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Chapter 12. INVESTMENTS. Bonds and notes (Debt securities). Common and preferred stock (Equity securities). Nature of Investments. Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship. Reporting Categories for Investments.
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Chapter 12 INVESTMENTS
Bonds and notes (Debt securities) Common and preferred stock (Equity securities) Nature of Investments Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.
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. PV of ordinary annuity of $1, n = 20, i = 6% PV of $1, n = 20, i = 6%
Securities to Be Held to Maturity Partial Bond Amortization Table
$114,699 - $3,118 = $111,581 unamortized discount Securities to Be Held to Maturity How would this investment appear on the balance sheet after one period of discount amortization?
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.
Adjustments to fair value are recorded: in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. as a net unrealized holding gain/loss on the Income Statement. Trading Securities Unrealized Gain Unrealized Loss Income Statement
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. Trading Securities
Trading Securities The Net Unrealized Holding Loss is reported on the Income Statement.
Trading Securities Unrealized holding gains and losses from trading securities are reported on the income statement.
Trading Securities On January 3, 2010, Matrix sold all trading securities for $65,000 cash.
Securities Available-for-Sale Adjustments to fair value are recorded: in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 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
Other Comprehensive Income (OCI) When we add other comprehensive income to net income we refer to the result as “comprehensive income.”
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 parAccumulated other comprehensive incomeRetained earnings Total Shareholders’ Equity Net unrealizedholding gains and losses.
Now assume the same facts for our Matrix, Inc. example, except that the investment is for available-for-sale securities rather than trading securities. Securities Available for Sale Example
This net unrealized holding gain is reported inother comprehensive income. Securities Available for Sale Example
Securities Available for Sale Example On January 3, 2010, Matrix sold all available-for-sale for $65,000 cash.
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
Transfers Between Reporting Categories Transfers are accounted for atfair valueon the transfer date. 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.
Disclosures Aggregate Fair Value Gross realized & unrealized holding gains & losses Maturities of debt securities Amortized cost basis by major security type Change in net unrealized holding gains and losses Inputs to fair value estimates
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 : the investee challenges the investor’s ability to exercise significant influence through litigation or other methods. the investor surrenders significant shareholder rights in a signed agreement. the investor is unable to acquire sufficient information about the investee to apply the equity method. the investor tries and fails to obtain representation on the board of directors of the investee.
Equity Method and Consolidation If a company acquires more than 50% of the voting stock of another company: it controls the company acquired (cannot be outvoted). The “parent” controls the “subsidiary.” 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. 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.
The investment account is increased by: Original investment cost. Proportionate share of investee's earnings. The investment account is decreasedby: Dividends received. 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.? Equity Method
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.
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.
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.
Equity Method Remember, goodwill is not amortized.
At the transfer date, the carrying value of the investment under the equity method is regarded as cost. Changing From the Equity Method to Another Method When the investor’s level of influence changes, it may be necessary to change 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. Changing From the Equity Method to Another 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. 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. Changing From Another Method to the Equity Method
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.
Financial Instruments & Derivatives Financial Instruments: Cash. Evidence of an ownership interest in an entity. Contracts meeting certain conditions. Derivatives: Value is derived from other securities. Derivatives are often used to “hedge” (offset) risks created by other investments or transactions
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 • Petty cash funds. • Payroll accounts. • In the long-run, funds are often set aside to: • Pay long-term debt when it comes due. • Acquire treasury stock. • Special purpose funds set aside for the long-term are classified as investments.
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.
Appendix 12B – Impairment of a Receivable Due to a 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.
