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ACCT 405 Lecture Notes Chapter 12: Investments

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Investment Accounting Approaches Many companies invest in securities, such as stocks and bonds, issued by other entities. The motivation for such an investment might be (a) to earn a return on temporarily idle cash or (b) to secure certain operating or financing arrangements with another company (perhaps a major customer or supplier). Such investments may be short-term or long-term. The investment initially should be recorded at ___________ (including incidental costs such as brokers' fees) in accordance with the cost principle, as in the acquisition of any asset. Following the acquisition, the appropriate accounting for an investment depends upon the type of the investment and its classification as differentiated below:

FVTNI (trading)

1.Accounting for Investment if Investor Lacks Significant Influence When the investor ________________________ over the investee, the investment is classified in one of three categories:  held-to-maturity securities (debt)  trading securities (debt) or FVTNI (equity)*  available-for-sale securities (debt) Each type of investment has its own reporting method. However, regardless of the investment type, investors can elect the “fair value option” that we discuss later in the chapter. Note: Lecture Notes vs Textbook difference!!! * Update 2016–1, issued in January of 2016, disallows accounting for investments in equity securities as available-for-sale investments (with changes in fair value shown in other comprehensive income). Instead, investments in equity securities will be accounted for as “FVTNI” (changes in fair value included in net income for the period). The effective date of this ASU is for fiscal years beginning after December 15, 2017. To implement the change, the company will record an adjustment to beginning retained earnings in the reporting period in which the guidance is adopted.

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A. Securities Classified “Held to Maturity” Only a debt security can have this classification because unlike a share of stock, debt has maturity date. If an investor has the ___________________________ to hold debt securities to their scheduled maturity date, those investments are classified as held-to-maturity (HTM). These investments are initially recorded at cost which may include a premium or discount. If the bonds pay interest at a rate that is lower than the market requires, they will trade at a discount; if the bonds pay interest at a rate that is higher than the market requires, they will trade at a premium. Discounts and premiums are amortized to interest revenue. Following their purchase, the bonds are carried on the balance sheet at amortized cost (face amount less unamortized discount, or plus unamortized premium), and not adjusted for changes in the fair value of the securities. Example 1: Securities Classified “Held to Maturity” On January 1, 2018, 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%. a) Calculate the present value of the bond issue and record journal entry for purchase of the bonds and first receipt of interest. Present Value Interest Principal Present value of bonds:

Partial Bond Amortization Table Effective Interest Method

Date 1/1/18 6/30/18 12/31/18 6/30/19 12/31/19

Interest Payment $

50,000 [c] 50,000 50,000 50,000

[c] 50,000 =1,000,000 x 10% x 6/12 [d] [e] [f] [g]

Interest Revenue

Discount Amortization [d]

53,305 53,503 53,714

Unamortized Discount [e]

3,305 3,503 3,714

Carrying Value [f]

108,276 104,772 101,059

888,419 891,724 895,228 898,941

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January 1, 2018 -Journal entry to record the initial purchase: Investment in bonds Discount on bond investment Cash

June 30, 2018 - Journal entry to record first receipt of interest by Matrix: Cash (stated rate × face amount) Discount on bond investment Investment revenue

b) If the fair value of the bonds is $900,000 on June 30, 2018, how will it appear on the balance sheet on that day? This investment would appear on the June 30, 2018, balance sheet as follows:

June 30, 2018 Investment in bonds Less: Discount on bond investment Book value (amortized cost) or carrying value Remember we do not recognize unrealized holding gains and losses for HTM investments, meaning we do not adjust them to the fair value but instead report them at amortized cost. c) On December 31, 2018, after interest is received by Matrix, all the bonds are sold for $900,000 cash. Make necessary journal entries. December 31, 2018: Receipt of interest:

Sale of investment:

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B. Securities Classified “Trading” (debt) or FVTNI (equity) Trading securities are investments in debt securities acquired principally for the _____________ ____________for the purpose of profiting from short-term price changes. FVTNI (fair value through net income) securities are investments in equity securities for which investor_______________________________. Trading and FVTNI securities initially are recorded at cost including any brokerage fees. When a balance sheet is prepared in subsequent periods, this type of investment is __________________ ______________, or “marked to market.” These adjustments are typically made to a fair value adjustment account, but could also be made directly to the investment account. The unrealized holding gains and losses for trading and FVTNI securities are reported as part of____________________. Example 2: Securities Classified “FVTNI” Matrix Inc. purchased securities classified as FVTNI on December 22, 2018. The fair value amounts for these securities on December 31, 2018, are shown below:

Type Name FVTNI Mining Inc FVTNI Toys and Things

No. of Shares 1,000 1,500

12/22/18 Unit Cost $ 42.00 15.00

Totals

12/31/18 Unrealized Total Fair Gain or Cost Value (Loss) $ 42,000 $ 41,000 $ (1,000) 22,500 20,000 (2,500) $ 64,500

$ 61,000

a) Prepare the journal entries for Matrix Inc. to show the purchase of the securities, and adjust the securities to fair value at 12/31/18. December 22, 2018 – Purchase of investment:

December 31, 2018 – Adjust to fair value:

Security

Cost

Fair Value

Mining Inc $ 42,000 $ 41,000 Toys and Things 22,500 20,000 Total $ 64,500 $ 61,000 Existing balance in fair value adjustment Change needed in fair value adjustment Cr.

Fair Value Adjustment

$ $ $

(1,000) (2,500) (3,500) -0(3,500)

$

(3,500)

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b) On January 1, 2019 Matrix received cash dividend of $300 from the Mining Inc. shares. Then on January 3, 2019, Matrix sold all FVTNI securities for $65,000 cash. Record the entry for the dividend, sale and the adjustment to the fair value adjustment account. January 1, 2019 – Receipt of dividend:

January 3, 2019 – Sale of investment: Adjust to fair value on date of sale:

Record sale:

Securities Classified “Trading” (debt) or FVTNI (equity) – Financial Statements Presentation: These 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. These investments do not affect other comprehensive income 2. Balance Sheet: Securities are reported at _________________, 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 these securities are classified as operating or investing based on the nature and purpose for which the securities were acquired. It may be classified as investing activities if they are not held for sale in the near term.

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Example 2 continued: Securities Classified “FVTNI” - Financial Statement Presentation c) Presented below are the partial financial statements showing the accounting for FVTNI Securities owned by Matrix for the years ended December 31, 2018 and 2019:

Income Statement Revenue Expenses Other income (expenses): Interest and dividend income Realized and unrealized gains and losses on investments Total expenses Net income Balance Sheet Assets: FVTNI securities Statement of Cash Flows (direct method) Operating Activities or Investing Activities: Cash from investment revenue Purchase of FVTNI securities Sale of FVTNI securities

2018

2019 t t

t t

t (3,500) t t

300 4,000 t t

61,000

-0-

-0(64,500) -0-

300 -065,000

Example 2 continued: Securities Classified “FVTNI” d) Now disregard the facts given in b) and c). Instead assume that Matrix still holds the investment in those FVTNI securities at the end of 2019. Market value of Matrix holding in Mining Inc. stock is $39,000 and in Toys and Things stock is $24,000 at 12/31/19. Prepare the journal entries for Matrix Inc. to adjust the securities to fair value at 12/31/19.

Security

Cost

Fair Value

Mining Inc $ 42,000 $ 39,000 Toys and Things 22,500 24,000 Total $ 64,500 $ 63,000 Existing balance in fair value adjustment Cr. Change needed in fair value adjustment Dr.

December 31, 2019 – Adjust to fair value:

Fair Value Adjustment

$ $ $ $

(3,000) 1,500 (1,500) (3,500) 2,000

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C. Securities Classified “Available-for-Sale” Investments in debt securities only that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS). Available-for-sale securities initially are recorded at cost including any brokerage fees. Same as for trading securities, for AFS securities when a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its __________________. These adjustments are typically recorded in account called fair value adjustment account, but could also be made directly to the investment account. However, unlike trading security, for AFS security, unrealized gains and losses that result from change in fair values are NOT included in ________________ (rather, they are included in other comprehensive income (OCI) and accumulated and reported as a separate component of shareholders’ equity called accumulated other comprehensive income (AOCI)).

Example 3: Securities Classified “Available-for-sale” Assume the same information as in example 1, except that the investments are now classified as available-for-sale securities rather than held to maturity securities: On January 1, 2018, 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%. a) Prepare the journal entries for Matrix Inc. to show the purchase of the securities, interest receipt and adjust the securities to fair value at 12/31/18. The fair value of the bonds is $900,000 on 12/31/18. January 1, 2018 – Purchase of investment: Same as in example 1 for HTM: Investment in bonds Discount on bond investment Cash

1,000,000 114,699 885,301

June 30, 2018 and December 31, 2018 - Journal entry to record receipt of interest by Matrix: Same as in example 1 for HTM: 6/30/18 Cash (stated rate × face amount) Discount on bond investment Investment revenue

50,000 3,118 53,118

ACCT 405 Lecture Notes Chapter 12: Investments 12/31/18 Cash Discount on bond investment Investment revenue

50,000 3,305 53,305

December 31, 2018 – Adjust to fair value (unrealized loss to OCI not NI): Fair Value

Fair Value Adjustment

$ 900,000

$

8,276

Total $ 891,724 $ 900,000 Existing balance in fair value adjustment Change needed Cr.

$

8,276 0 8,276

Security

Bonds

Amortized Cost

$ 891,724

$

Fair value adjustment Unrealized holding gains – OCI

b) Assume that on January 1, 2019 Matrix sold all of the bond securities for $905,000 cash. January 1, 2019 – Sale of investment: Adjust to fair value on date of sale:

Reclassify prior holding gain:

Record sale:

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Securities Classified “Available-for-sale” – Financial Statements Presentation: AFS securities are presented on the financial statement as follows: 1. 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 _ _____ in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. 2. Balance Sheet: Investments in AFS securities are reported at ___________. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold. 3. Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities. Example 3 continued: Securities Classified AFS - Financial Statement Presentation c) Presented below are the partial financial statements showing the accounting for Available-forsale Securities owned by Matrix for the years ended December 31, 2018 and 2019: Income Statement Revenue Expenses Other income (expenses): Interest and dividend income Realized gains and losses on investments Total expenses Net income Statement of Comprehensive Income Other comprehensive income (loss) items (OCI): Unrealized holding gains (losses) on investments Reclassification adjustment for net gains and losses included in net income Comprehensive Income Balance Sheet Assets: Available-for-sale securities Stockholders' equity Accumulated other comprehensive income (AOCI) Statement of Cash Flows (direct method) Operating Activities: Cash from investment revenue Investing Activities: Purchase of available-for-sale securities Sale of available-for-sale securities

2018

2019 t t

t t

106,423 -0t t

t 13,276 t t

8,276

5,000

-0t

(13,276) t

900,000

-0-

8,276

-0-

106,423

0

(885,301) -0-

-0905,000

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Accounting for Investment if Investor Lacks Significant Influence – Compare Classifications:

Reporting Approach Held-to-maturity (HTM): used for debt that is planned to be held for its entire life

Treatment of Unrealized Holding Gains and Losses Not recognized

Investment Reported in the Balance Sheet at Amortized Cost

Trading used for debt or FVTNI (fair value through net income) used for equity

Recognized in net income and therefore in retained earnings as part of stockholders' equity

Fair Value

Available-for-sale (AFS): used for debt that does not qualify as held-to-maturity or trading.

Recognized in other comprehensive income, and therefore in accumulated other comprehensive income in shareholders' equity

Fair Value

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D. Transfers Between Reporting Categories When debt security is purchased, investor assigns it to one of the three reporting classifications – HTM, TS or AFS. At each reporting date, the appropriateness of the classification is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. Reclassifications are quite unusual, so when they occur, disclosure notes should describe the circumstances that resulted in the transfers. When a security is reclassified between two reporting categories, the security is transferred at its__ _____________ on the date of transfer. Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification ________ ___________the security is being transferred. Unrealized Gain or Loss from Transfer at Fair Market Value Include in current net income the total unrealized gain or loss, as if it all occurred in the current period.

Transfer from: Either of the other

To: Trading

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

Available-for-sale

Held-to-maturity

No current income effect. Report total unrealized gain or loss as a separate component of shareholders’ equity (in AOCI 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).

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E. Impairment of Debt Investments Note: Lecture Notes vs Textbook (p675) difference!!! * Update 2016–13, issued in June of 2016, require companies to use new guidance to account for impairments of HTM and AFS investments. The effective date of this ASU is for fiscal years beginning after December 15, 2019. To implement the change, the company will record an adjustment to beginning retained earnings in the reporting period in which the guidance is adopted For HTM debt investments, companies will recognize bad debt the same way they recognize it for any other note receivables with debit to bad debt expense and credit to allowance account. For AFS debt investments, if company plans to sell the investment before fair value recovers, they will recognize in net income an amount of impairment loss equal to the entire difference between amortized cost and fair value. If they don’t think the investment will be sold before fair value recovers, only credit loss will be recognized in ______________and noncredit loss will be recognized in___________.  Credit losses are due to anticipated reduction in cash flows from default on interest or principal payments.  Noncredit losses are other reduction in fair value of investment such as those due to changes in general economic conditions.

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2. Accounting for Investment if Investor Has Significant Influence When an investor is able to exercise significant influence over the operating and financial policies of the investee, the investment should be accounted for by the equity method. It should be presumed, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when an investor owns between 20% and 50% of the investee's voting shares. If investor own more than 50% of the voting common stock, the investor control over the investee is presumed because by using their majority voting rights investor can control the...