CHAPETR 12: INVESTMENTSLearning Objectives1.Demonstrate how to identify and account for investments classified for reporting purposes as held-to-maturity. 2. Demonstrate how to identify and account for investments classified for reporting purposes as trading securities.3.Demonstrate how to identify and account for investments classified for reporting purposes as available-for-sale securities.8. Discuss the primary differences between U.S. GAAP and IFRS with respect to investments.

NOT COVERED4. Explain what constitutes significant influence by the investor over the operating and financial policies of the investee.5. Demonstrate how to account for investments accounted for under the equity method.6. Explain the adjustments made in the equity method when the fair value of the net assets underlying the investment exceeds their book value. 7. Explain how electing the fair value option affects accounting for investments.

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.

12-3Reporting Categories for InvestmentsControl Characteristics of the Investment Reporting Method Used by the Investor

The investor lacks significant influence over the operating and financial policies of the investee:

Investment in debt securities for which the investor has the "positive intent and ability" to hold to maturity.

Held-to-maturity (HTM) - investment reported at amortized cost.*

Investment held in an active trading account.Trading securities (TS) - investment reported at fair value with unrealized holding gains and losses included in net income.

Other: Not HTM nor TS

Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and losses excluded from net income and reported in other comprehensive income.*

The investor has significant influence over the operating and financial policies of the investee:

Typically the investor owns between 20% and 50% of the voting stock of the investee.

Equity method - investment cost adjusted for subsequent earnings and dividends of the investee.*

The investor controls the investee:The investor owns more than 50% of the voting stock of the investee.

Consolidation - the financial statements of the investor and investee are combined as if they are a single company.

Reporting Categories for Investments

12-4Investor Lacks Significant Influence

Reporting Approach

Treatment of Unrealized Holding Gains and Losses

Investment Reported in the Balance Sheet at

Held-to-maturity (HTM): used for debt Not recognized Amortized Costthat is planned to be held for its entirelife

Trading (TS): used for debt or equity Recognized in net income Fair Valuethat is held in an active trading and therefore in retainedaccount for immediate resale, or for earnings as part ofwhich the fair value option had been stockholders' equityelected.

Available-for-sale (AFS): used for debt Recognized in other Fair Valueor equity that does not qualify as comprehensive income,held-to-maturity or trading. and therefore in

accumulated othercomprehensive incomein shareholders' equity

12-5Securities to Be Held to MaturitySecurities are investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the “positive intent and ability” to hold the securities to maturity and can therefore be classified as held-to-maturity (HTM).They are reported on the balance sheet at “amortized cost.”

Amortized cost (Face amount less unamortized discount, or plus unamortized premium).

Amortized cost (Face amount less unamortized discount, or plus unamortized premium).

BalanceSheet

BalanceSheet

12-6

Securities to Be Held to MaturityOn January 1, 2013, 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 the 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%

12-7

Interest Interest Discount Unamortized CarryingDate Payment Revenue Amortization Discount Value

1/1/13 114,699$ 885,301$ 6/30/13 50,000$ 53,118$ 3,118$ 111,581 888,419

12/31/13 50,000 53,305 3,305 108,276 891,724 6/30/14 50,000 53,503 3,503 104,772 895,228

12/31/14 50,000 53,714 3,714 101,059 898,941

Securities to Be Held to MaturityPartial Bond Amortization Table

January 1, 2013Investment in bonds 1,000,000

Discount on bond investment 114,699Cash 885,301

June 30, 2013Cash (stated rate × face amount) 50,000Discount on bond investment 3,118

Investment revenue 53,118

12-8

Securities to Be Held to Maturity

June 30, 2013Investment in bonds 1,000,000$ Less: Discount on bond investment 111,581 Book value (amortized cost) 888,419$

$114,699 - $3,118 = $111,581 unamortized discount$114,699 - $3,118 = $111,581 unamortized discount

This investment would appear on the June 30, 2013, balance sheet as follows:

Unrealized holding gains and losses are not recognized for HTM investments.

Unrealized holding gains and losses are not recognized for HTM investments.

12-9

Interest Interest Discount Unamortized CarryingDate Payment Revenue Amortization Discount Value

1/1/13 114,699$ 885,301$ 6/30/13 50,000$ 53,118$ 3,118$ 111,581 888,419

12/31/13 50,000 53,305 3,305 108,276 891,724 6/30/14 50,000 53,503 3,503 104,772 895,228

12/31/14 50,000 53,714 3,714 101,059 898,941

Securities to Be Held to MaturityOn December 31, 2013, after interest is received by Matrix, all the bonds

are sold for $900,000 cash.

December 31, 2013Cash 50,000Discount on bond investment 3,305

Investment revenue 53,305

December 31, 2013Cash 900,000Discount on bond investment 108,276

Investment in bonds 1,000,000Gain on sale of investment 8,276

12-10

Trading SecuritiesInvestments in debt or equity securities acquired principally for the purpose of selling them in the near term. Adjustments to fair value are recorded1.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 Gain

Unrealized Loss Unrealized Loss

Income Statement

Income Statement

Trading Securities

Matrix Inc. purchased securities classified as Trading Securities (TS) on Matrix Inc. purchased securities classified as Trading Securities (TS) on December 22, 2013. The fair value amounts for these securities on December 22, 2013. The fair value amounts for these securities on

December 31, 2013, are shown below. Prepare the journal entries for December 31, 2013, are shown below. Prepare the journal entries for Matrix Inc. to show the purchase of the securities, and adjust the Matrix Inc. to show the purchase of the securities, and adjust the

securities to fair value at 12/31/13.securities to fair value at 12/31/13.

12/31/13 UnrealizedNo. of Unit Total Fair Gain or

Type Name Shares Cost Cost Value (Loss)TS Mining Inc 1,000 42.00$ 42,000$ 41,000$ (1,000)$ TS Toys and Things 1,500 15.00 22,500 20,000 (2,500)

Totals 64,500$ 61,000$ (3,500)$

12/22/13

12-12

Trading SecuritiesDecember 22, 2013Investment in Mining Inc. stock 42,000Investment in Toys and Things stock 22,500

Cash 64,500

December 31, 2013Net unrealized holding gains and losses – I/S 3,500

Fair value adjustment 3,500

Security Cost Fair Value AdjustmentMining Inc 42,000$ 41,000$ (1,000)$ Toys and Things 22,500 20,000 (2,500) Total 64,500$ 61,000$ (3,500)$ Existing balance in fair value adjustment -0-Change needed in fair value adjustment (3,500)$

Reported on the balance sheet asa adjunct account to the investment.Reported on the balance sheet asa adjunct account to the investment.

The Net Unrealized Holding Loss is reported on the Income Statement.The Net Unrealized Holding Loss is reported on the Income Statement.

12-13

Trading SecuritiesOn January 3, 2014, Matrix sold all trading securities for $65,000 cash. Let’s record the entry for the sale and the adjustment to the fair value adjustment account.

January 3, 2014Cash 65,000

Investment in Mining, Inc. stock – T/S 42,000Investment in Toys and Things stock – T/S 22,500Gain on sale of investment 500

December 31, 2014Fair value adjustment 3,500

Net unrealized holding gains or losses – I/S 3,500

12-14Financial Statement PresentationTrading securities are presented on the financial statement as follows:

1. Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income.

2. Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.

3. Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations.

Trading securities are presented on the financial statement as follows:1. Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income.

2. Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.

3. Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations.

12-15Financial Statement PresentationPresented below are the partial financial statements showing the accounting for TS owned by Matrix:

Income Statement 2013 2014Revenue t tExpenses t tOther income (expenses): Gain on sale of investment t 500 Realized and unrealized gains and losses on investments (3,500) 3,500 Total expenses t tNet income t tBalance SheetAssets: Trading securities 61,000 -0-Statement of Cash Flows (direct method)Operating Activities: Cash from investment revenue -0- -0- Purchase of trading securities (64,500) -0- Sale of trading securities -0- 65,000

12-16Securities Available-for-SaleInvestments in debt or equity securities that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS).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 Gain

Unrealized Loss

Unrealized Loss

Other Comprehensive Income (OCI)

Other Comprehensive Income (OCI)

12-17Other Comprehensive Income (OCI)Other comprehensive income:

Foreign currency translation gains (losses) $ XX,XXXNet unrealized holding gains (losses) on investments -12,500Minimum pension liability adjustment XXXDeferred gains (losses) from derivatives XXX $ XX,XXXLess: aggregate income tax expense (benefit) X,XXX

Other comprehensive income $ XX,XXX

When we add other comprehensive income to net income we refer to the result as “comprehensive income.”

When we add other comprehensive income to net income we refer to the result as “comprehensive income.”

12-18Accumulated Other Comprehensive IncomeUnrealized 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 (AOCI).

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 (AOCI).

Shareholders’ EquityCommon stockPaid-in capital in excess of parAccumulated other comprehensive incomeRetained earningsTotal shareholders’ equity

Shareholders’ EquityCommon stockPaid-in capital in excess of parAccumulated other comprehensive incomeRetained earningsTotal shareholders’ equity

Net unrealizedholding gains and losses.

12-19Securities Available for Sale ExampleAssume the same information for our T/S example for

Matrix Inc., except that the investments are classified as available-for-sale securities rather than

trading securities.

Security Cost Fair Value AdjustmentMining Inc 42,000$ 41,000$ (1,000)$ Toys and Things 22,500 20,000 (2,500) Total 64,500$ 61,000$ (3,500)$ Existing balance in fair value adjustment -0-Change needed (3,500)$

December 31, 2013Net unrealized holding gains and losses – OCIOCI 3,500

Fair value adjustment 3,500

12-20Financial Statement PresentationAFS securities are presented on the financial statement as

follows:•Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. •Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.•Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

AFS securities are presented on the financial statement as follows:

•Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. •Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.•Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

12-21U. S. GAAP vs. IFRS

• U.S. GAAP also allows transfers out of the trading security category.

• Reclassifications under U.S. GAAP are rare.

• IAS No. 39 now allows transfer of debt investments out of the fair value category into AFS or HTM in “rare circumstances.”

• The current financial crisis qualified as one of those circumstances.

Until recently, IFRS did not allow transfers out of their “Fair Value through Profit and Loss” (FVTPL) classification.

12-22U. S. GAAP vs. IFRS

• U.S. GAAP permits classification as HTM, AFS, and TS.

• No significant tests are required to classify a debt investment.

• There is no comparable FVTPL or FVTOCI classification.

• Investments in debt securities are classified as either “Amortized Cost” or FVTPL.

• To be classified as a debt investment, two important tests must be met. The current financial crisis qualified as one of those circumstances.

• Investments in equity securities are classified as either “FVTPL” or “FVTOCI” (“Fair Value through Other Comprehensive Income).

IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at “Fair Value Through Profit & Loss” (FVTPL), and thus having unrealized gains and losses included in net income.

12-23Transfers Between Reporting CategoriesAny unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Securities are transferred at fair market value on the date of transfer.

Unrealized Gain or Loss fromTransfer from: To: Transfer at Fair Market ValueEither of the other Trading Include in current net income the total

unrealized gain or loss, as if it all occurred in the current period.

Trading Either of the other Include in current net income any unrealized gain or loss that occurred in the current period prior to the transfer. (Unrealized gains and losses that occurred in prior periods already were included in net income in those periods.)

Held-to-maturity Available-for-sale No current income effect. Report total unrealized gain or loss as a separate component of shareholders’ equity (in AOCI

Available-for-sale Held-to-maturity No current income effect. Don’t write off any existing unrealized holding gain or loss in AOCI, but amortize it to net income over the remaining life of the security (fair value amount becomes the security’s amortized cost basis).

12-24

Impairment of InvestmentsOccasionally, an Occasionally, an

investmentinvestment’’s value will s value will decline for reasons that decline for reasons that

are other-than- are other-than- temporary (OTT).temporary (OTT).

For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an “other than temporary” decline for debt securities can be quite complex. For both equity and

debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an “other than temporary” decline for debt securities can be quite complex. For both equity and

debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

12-25

U. S. GAAP vs. IFRS

• U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified.

• Under IAS No. 39 transfers of debt investments out of the FVTPL category into AFS or HTM in “rare circumstances.”

• The 2008 financial crisis qualifies as one of those “rare circumstances.”

Until recently, IFRS did not allow transfers out of the “fair value through P&L” (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP).

12-26Financial Statement Presentationand Disclosure

Aggregate Fair ValueAggregate Fair Value

Maturities of debt securitiesMaturities of

debt securities

Change in net unrealized holding

gains and losses

Change in net unrealized holding

gains and losses

Gross realized & unrealized holding

gains & losses

Gross realized & unrealized holding

gains & losses

Amortized cost basis by major security

type

Amortized cost basis by major security

type

Inputs to fair value estimates

Inputs to fair value estimates

12-27Investor Has Significant Influence

Control Characteristics of the Investment Reporting Method Used by the InvestorThe investor lacks significant influence over the operating and financial policies of the investee:

Investment in debt securities for which the investor has the "positive intent and ability" to hold to maturity.

Held-to-maturity (HTM) - investment reported at amortized cost.*

Investment held in an active trading account. Trading securities (TS) - investment reported at fair value with unrealized holding gains and losses included in net income.

Other. Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and losses excluded from net income and reported in Other Comprehensive income.*

The investor has significant influence over the operating and financial policies of the investee:

Typically the investor owns between 20% and 50% of the voting stock of the investee.

Equity method - investment cost adjusted for subsequent earnings and dividends of the investee.*

The investor controls the investee:The investor owns more than 50% of the voting stock of the investee.

Consolidation - the financial statements of the investor and investee are combined as if they are a single company.

Reporting Categories for Investments

* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.

12-28

Investor Has Significant Influence

Extent of Investor Influence Reporting 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

12-29What 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.

12-30A Single Entity Concept

Under the equity method . . .1.The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.

2.Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is:

• Increased by the investor’s percentage share of the investee’s net income (or decreased by its share of a loss).

• Decreased by dividends paid.

Under the equity method . . .1.The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.

2.Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is:

• Increased by the investor’s percentage share of the investee’s net income (or decreased by its share of a loss).

• Decreased by dividends paid.

12-31Equity Method On January 1, 2013, Wilmer 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 2013, Apex paid cash dividends of

$150,000 and reported net income of $1,750,000.

What amount will Wilmer Inc. report on the balance sheet as Investment in Apex Inc. on December 31, 2013?

12-32Equity Method

3,000,000$ Fair value of net assets× 45% Percentage ownership

1,350,000$ Fair value of assets purchased

January 1, 2013Investment in Apex Inc. stock 1,350,000

Cash 1,350,000

1,750,000$ Reported earnings× 45% Percentage ownership

787,500$ Share of earnings

2013Investment in Apex Inc. stock 787,500

Investment revenue 787,500

2013Cash 67,500

Investment in Apex Inc. stock 67,500

150,000$ Dividends paid× 45% Percentage ownership

67,500$ Share of dividends

12-33

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 with a credit.

12-34Equity MethodOn January 1, 2013, Wilmer Inc. purchased 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 fair value of these assets is $600,000. During 2013, Apex paid cash dividends of $40,000, and

reported earnings of $100,000.

Fair value of assets 600,000$ Percentage ownership 25%Share of fair value of assets 150,000 Cost of investment in Apex 180,000 Excess of cost over fair value 30,000$

12-35Equity MethodThe excess of the fair value of net assets over book value of

those net assets is 75% attributable to depreciable assets with a remaining life of 20 years and is 25% attributable to land. Wilmer

uses the straight-line depreciation.

Fair value of net assets 600,000$ Book value of net assets 400,000 Difference 200,000 Percentage of net assets acquired × 25%Excess 50,000 Amount attributable to land (25% or excess) 12,500 Amount attributable to depreciable assets 37,500 Remaining life of depreciable assets 20 yearsAdditional depreciation expense per year 1,875$

12-36Equity Method

40,000$ Dividends paid× 25% Percentage ownership

10,000$ Share of dividends

100,000$ Reported earnings× 25% Percentage ownership

25,000$ Share of earnings

January 1, 2013Investment in Apex stock 180,000

Cash 180,000

2013Cash 10,000

Investment in Apex stock 10,000

Investment in Apex stock 25,000Investment revenue 25,000

December 31, 2013Investment revenue 1,875

Investment in Apex stock 1,875

12-37Changing 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.

12-38Changing 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.

Reported earnings– Dividends paid= Undistributed Earnings

12-39Changing 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.

12-40Fair Value OptionGAAP 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 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.

GAAP 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 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.

12-41Financial Instruments andInvestment Derivatives

Financial Instruments:Financial Instruments:1.1.Cash.Cash.

2.2.Evidence of an Evidence of an ownership interestownership interest in an in an entity.entity.

3.3.Contracts meeting Contracts meeting certain conditions.certain conditions.

Financial Instruments:Financial Instruments:1.1.Cash.Cash.

2.2.Evidence of an Evidence of an ownership interestownership interest in an in an entity.entity.

3.3.Contracts meeting Contracts meeting certain conditions.certain conditions.

Investment Derivatives:Investment Derivatives:1.1. Value is derived from Value is derived from

other securities.other securities.

2.2. Derivatives are often Derivatives are often used to used to ““hedgehedge”” (offset) (offset) risks created by other risks created by other investments or investments or transactionstransactions

Investment Derivatives:Investment Derivatives:1.1. Value is derived from Value is derived from

other securities.other securities.

2.2. Derivatives are often Derivatives are often used to used to ““hedgehedge”” (offset) (offset) risks created by other risks created by other investments or investments or transactionstransactions

12-42Appendix 12A – Other InvestmentsIt 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.

12-43

Appendix 12A – Other InvestmentsIt 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.

12-44Appendix 12B– Impairment of InvestmentsIf the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (“OTT”) impairment loss in earnings.

We use a three-step process to determine whether an OTT impairment loss must be recognized: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) determine where to report the OTT impairment.

12-45

Appendix 12B – Impairment of InvestmentsEquity Debt

Investment InvestmentIs the investment impaired? Yes, if the fair value is less

than the investment's costSame (yes, if the fair value is less than the investment's amortized costs)

Is any of the impairment other-than-temporary (OTT)?

Yes, if the investor cannot assert that it has the intent and ability to hold the investment until fair value recovers

Yes, if the investor (a) intends to sell the investment, (b) believes it is "more likely than not" that the investor will be required to sell the investment prior to recovering the amortized cost of the investment, or ( c ) has incurred credit losses.

12-46

Appendix 12B – Impairment of InvestmentsEquity Debt

Investment InvestmentWhere is the OTT inpairment reported?

In net income In net income, if the investor intends to sell the security or is "more likely than not" to be required to sell it before recovery of its amortized cost.Otherwise:lCredit loss portion in net income. (Credit loss = amortized cost - PV of expected cash flows);l Noncredit loss portion in OCI (Noncredit loss portion = total impairment - credit loss)

12-47Appendix 12B – Impairment of InvestmentsUnited Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2013 and 2014 pertain to the investment portfolio. Purchase Investment: July 1, 2013, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value:

• December 31, 2013: Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment.

• December 31, 2014 : Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment

The journal entries to record the adjustments of the Bendac stock investment to fair value are:

United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2013 and 2014 pertain to the investment portfolio. Purchase Investment: July 1, 2013, $1,000,000 of Bendac common stock. Adjust Investment to Fair Value:

• December 31, 2013: Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment.

• December 31, 2014 : Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment

The journal entries to record the adjustments of the Bendac stock investment to fair value are:

December 31, 2013Net unrealized holding gains and losses – OCI 10,000 Fair value adjustment 10,000

December 31, 2014Other-than-temporary impairment loss – I/S 15,000

Investment in Bendac 15,000

Fair value adjustment 10,000Net unrealized holding gains and losses – OCI 10,000

12-48Appendix 12B – Impairment of InvestmentsUnited Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. United’s fiscal year-end is December 31. The following events occurred during 2014: Purchase Investment: July 1, 2014, $1,000,000 of Bendac bonds, maturing on December 31, 2019. Adjust Investment to Fair Value: December 31, 2014, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss.Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers.Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred.

United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments, and classifies these investments as AFS. United’s fiscal year-end is December 31. The following events occurred during 2014: Purchase Investment: July 1, 2014, $1,000,000 of Bendac bonds, maturing on December 31, 2019. Adjust Investment to Fair Value: December 31, 2014, valued the Bendac bonds at $950,000. Of the $50,000, impairment, $30,000 is credit loss and $20,000 is noncredit loss.Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers.Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred.

Let’s look at the necessary journal entries in these two cases.

12-49Appendix 12B – Impairment of Investments

December 31, 2014OTT impairment loss – I/S 50,000

Discount on bond investment 50,000

Case 1

Case 2

December 31, 2014OTT impairment loss – I/S 30,000

Discount on bond investment 30,000

OTT impairment loss - OCI 20,000Fair value adjustment – Noncredit loss 20,000

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U. S. GAAP vs. IFRS

• U.S. GAAP recognizes in OCI any non-credit losses on debt investments.

• Calculation of the amount of impairment differs depending on the classification of an investment.

• Under IFRS, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM.

Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset.

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Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

12-51

Investments:A Chapter SupplementSupplement to Chapter 12

The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together. This Supplement discusses the FASB’s Exposure Draft of a proposed Accounting Standards Update (ASU) that addresses accounting for financial instruments and “tentative decisions” of the Board after receiving feedback

12-52GAAP vs. Proposed Accounting Standard UpdateCurrent GAAP Proposed ASU Accounting Approach

Held-to-maturity ("HTM)* Amortized Cost** Investment recorded at amortized cost.

Trading securities ("TS") Fair Value through Net Income ("FV-NI")

Investment reported at fair value. Unrealized holding gains and losses included in net income.

Securities available-for-sale ("AFS")

Fair Value through Other Comprehensive Income ("FV-OCI")**

Investment reported at fair value. Unrealized holding gains and losses excluded from net income and reported in OCI. Gains and losses reclassified from OCI and reported in net income whenrealized through the sale of the investment.

Equity method* Equity method** Investment reported at cost adjusted for subsequent earnings and dividends of the investee.

Consolidation Consolidation The financial statements of the investor and investee are combined as if they are a single company.

Reporting Category Used in

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Accounting for Equity InvestmentsDetermining how to account for equity investments in stock under the proposed ASU is easy. If the investor does not have “significant influence” over the investee, the equity investment is accounted for as FV-NI. If the investor has significant influence over the investee, but lacks control, the equity method is used. If the investor has control, the investment is consolidated.

Under current GAAP, the investor accounts for the equity investment as a trading or as an AFS security.

Under current GAAP, the investor accounts for the equity investment as a trading or as an AFS security.

Under the ASU an equity investment always is treated as FV-NI (equivalent to being accounted for as a trading security).

Under the ASU an equity investment always is treated as FV-NI (equivalent to being accounted for as a trading security).

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Accounting for Debt InvestmentsDetermining how to account for debt investments under the proposed ASU is more complicated than accounting for equity investments. Under the proposed ASU we base classification of debt investments on two criteria: 1.The characteristics of the debt instrument.2.The business activity in which the instrument is used. We discuss each of the criteria in turn.

Determining how to account for debt investments under the proposed ASU is more complicated than accounting for equity investments. Under the proposed ASU we base classification of debt investments on two criteria: 1.The characteristics of the debt instrument.2.The business activity in which the instrument is used. We discuss each of the criteria in turn.

Characteristics of a Simple Debt Instrument1. An amount is transferred to the borrower (debtor) when the debt instrument is issued that will be returned to the lender (creditor) when the debt matures or is settled. The amount is the principal or face amount of the debt adjusted for any discount or premium.

2.The debt cannot be prepaid or settled in such a way that the lender does not recover substantially all of its original investment, unless the lender chooses to allow it.

3.The debt instrument is not a derivative.

Characteristics of a Simple Debt Instrument1. An amount is transferred to the borrower (debtor) when the debt instrument is issued that will be returned to the lender (creditor) when the debt matures or is settled. The amount is the principal or face amount of the debt adjusted for any discount or premium.

2.The debt cannot be prepaid or settled in such a way that the lender does not recover substantially all of its original investment, unless the lender chooses to allow it.

3.The debt instrument is not a derivative.

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Accounting for Debt InvestmentsCharacteristics of a Complex Debt Instrument

Debt that lacks one or more of the characteristics of simple debt is considered complex. Under the proposed ASU, debt that is complex always is

classified as fair value in net income.

Characteristics of a Complex Debt Instrument

Debt that lacks one or more of the characteristics of simple debt is considered complex. Under the proposed ASU, debt that is complex always is

classified as fair value in net income.

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Business Purpose of a Debt Instrument

For simple debt, we next must consider the business activity that motivates the investor to hold the debt. The proposed ASU identifies three primary business activities as1.lending, 2.long-term investing, or 3.held for sale.

The debt holder’s purpose is lending or customer financing with a focus on collecting cash flows (interest and principal). The debt holder must have the ability to renegotiate, sell, or settle the debt to minimize losses due to a borrower's deteriorating credit. The appropriate accounting approach is amortized cost.

The debt holder’s purpose is lending or customer financing with a focus on collecting cash flows (interest and principal). The debt holder must have the ability to renegotiate, sell, or settle the debt to minimize losses due to a borrower's deteriorating credit. The appropriate accounting approach is amortized cost.

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Business Purpose of a Debt InstrumentFor simple debt, we next must consider the business activity that motivates the investor to hold the debt. The ASU identifies three primary business activities as1.lending, 2.long-term investing, or 3.held for sale.

The debt holder may choose to hold on to the debt investment or sell it as a way of either (a) maximizing its return on investment or (b) managing risk. The appropriate accounting approach is Fair Value – Other Comprehensive Income (FV-OCI)

The debt holder may choose to hold on to the debt investment or sell it as a way of either (a) maximizing its return on investment or (b) managing risk. The appropriate accounting approach is Fair Value – Other Comprehensive Income (FV-OCI)

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Business Purpose of a Debt InstrumentFor simple debt, we next must consider the business activity that motivates the investor to hold the debt. The ASU identifies three primary business activities as1.lending, 2.long-term investing, or 3.held for sale.

For the business purpose to be classified as held for sale, the debt instrument is either (a) held for the purpose of being sold or (b) actively managed internally on a fair value basis. The appropriate accounting approach is Fair Value – Net Income.

For the business purpose to be classified as held for sale, the debt instrument is either (a) held for the purpose of being sold or (b) actively managed internally on a fair value basis. The appropriate accounting approach is Fair Value – Net Income.

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Summary of Classification CriteriaAccounting Approach

Debt investment Characteristics: Simple Debt Business Purpose: 1. Lending or Customer Financing Amortized Cost 2. Investment Returns or Risk Management FV-OCI 3. Trading Gains from Sale FV-NI Characteristics: Complex Debt FV-NIEquity investment FV-NI

Classification Criteria

The proposed ASU does not allow transfers of debt from one category to another. After the debt is initially classified, reclassifications are not permitted.

12-60Impairments When the Investor Does Not Exercise Significant Influence

Because equity investments are reported at FV-NI, no impairment guidance is necessary. The same is true for debt investments recorded at FV-NI. Declines in fair value always are reported in net income. However, for debt investments reported at amortized cost or at FV-OCI, impairment losses are possible. Let’s look at the “three-bucket” approach currently under consideration.

Because equity investments are reported at FV-NI, no impairment guidance is necessary. The same is true for debt investments recorded at FV-NI. Declines in fair value always are reported in net income. However, for debt investments reported at amortized cost or at FV-OCI, impairment losses are possible. Let’s look at the “three-bucket” approach currently under consideration.

Investments not affected by observed events.

Investments affected by observed events (but individual defaults have not been identified).

Individual debt investments suffering credit losses.

1 2 3

12-61Debt Impairment (continued)Objective: Use expected value (probability-weighted average) of losses of principal and interest on a discounted basis.

Time horizon of estimated losses:

Bucket 1: over near term (say, 1-2 years).

Buckets 2 and 3: over remaining life of investment.

No impairment upon acquisition of distressed debt (interest based on expected cash flows rather than contractual cash flows).

Objective: Use expected value (probability-weighted average) of losses of principal and interest on a discounted basis.

Time horizon of estimated losses:

Bucket 1: over near term (say, 1-2 years).

Buckets 2 and 3: over remaining life of investment.

No impairment upon acquisition of distressed debt (interest based on expected cash flows rather than contractual cash flows).

12-62Equity MethodThe criteria for applying the equity method are the same in the ASU as in current GAAP. If a company is holding an investment for sale that normally would qualify for the equity method, the investment is accounted for as FV-NI.

If facts indicate an impairment in value of an equity method investment, the investor recognizes an

amount equal to the difference between the investment’s carrying value and its fair value. If fair

value increases in the future, the impairment cannot be reversed.

If facts indicate an impairment in value of an equity method investment, the investor recognizes an

amount equal to the difference between the investment’s carrying value and its fair value. If fair

value increases in the future, the impairment cannot be reversed.