Fair value option

  4. Investment Accounting Approaches • Different motivations for investing: • To earn a high rate of return e.g. interest revenue from a debt investment or dividend revenue from an equity investment. • To secure certain operating or financing arrangements with another company.

  5. Investment Accounting Approaches • Companies account for investments based on • the type of security (debt or equity) and • their intent with respect to the investment. • Illustration 17-1

  6. Investments in Debt Securities • Debt securities (creditor relationship with anther entity): • Type • Accounting Category • government securities • Municipal securities • Corporate bonds • Convertible debt • Commercial paper • Held-to-maturity • Trading • Available-for-sale • LO 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.

  7. Investments in Debt Securities • Accounting for Debt Securities by Category • Illustration 17-2 • LO 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.

  8. Held-to-Maturity Securities • Classify a debt security as held-to-maturity only if it has both • the positive intent and • the ability to hold securities to maturity. • Accounted for at amortized cost, not fair value. • Amortize premium or discount using the effective-interest methodunless the straight-line method yields a similar result. • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  9. Held-to-Maturity Securities • Illustration: KC Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2009, at a discount, paying $92,278. The bonds mature January 1, 2014 and yield 10%; interest is payable each July 1 and January 1. KC records the investment as follows: • January 1, 2009 • Held-to-Maturity Securities 92,278 • Cash 92,278 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  10. Held-to-Maturity Securities • Illustration 17-3 • Schedule of Interest • Revenue and Bond • Discount Amortization— • Effective-Interest Method • LO 2

  11. Held-to-Maturity Securities • Illustration: KC Company records the receipt of the first semiannual interest payment on July 1, 2009, as follows: • July 1, 2009 • Cash 4,000 • Held-to-Maturity Securities 614 • Interest Revenue 4,614 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  12. Held-to-Maturity Securities • Illustration: KC is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2009, as follows: • December 31, 2009 • Interest Receivable 4,000 • Held-to-Maturity Securities 645 • Interest Revenue 4,645 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  13. Held-to-Maturity Securities • Reporting of Held-to-Maturity Securities • Illustration 17-4 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  14. Held-to-Maturity Securities • Illustration: Assume that KC Company sells its investment in Evermaster bonds on November 1, 2013, at 99,750 plus accrued interest. KC records this discount amortization as follows: • November 1, 2013 • Held-to-Maturity Securities 635 • Interest Revenue 635 • $952 x 4/6 = $635 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  15. Held-to-Maturity Securities • Computation of the realized gain on sale. • Illustration 17-5 • Cash 99750+2667= 102,417 • Interest Revenue (4/6 x $4,000) 2,667 • Held-to-Maturity Securities 99,683 • Gain on Sale of Securities 67 • LO 2

  16. Available-for-Sale Securities • Debt Securities • Companies report available-for-sale securities at • fair value, with • unrealized holding gains and losses reported as part of comprehensive income (equity). • Any discount or premium is amortized. • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  17. Available-for-Sale Securities • Debt Securities • Illustration(Single Security): Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2009, with interest payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective interest rate of 8 percent. Graff records the purchase of the bonds on January 1, 2009, as follows. • Available-for-Sale Securities 108,111 • Cash 108,111 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  18. Available-for-Sale Securities • Debt Securities • Illustration 17-6 • Schedule of Interest • Revenue and Bond • Premium Amortization— • Effective-Interest Method • LO 2

  19. Available-for-Sale Securities • Debt Securities • Illustration(Single Security): The entry to record interest revenue on July 1, 2009, is as follows. • Cash 5,000 • Available-for-Sale Securities 676 • Interest Revenue 4,324 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  20. Available-for-Sale Securities • Debt Securities • Illustration(Single Security): At December 31, 2009, Graff makes the following entry to recognize interest revenue. • Interest Receivable 5,000 • Available-for-Sale Securities 703 • Interest Revenue 4,297 • Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297). • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  21. Available-for-Sale Securities • Debt Securities • Illustration (Single Security): To apply the fair value method to these debt securities, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732. Graff makes the following entry. • Unrealized Holding Gain or Loss—Equity 1,732 • Securities Fair Value Adjustment (AFS) 1,732 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  22. Available-for-Sale Securities • Debt Securities • Illustration(Portfolio of Securities): Webb Corporation has two debt securities classified as available-for-sale. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss. • Illustration 17-7 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  23. Available-for-Sale Securities • Debt Securities • Illustration(Portfolio of Securities): Webb makes an adjusting entry to a valuation allowance on December 31, 2010 to record the decrease in value and to record the loss as follows. • Unrealized Holding Gain or Loss—Equity 9,537 • Securities Fair Value Adjustment (AFS) 9,537 • Webb reports the unrealized holding loss of $9,537 as other comprehensive income and a reduction of stockholders’ equity. • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  24. Available-for-Sale Securities • Debt Securities • Sale of Available-for-Sale Securities • If company sells bonds before maturity date: • Must make entry to remove the, • Cost in Available-for-Sale Securities and • Securities Fair Value Adjustment accounts. • Any realized gain or loss on sale is reported in the “Other expenses and losses” section of the income statement. • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  25. Available-for-Sale Securities • Debt Securities • Illustration (Sale of Available-for-Sale Securities): Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1, 2011, for $90,000, at which time it had an amortized cost of $94,214. • Illustration 17-8 • Cash 90,000 • Loss on Sale of Securities 4,214 • Available-for-Sale Securities 94,214 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  26. Available-for-Sale Securities • Debt Securities • Illustration (Sale of Available-for-Sale Securities): Webb reports this realized loss in the “Other expenses and losses” section of the income statement. Assuming no other purchases and sales of bonds in 2011, Webb on December 31, 2011, prepares the information: • Illustration 17-9 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  27. Available-for-Sale Securities • Debt Securities • Illustration (Sale of Available-for-Sale Securities): Webb records the following at December 31, 2011. • Illustration 17-9 • Securities Fair Value Adjustment (AFS) 4,537 • Unrealized Holding Gain or Loss—Equity 4,537 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  28. Available-for-Sale Securities • Debt Securities • Financial Statement Presentation • Illustration 17-10 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  29. Trading Securities • Debt Securities • Companies report trading securities at • fair value, with • unrealized holding gains and losses reported as part of net income. • Any discount or premium is amortized. • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  30. Trading Securities • Illustration: On December 31, 2010, Western Publishing Corporation determined its trading securities portfolio to be as follows: • Debt Securities • Illustration 17-11 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  31. Trading Securities • Illustration: At December 31, Western Publishing makes an adjusting entry: • Debt Securities • Illustration 17-11 • Securities Fair Value Adjustment (Trading) 3,750 • Unrealized Holding Gain or Loss—Income 3,750 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  32. Trading Securities • BE17-4:(Trading Securities) Hendricks Corporation purchased trading investment bonds for $50,000 at par. At December 31, Hendricks received annual interest of $2,000, and the fair value of the bonds was $47,400. • Instructions: • Prepare the journal entry for the purchase of the investment. • Prepare the journal entry for the interest received. • Prepare the journal entry for the fair value adjustment. • Debt Securities • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  33. Trading Securities • BE17-4: Prepare the journal entries for (a) the purchase of the investment, (b) the interest received, and (c) the fair value adjustment. • Debt Securities • (a) Trading securities 50,000 • Cash 50,000 • (b) Cash 2,000 • Interest revenue 2,000 • (c) Unrealized Holding Loss - Income 2,600 • Securities Fair Value Adj.- Trading 2,600 • LO 2 Understand the procedures for discount and premium amortization on bond investments.

  34. Investments in Equity Securities • Represent ownership of capital stock. • Cost includes: • price of the security, plus • broker’s commissions and fees related to purchase. • The degree to which one corporation (investor)acquires an interest in the common stock of another corporation (investee)generally determines the accounting treatment for the investment subsequent to acquisition. • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  35. Investments in Equity Securities 0 --------------20% ------------ 50% -------------- 100% • Ownership Percentages • SFAS 141, SFAS 142 • APBO 18, SFAS 142 • SFAS 115 • No significant influence usually exists • Significant influence usually exists • Control usually exists • Investment valued using Fair Value Method • Investment valued using Equity Method • Investment valued on parent’s books using Cost Method or Equity Method (investment eliminated in Consolidation) • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  36. Investments in Equity Securities • Accounting and Reporting for Equity Securities by Category • Illustration 17-13 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  37. Holdings of Less Than 20% • Accounting Subsequent to Acquisition • Market Price Available • Market Price Unavailable • Value and report the investment using the fair value method. • Value and report the investment using the cost method.* • * Securities are reported at cost. Dividends are recognized when received and gains or losses only recognized on sale of securities. • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  38. Holdings of Less Than 20% • Upon acquisition, companies record available-for-sale securities at cost. • Illustration: On November 3, 2010 Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest. • Available-for-Sale Securities • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  39. Holdings of Less Than 20% • Illustration: Republic records these investments on November 3, 2010, as follows. • On December 6, 2010, Republic receives a cash dividend of $4,200 from Campbell Soup Co. • Available-for-Sale Securities • Available-for-Sale Securities 718,550 • Cash 718,550 • Cash 4,200 • Dividend revenue 4,200 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  40. Holdings of Less Than 20% • Illustration: Republic’s available-for-sale equity security portfolio on December 31, 2010: • Available-for-Sale Securities • Illustration 17-14 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  41. Holdings of Less Than 20% • Illustration: On December 31, 2010, Republic records the net unrealized gains and losses related to changes in the fair value of available-for-Sale equity securities in an Unrealized Holding Gain or Loss—Equity account. • Available-for-Sale Securities • Unrealized Holding Gain or Loss—Equity 35,550 • Securities Fair Value Adjustment (AFS) 35,550 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  42. Holdings of Less Than 20% • Illustration: On January 23, 2011, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. • Available-for-Sale Securities • Illustration 17-15 • Cash 287,220 • Available-for-Sale Securities 259,700 • Gain on Sale of Stock 27,520 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  43. Holdings of Less Than 20% • Illustration: On February 10, 2011, Republic purchased 20,000 shares of Continental Trucking at a price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850). • Available-for-Sale Securities • Illustration 17-16 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  44. Holdings of Less Than 20% • Illustration: • Available-for-Sale Securities • Illustration 17-16 • Securities Fair Value Adjustment (AFS) 99,800 • Unrealized Holding Gain or Loss—Equity 99,800 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  45. Holdings of Less Than 20% • P17-6:McElroy Company has the following portfolio of securities at September 30, 2010, its last reporting date. • On Oct. 10, 2010, the Horton shares were sold at a price of $54 per share. In addition, 3,000 shares of Patriot common stock were acquired at $54.50 per share on Nov. 2, 2010. The Dec. 31, 2010, fair values were: Monty $106,000, Patriot $132,000, and the Oakwood common $193,000. • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  46. P17-6:Prepare the journal entries to record the sale, purchase, and adjusting entries related to the trading securities in the last quarter of 2010. • Holdings of Less Than 20% • Portfolio at September 30, 2010 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  47. P17-6:Prepare the journal entries to record the sale, purchase, and adjusting entries related to the trading securities in the last quarter of 2010. • Holdings of Less Than 20% • October 10, 2010 (Horton): • Cash (5,000 x $54) 270,000 • Trading securities 215,000 • Gain on sale 55,000 • November 2, 2010 (Monty): • Trading securities (3,000 x $54.50) 163,500 • Cash 163,500 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  48. Holdings of Less Than 20% • P17-6: Portfolio at December 31, 2010 • December 31, 2010: • Unrealized holding loss - Income 36,500 • Securities fair value adj. - Trading 36,500 • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

  49. Holdings of Less Than 20% • P17-6:How would the entries change if the securities were classified as available-for-sale? • The entries would be the same except that the • Unrealized Holding Gain or Loss—Equity account is used instead of Unrealized Holding Gain or Loss—Income. • The unrealized holding loss would be deducted from the stockholders’ equity section rather than charged to the income statement. • LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

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