Date Account Debit Credit 1/1/00 Investment in bonds $40,000 Premium on bonds 3,412 Cash $43,412 To record the purchase of held-to-maturity bonds

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1 ACCOUNTING FOR INVESTMENT SECURITIES There are two potential types of investments that a corporation might hold: investments in equity securities and investments in debt securities. The type of investment has an impact on the accounting treatment. In addition, management s intent with respect to the holding of the investment affects how the investment is accounted for in the financial statements. The following is a schedule of the accounting treatment based on the type of investment and management s intentions. Control Reporting Category Management Intent Type of Security < 20% Held-to-Maturity Positive intent and ability to hold Debt < 20% Available-for-Sale Sale subject to market factors and Debt or Equity company financial requirements < 20% Trading Subject to immediate sale Debt or Equity 20% - 50% Equity Method Significant influence Equity > 50% Consolidation Control Equity Securities to Be Held to Maturity Debt securities that are classified as held-to-maturity indicate that the company has both the ability and intent to hold the securities until maturity. The investor company does not have any influence over the operating or financial policies of the investee company. The investment in debt securities that are held-to-maturity are recorded at the market value (original cost) on the date of acquisition. Example: Spencer Company purchased $40,000 of the 8%, 5-year bonds of Alexander Company for $43,412, which provides a 6% return. The bonds pay interest semiannually. Spencer Company has both the ability and intent to hold the securities until the maturity date. The journal entry to record the investment would be as follows: 1/1/00 Investment in bonds $40,000 Premium on bonds 3,412 Cash $43,412 To record the purchase of held-to-maturity bonds The following amortization table has been prepared to assist in the discussion related to the recording of interim interest revenue and reporting the investment on the balance sheet at the end of the accounting period. F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 1

2 Amortization Schedule, 8% 5-Year Bonds to Yield 6% Date Payment Interest Amortization of Premium Carrying Amount 1/1/00 $43,412 6/30/00 $1,600 $1,302 $298 43,114 12/31/00 1,600 1, ,807 6/30/01 1,600 1, ,491 12/31/01 1,600 1, ,166 6/30/02 1,600 1, ,831 12/31/02 1,600 1, ,486 6/30/03 1,600 1, ,131 12/31/03 1,600 1, ,765 6/30/04 1,600 1, ,388 12/31/04 1,600 1, ,000 We are assuming that the first interest payment will be received on June 30, The bond is scheduled to pay $1,600 but the company paid a premium so the effective interest earned is $1,302, the cash received net the amortization of the premium. The following journal entry would be recorded to reflect this transaction. 6/30/00 Cash $1,600 Premium on bonds $298 Interest revenue 1,302 To record interest received, amortization of premium, and interest rearned on the first payment The debt securities classified as held-to-maturity are carried in the accounting records at amortized cost (face amount plus premium/less discount). No interim unrealized gains or losses are recognized. If Spencer Company prepares financial statements at December 31, 2001 the investment would be reported on the balance sheet as follows: Held-to-Maturity Investments Corporate bonds $40,000 Plus: unamortized premium 2,166 Book value (amortized cost) $42,166 Available-For-Sale Securities Equity or debt securities that are classified as available-for-sale indicate that the company is holding these securities for some purpose other than short-term trading. The timing of the disposition of such securities would be dictated by changes in the market for the securities or changes in the cash flow requirements of the investor company. At the end of each accounting F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 2

3 period these securities are marked-to-market. Because the securities are held for an unspecified period, the resulting gain or loss is recorded in a special equity account, Unrealized holding gain/loss on investments-equity. When a company has a portfolio of investments it can be difficult to keep track of the original or amortized cost of investments. To maintain a clean record a separate account is established to record the resulting adjustment to the asset account, Available-for-Sale Investments. This is an accretion or contra-asset account, Available-for- Sale Securities Fair Value Adjustment, depending on whether the adjustment increases or decreases the carrying amount of the investment. Example: Spencer Company purchased $50,000 of the 9%, 5-year bonds of Alexander Company $46,304, which provides an 11% return. Management intends to hold this debt security until there is a change in interest rates or the company requires the cash. The fair value of the bonds at year-end is $47,200. To record the original purchase the company would prepare the following journal entry. 1/1/00 Investment in bonds $50,000 Discount on bonds $3,696 Cash 46,304 To record the purchase of available-for-sale bonds The following amortization table has been prepared to assist in the discussion related to the recording of interim interest revenue, recording unrealized gains (or losses) at the end of the accounting period, reporting the investment at market on the balance sheet at year-end. Amortization Schedule, 9% 5-Year Bonds to Yield 11% Date Payment Interest Amortization of Discount Carrying Amount 1/1/00 $46,304 1/1/01 $4,500 $5,093 $593 46,897 1/1/02 4,500 5, ,556 1/1/03 4,500 5, ,287 1/1/04 4,500 5, ,099 1/1/05 4,500 5, ,000 We are assuming that the first interest payment will be made on January 1, In order to prepare the year end financial statements for December 31, 2000 the company will have to accrue the interest that will be received on the first day of The following journal entry will accomplish this. F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 3

4 12/31/00 Interest receivable $4,500 Discount on bonds 593 Interest revenue $5,093 To record interest receivable, amortization of discount, and interest rearned on the first payment at December 31, Available-for-sale securities are marked-to-market for financial reporting purposes. If we assume that the fair value of the bonds at year-end are $47,200 then the following journal entry needs to be made in order to properly reflect the fair value of the securities for financial reporting purposes. 12/31/00 Unrealized holding loss on AFS investments $303 FVA, AFS investments $303 To mark-to-market the available-for-sale securities at year-end Analysis of unrealized holding gain (loss) Market value, December 31, 2000 $47,200 Carrying value 46,897 Unrealized holding gain (loss) $303 T-Account: Fair value adjustment, AFS debt securities 1/1/00 Beginning balance $0 12/31/00 Required AJE /31/00 Ending balance $303 T-Account: Unrealized holding (gain) loss, equity 1/1/00 Beginning balance 0 12/31/00 Required AJE $303 12/31/00 Ending balance $303 To calculate this year-end adjustment, refer to the amortization table above. The carrying amount of the investment is $46,897 and the fair market value is $47,200. The difference of $300 increases the carrying value of the investment and end up separately stated in the equity section of the balance sheet as presented below: F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 4

5 ASSETS Available-for-Sale Debt Securities: Corporate bonds $50,000 Less: unamortized discount 3,103 Carrying value (amortized cost) 46,897 Fair value adjustment, AFS investments 303 Investment at fair value $47,200 SHAREHOLDERS' EQUITY Unrealized holding gain on AFS investments $303 If the ownership of available-for-sale investments continues for several accounting periods the accounting for unrealized gains or losses becomes a little more complicated. The change in market value is recorded from the end of the previous accounting period. Example: At December 31, 2000, Spencer Company had the following balances in its availablefor-sale investment account and the related available-for-sale securities adjustment, and unrealized holding gain accounts. Available-for-Sale Equity Securities: Original Cost Fair Value Unrealized Gain (Loss) Baker Equipment, common stock $103,000 $101,000 ($2,000) Sizemore Corporation, common stock 45,000 51,000 6,000 Totals $148,000 $152,000 $4,000 T-Account: Fair value adjustment, AFS equity securities 1/1/00 Beginning balance $0 12/31/00 Required AJE 4,000 12/31/00 Ending balance $4,000 T-Account: Unrealized holding (gain) loss, equity 1/1/00 Beginning balance $0 12/31/00 Required AJE 4,000 12/31/00 Ending balance $4,000 The journal entry to record this fair value adjustment is as follows: F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 5

6 12/31/00 Fair value adjustment, AFS equity securities $4,000 Unrealized holding gain, AFS equity securities $4,000 To mark-to-market the available-for-sale securities at December 31, 2000 No available-for-sale investments have been purchased or sold during As of December 31, 2001 the fair market values of the two equity investments are as follows: Baker Equipment, common stock $97,500 Sizemore Corporation, common stock 44,000 Total market value $141,500 In order to prepare the December 31, 2001 financial statements the available-for-sale investments account and related available-for-sale securities adjustment and unrealized holding gain accounts need to be adjusted to reflect the new fair values of the equity investments. The following provides such an analysis: Available-for-Sale Equity Securities: Original Cost Fair Value Unrealized Gain (Loss) Baker Equipment, common stock $103,000 $97,500 ($5,500) Sizemore Corporation, common stock 45,000 44,000 (1,000) Totals $148,000 $141,500 ($6,500) T-Account: Fair value adjustment, AFS equity securities 1/1/01 Beginning balance $4,000 12/31/01 Required AJE $10,500 12/31/01 Ending balance $6,500 T-Account: Unrealized holding (gain) loss, equity 1/1/01 Beginning balance $4,000 12/31/01 Required AJE $10,500 12/31/01 Ending balance $6,500 The required adjusting journal entry at the end of December 31, 2001 is as follows: F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 6

7 12/31/01 Unrealized holding loss, AFS equity securities $10,500 Fair value adjustment, AFS equity securities $10,500 To mark-to-market the available-for-sale securities at December 31, 2001 If an available-for-sale security has been marked-to-market and then subsequently sold the sale must be recorded by removing the marked-to-market amounts in the available-for-sale securities adjustment and unrealized holding gains/losses accounts. For example, if on January 1, 2002 Spencer Company sold the stock in Baker Equipment for $100,000 the following journal entry would be prepared to record the transaction. Original Unrealized Available-for-Sale Equity Securities: Cost Fair Value Gain (Loss) Sizemore Corporation, common stock $45,000 $44,000 ($1,000) T-Account: FVA, Available-for-Sale Securities 1/1/02 Beginning balance $6,500 Required AJE $5,500 Ending balance $1,000 T-Account: Unrealized Holding Gain, Equity 1/1/02 Beginning balance $6,500 Required AJE $5,500 Ending balance $1,000 1/1/02 Cash $100,000 FVA, available-for-sale securities 5,500 Loss on sale of investments 3,000 Investment in AFS, Baker Equipment $103,000 Unrealized holding loss on AFS securities 5,500 To record the sale of Baker Equipment stock and remove the allocation of unrealized holding losses from the FVA, available-for-sale securities and the unrealized holding loss on AFS equity accounts on January 1, As with impairment losses on plant, property and equipment or intangible assets, if the decline in value of an available-for-sale investment is other than temporary, it is considered an impairment and must be recognized in the accounting period discovered. The carrying value of the asset is written down to the market value and recorded in the income statement. F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 7

8 Trading Securities Equity and debt securities that are classified as trading securities indicate that the company has purchased the securities for the purposes of making a short term profit. These securities are not being held for interest income but rather for short-term appreciation on the market price of the security. At the end of each accounting period the securities are marked-to-market with the resulting gains and losses reported in the income statement. A nominal account is used to report such gains and losses, Unrealized holding gain/loss on investments-income. Unlike the available-for-sale investments the carrying value of the trading securities are actually written up or down to their new market values, therefore there is no need for an accretion or contra-asset account. The purchase of trading securities is record at net cost. At the end of each accounting period the market value is determined and the carrying value of the securities is marked-to-market. Example: Spencer Company purchased the following securities during Supreme Products, 490 shares stock $240,000 Alexander Company, 5,200 shares stock 132,800 Total cost of trading securities $372,800 At December 31, 2000 management determined that the fair market values of the trading securities were as follows. Trading Securities: Original Cost Fair Value Unrealized Gain (Loss) Supreme Products, 490 shares stock $245,000 $240,000 ($5,000) Alexander Company, 5,200 shares stock 130, ,800 2,800 Totals $375,000 $372,800 ($2,200) T-Account: FVA, Trading Securities 1/1/00 Beginning balance $0 12/31/00 Required AJE $2,200 12/31/00 Ending balance $2,200 The company will record an adjusting journal entry to reflect this unrealized loss. The loss will be reported on the income statement and the carrying value of the investments will be adjusted to market value at December 31, Any realized gain or loss on the subsequent sale of the investments will be based on the carrying value as of December 31, The journal entry would be as follows: F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 8

9 12/31/00 Unrealized holding loss, income $2,200 FVA, trading securities $2,200 To record the unrealized holding loss on trading securities at December 31, Transfers between Reporting Categories If management decides to transfer an investment security from one category to another the resulting unrealized gain or loss is recognized or deferred based on the follow schedule: Transfer From To Unearlized Gain or Loss from Transfer Held-to-Maturity Available-for-Sale Unrealized Gain/Loss, Equity Held-to-Maturity Trading Unrealized Gain/Loss, Income Available-for-Sale Held-to-Maturity Amortize over remaining life of security Available-for-Sale Trading Unrealized Gain/Loss, Income Trading Available-for-Sale None, already at FMV Trading Held-to-Maturity None, already at FMV F:\Teaching\3321\web\module3\c12\tnotes\c12a.doc 2/19/2007 9