1. Debt securities are instruments representing a creditor relationship with an enterprise.

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1 Chapter 18 Investments LECTURE OUTLINE The material in this chapter can be covered in three class periods. Students will have some difficulty with the classifications of debt securities into trading, available-for-sale, and held-to-maturity. Also, the same problems will develop with equity securities as they are classified as trading or available-for-sale (assuming ownership interest less than 20%). Illustrations 18-1, 18-3, and 18-5 can be used to clarify the issues. When discussing investments in debt securities it is often useful to contrast the entries made for debt securities with the entries made for debt obligations on the issuers book (see Chapter 14). Illustration 18-2 provides an example of entries made for investments and issuances of debt securities. A. Accounting for Investments in Debt Securities. 1. Debt securities are instruments representing a creditor relationship with an enterprise. 2. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, commercial paper, and all securitized debt instruments. 3. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. 4. Investments in debt securities are classified into three separate categories: a. Held-to-maturity: Debt securities that the enterprise has the positive intent and ability to hold to maturity. b. Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. c. Available-for-sale: Debt securities not classified as held-tomaturity or trading securities.

2 5. Accounting and reporting for debt securities. Illustration 18-1 indicates the accounting for debt securities by category and provides an overview for subsequent discussion. 6. Held-to-maturity securities are accounted for at amortized cost, not fair value. Rationale: If management intends to hold certain investment securities to maturity and has no plans to sell them, fair values are not relevant for measuring and evaluating the cash flows associated with these activities. a. Effective interest method is applied to bond investments in a fashion similar to bonds payable. b. Use of a separate discount or premium account as a valuation account is acceptable procedure for investments, but in practice not widely used. Illustration 18-2 indicates the accounting for held-to-maturity securities. 7. Available-for-sale debt securities are reported at fair value. a. The unrealized holding gains and losses related to changes in fair value of available-for-sale debt securities are recognized as other comprehensive income and reported as a separate component of stockholders equity. b. At each reporting date, available-for-sale debt securities are reported at fair value with an adjustment to an Unrealized Holding Gain or Loss Equity account. c. A Securities Fair Value Adjustment (Available-for-Sale) account is used to record the difference between fair value and amortized cost. d. When sold, a realized gain/loss is recognized in an amount equal to the difference between amortized cost and the selling price.

3 8. Trading debt securities are reported at fair value. a. The unrealized holding gain or loss is reported as part of income. b. Any discount or premium is not amortized. c. A Securities Fair Value Adjustment (Trading) account is used to record the difference between fair value and cost. d. When securities are actively traded, the FASB believes that financial reporting is improved when economic events affecting the company (changes in fair value) are reported in income immediately. B. Investment in Equity Securities. 1. Equity securities are securities representing ownership interests such as common, preferred, or other capital stock. 2. Investments by one corporation in the common stock of another can be classified according to percentage ownership. a. Holdings of less than 20% (fair value method). b. Holdings between 20% and 50% (equity method). c. Holdings of more than 50% (consolidated statement). Illustration 18-3 indicates how the levels of ownership determine accounting methods. 3. Holdings of less than 20%. In such cases, if market prices are available, the investment is valued and reported subsequent to acquisition using the fair value method.

4 a. Available-for-sale securities. As with available-for-sale debt securities, the net unrealized gains or losses is recorded in an Unrealized Holding Gain or Loss Equity account that is recognized as other comprehensive income and is reported as a separate component of stockholders' equity until realized. b. Trading equity securities, the unrealized holding gains or losses are reported as part of net income in an Unrealized Holding Gain or Loss Income account. 4. Holdings Between 20% and 50%. Use the equity method. The investment account is increased (decreased) by the investor's share of the earnings (losses) of the investee and decreased by all dividends received. The investor also treats a proportionate share of the investee's extraordinary items as its own extraordinary items. a. Under the equity method, fair values are not used. b. The difference between the investor's initial cost and the investor's proportionate share of the underlying book value of the investee at date of acquisition is amortized. This may be attributable to: (1) Undervalued depreciable assets and/or (2) Unrecorded goodwill c. If the investee's net income includes extraordinary items, the investor recognizes its proportionate share of both the ordinary and extraordinary components. 5. Holding over 50%. Generally consolidated. C. Financial statement presentation of investments. 1. Changes in unrealized gains and losses related to available-for-sale securities are reported as part of other comprehensive income, and reflected as a separate component of stockholders' equity.

5 a. Remember, other comprehensive income may be reported in: (1) a combined statement of income and comprehensive income or, (2) a separate statement of comprehensive income beginning with net income, or (3) a statement of stockholders equity. 2. Reclassification adjustments are made to prevent double counting when realized gains or losses are reported as part of net income and also shown as part of other comprehensive income in the current or previous periods. a. The adjustment may be shown on the face of the financial statement in which comprehensive income is reported, or b. It may be disclosed in the notes to the financial statements. D. Impairment of Value. If the decline is judged to be other than temporary, the cost basis of the individual security is written down to a new cost basis. The amount of the writedown is accounted for as a realized loss. 1. For debt securities, the impairment test is to determine whether it is probable that the investor will be unable to collect all amounts due according to the contractual terms. 2. For equity securities, guidelines are less precise. Any time realizable value is lower than carrying amount, an impairment must be considered. E. Transfers Between Categories 1. Transfers between categories are accounted for at fair value. 2. The "fair value rule" assures that a company cannot escape recognition of fair value by simply transferring securities to held-to-maturity.

6 3. Appendix 18A illustrates the accounting entries to record the transfer of securities between categories. Illustration 18-4 provides a summary table of accounting for transfers. F. Fair Value Accounting Controversy. 1. Measurement based on intent. A subjective evaluation which will result in arbitrary classifications. 2. Gains trading. Selling "winners" and holding on to "losers." 3. Liability not fairly valued. Recognizing changes in asset values while ignoring similar changes in liabilities will lead to a high degree of volatility in income and stockholders equity. 4. Subjectivity of fair values. Results in opportunity gains and losses being recognized in the financial statements. Illustration 18-5 provides a summary chart of the reporting requirements for debt and equity securities. G. Appendix 18-A. Transfers of Marketable Securities 1. Transfer from trading to available-for-sale. a. Securities are transferred at fair value, which becomes new cost basis. b. Any unrealized holding gain or loss is recognized in income. c. After transfer is made, an adjusting entry is made to record changes in fair values of trading and available-for-sale portfolios.

7 2. Transfer from available-for-sale to trading. a. Same procedures as above for trading to available-for-sale transfers. 3. Transfer from Hold-to-maturity to available-for-sale. a. Securities transferred at fair value. b. Difference between cost and fair value is recorded in the Securities Fair Value Adjustment and Unrealized Holding Gain or Loss accounts. 4. Transfer from available-for-sale to held-to-maturity. a. Same steps as above for held-to-maturity to available-for-sale. b. Both the Securities Fair Value Adjustment and Unrealized Holding Gain or Loss accounts are amortized of the remaining life of the bonds. H. Appendix 18-B. Changing From and To the Equity Method 1. Change in Method from the Equity Method. a. Occurs when investor s level of influence, or ownership, falls below that necessary for use of the equity method. b. Change from equity method to fair value method or cost method. c. Equity carrying amount at time of change becomes cost basis for future use of new method. d. Dividends received in subsequent periods that exceed share of investee s earnings in subsequent periods must be accounted for as a reduction of the investment account (instead of revenue). 2. Change in Method to the Equity Method. a. Occurs when investor s level of influence, or ownership, increases. b. Change is from fair value method, or cost method, to equity method. c. The investment account is adjusted retroactively to reflect what the effect would have been had the equity method been used since the investment was purchased. Offset of entry is to retained earnings.

8 d. Equity method used in current and future periods. Illustration 18-6 provides an analysis of changing from and to the equity method. I. Appendix 18-C. Special Issues Related to Investments 1. Revenue from investments in equity securities. 2. Dividends received in stock. Shares received as a result of a stock dividend or stock split do not constitute revenue to the recipients. The carrying amount per share is computed by dividing the total shares into the carrying amount of the original shares issued. 3. Stock rights represent rights to purchase additional shares. a. When a right is received, the stockholders have received nothing that they did not have before. b. If the value allocated to the rights is maintained in a separate account, an entry would be made debiting Available-for-Sale Securities (Stock Rights) and crediting Available-for-Sale Securities. c. The investor who received rights to purchase additional shares has three alternatives: (1) To exercise the rights by purchasing additional stock. (2) To sell the rights. (3) To permit them to expire without selling or using them. Illustration 18-7 provides an example of accounting for stock rights. 4. Cash surrender value of life insurance (CSV): When the company is beneficiary, CSV is an asset (investment) of the company. Discuss journal entries.

9 5. Funds: Assets may be set aside in special funds for specific purposes such as repayment of long-term debt or plant expansion. Emphasize that a fund is always an asset while a reserve, when the term is used in the recommended sense, is always an appropriation of retained earnings and is never an asset. Discuss journal entries. J. Appendix 18-D. Accounting for Financial Instruments 1. Traditional financial instruments include accounts receivable/payable, bonds, CDs, mortgages, and currencies. 2. Derivative financial instruments include futures, options, forwards, swaps, and caps. 3. Accounting profession pronouncements a. SFAS No. 105 addressed how to account for financial instruments that were not reported in the financial statements but which could affect a company s financial position. b. SFAS No. 107 requires disclosure of financial instruments fair values. c. SFAS No. 119 requires disclosure of information about derivatives and changes the way fair values are disclosed. d. Exposure Draft, "Accounting for Derivative and Similar Financial Instruments and for Hedging Activities." 1. Recommends uniform accounting guidance for all derivative financial instruments and hedging activities. 2. Extremely controversial.