Topic 6 INVESTMENTS Download Excel file Brief Exercises

Topic 6 INVESTMENTS Download Excel file Brief Exercises” in topic 6 area of Handouts

12 -2 Nature of Investments Bonds and notes (Debt 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 -3 Reporting Categories for Investments

12 -4 Investor Lacks Significant Influence

12 -5 Securities to Be Held to Maturity Securities 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). Balance Sheet

12 -6 Securities to Be Held to Maturity On January 1, 2013, Matrix Inc. purchased as an investment $1, 000, of 10%, 10 -year bonds, interest paid semiannually. 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 × 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 Securities to Be Held to Maturity Partial Bond Amortization Table January 1, 2013 Investment in bonds Discount on bond investment Cash June 30, 2013 Cash (stated rate × face amount) Discount on bond investment Investment revenue 1, 000 114, 699 885, 301 50, 000 3, 118 53, 118

12 -8 Securities to Be Held to Maturity This investment would appear on the June 30, 2013, balance sheet as follows: $114, 699 - $3, 118 = $111, 581 unamortized discount Unrealized holding gains and losses are not recognized for HTM investments.

12 -9 Securities to Be Held to Maturity On December 31, 2013, after interest is received by Matrix, all the bonds are sold for $900, 000 cash. December 31, 2013 Cash Discount on bond investment Investment revenue 50, 000 3, 305 December 31, 2013 Cash 900, 000 Discount on bond investment 108, 276 Investment in bonds Gain on sale of investment 53, 305 1, 000 8, 276

12 -10 Brief Exercise 12 -1 Lance Brothers Enterprises acquired $720, 000 of 3% bonds, dated July 1, on July 1, 2013, as a long-term investment. Management has the positive intent and ability to hold the bonds until maturity. The market interest rate (yield) was 4% for bonds of similar risk and maturity. Lance Brothers paid $600, 000 for the investment in bonds and will receive interest semiannually on June 30 and December 31. Prepare the journal entries (a) to record Lance Brothers’ investment in the bonds on July 1, 2013, and (b) to record interest on December 31, 2013, using the effective (market) rate method.

12 -11 Trading Securities Investments in debt or equity securities acquired principally for the purpose of selling them in the near term. 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 on the income statement. Unrealized Gain Unrealized Loss Income Statement

12 -12 Trading Securities Matrix Inc. purchased securities classified as Trading Securities (TS) on December 22, 2013. The fair value amounts for these securities on December 31, 2013, are shown below. Prepare the journal entries for Matrix Inc. to show the purchase of the securities, and adjust the securities to fair value at 12/31/13.

12 -13 Trading Securities December 22, 2013 Investment in Mining Inc. stock Investment in Toys and Things stock Cash 42, 000 22, 500 64, 500 Reported on the balance sheet as a adjunct account to the investment. December 31, 2013 Net unrealized holding gains and losses – I/S Fair value adjustment The Net Unrealized Holding Loss is reported on the Income Statement. 3, 500

12 -14 Trading Securities On 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, 2014 Cash Investment in Mining, Inc. stock – T/S Investment in Toys and Things stock – T/S Gain on sale of investment December 31, 2014 Fair value adjustment Net unrealized holding gains or losses – I/S 65, 000 42, 000 22, 500 3, 500

12 -15 Financial Statement Presentation 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 -16 Financial Statement Presentation Presented below are the partial financial statements showing the accounting for TS owned by Matrix:

12 -17 Securities Available-for-Sale Investments 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 Loss Other Comprehensive Income (OCI)

12 -18 Other Comprehensive Income (OCI) When we add other comprehensive income to net income we refer to the result as “comprehensive income. ”

12 -19 Accumulated Other Comprehensive Income Unrealized holding gains and losses on availablefor-sale securities are accumulated in the shareholders’ equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income (AOCI). Net unrealized holding gains and losses. Shareholders’ Equity Common stock Paid-in capital in excess of par Accumulated other comprehensive income Retained earnings Total shareholders’ equity

12 -20 Securities Available for Sale Example Assume 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. December 31, 2013 Net unrealized holding gains and losses – OCI Fair value adjustment 3, 500

12 -21 Financial Statement 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 OCI 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 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. 3. Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

12 -22 Brief Exercise 12 -2 S&L Financial buys and sells securities expecting to earn profits on short-term differences in price. On December 27, 2013, S&L purchased Coca-Cola common shares for $875, 000 and sold the shares on January 3, 2014, for $880, 000. At December 31, the shares had a fair value of $873, 000. What journal entries would S&L make in 2013 and 2014 as a result of this investment?

12 -23 Brief Exercise 12 -3 S&L Financial buys and sells securities with the intent of holding for an extended period of time. Since this is their intent all securities are reported as available for sale. On December 27, 2013, S&L purchased Coca-Cola common shares for $875, 000 and sold the shares on January 3, 2014, for $880, 000. At December 31, the shares had a fair value of $873, 000. What journal entries would S&L make in 2013 and 2014 as a result of this investment?

12 -24 Brief Exercise 12 -2 & 12 -3 For trading securities, unrealized holding gains and losses: are or are not included in earnings. For securities available-for-sale, unrealized holding gains and losses: are or are not included in earnings.

12 -25 BE 12 -4 For several years Fister Links Products has held shares of Microsoft common stock, considered by the company to be securities available-for-sale. The shares were acquired at a cost of $500, 000. Their fair value last year was $610, 000 and is $670, 000 this year. At what amount will the investment be reported in this year’s balance sheet? What adjusting entry is required to accomplish this objective?

12 -26 Transfers Between Reporting Categories Any 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.

Financial Statement Presentation and Disclosure Aggregate Fair Value Gross realized & unrealized holding gains & losses Maturities of debt securities Amortized cost basis by major security type Change in net unrealized holding gains and losses Inputs to fair value estimates 12 -27

12 -28 Impairment of Investments Occasionally, an investment’s value will decline for reasons that are other-thantemporary (OTT). For HTM and AFS investments, a company recognizes an 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 impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

12 -29 Brief Exercise 12 -13 LED Corporation owns 100, 000 shares of Branch Pharmaceuticals common stock and classifies its investment as securities available-for-sale. The market price of Branch’s stock fell over 30%, by $4. 50 per share when the FDA banned one of the company’s principal drugs. What journal entry should LED record to account for the decline in market value? How should the decline be reported?

12 -30 Investor Has Significant Influence

12 -31 Investor Has Significant Influence Extent of Investor Influence Lack of significant influence (usually < 20% equity ownership) Significant influence (usually 20% - 50% equity ownership) Has control (usually > 50% equity ownership) Reporting Method Varies depending on classification previously discussed Equity method Consolidation

Criteria for Determining Whether There is Influence FASC Sec 323 Representation on the investee’s Board of Directors Participation in the investee’s policy-making process Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership in relationship to other ownership percentages. 12 -32

12 -33 What Is Significant Influence? If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if 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 -34 Equity Method 1. The investment account is increased by: n n 2. Original investment cost. Proportionate share of investee's earnings. The investment account is decreased by: n Dividends received.

12 -35 Equity Method The investment account is reported on the balance sheet as a single amount. The investor’s share of the investee’s earnings from date of acquisition is reported as a single item on the investor’s income statement.

12 -36 Equity 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. 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 -37 Equity Method January 1, 2013 Investment in Apex Inc. stock Cash 1, 350, 000 2013 Investment in Apex Inc. stock Investment revenue 787, 500 2013 Cash 1, 350, 000 787, 500 67, 500 Investment in Apex Inc. stock 67, 500

12 -38 Equity Method Investment in Apex Inc. Investment 1, 350, 000 45% Earnings 787, 500 67, 500 45% Dividends Reported amount 2, 070, 000 If the investee had a loss, the investment account would have been reduced with a credit.

12 -39 Equity Method On 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.

12 -40 Equity Method The 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.

12 -41 Equity Method January 1, 2013 Investment in Apex stock Cash 2013 Cash 180, 000 10, 000 Investment in Apex stock Investment revenue December 31, 2013 Investment revenue Investment in Apex stock 10, 000 25, 000 1, 875

12 -42 Brief Ex 12 -8 Turner Company owns 10% of the outstanding stock of ICA Company. During the current year, ICA paid turner a $500, 000 cash dividend. What journal entry is made for the dividend Turner receives in the current year?

12 -43 Brief Ex 12 -8 Explanation Turner should account for the dividends as trading or available for sale investments, unless they have the ability to exercise significant influence, then Turner would account for the investment using the equity method as investment revenue. Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company.

12 -44 Brief Exercise 12 -7 Turner Company owns 40% of the outstanding stock of ICA Company. During the current year, ICA paid a $2 million cash dividend to Turner. What journal entry is made for the dividend Turner receives in the current year?

12 -45 Brief Exercise 12 -7 Explanation Turner is presumed to have the ability to exercise significant influence over ICA based on the 40% ownership. Turner should account for ICA’s dividends as a reduction in its Investment in ICA account. Since investment revenue is recognized as ICA earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investment in ICA’s net assets, reflecting the fact that the Turner’s ownership interest in those net assets declined proportionately.

12 -46 Brief Ex 12 -9 The fair value of Wallis, Inc. ’s depreciable assets exceeds their book value by $50 million. The assets have an average remaining useful life of 15 years and are being depreciated by the straight-line method. Park Industries buys 30% of Wallis’s common shares. When Park adjusts investment revenue and the investment by the equity method, what adjusting journal entry will be made?

12 -47 Brief Ex 12 -9 Explanation The equity method reports acquired net assets at their fair values. Both the accounts Equity Income and Investment in Wallis would be reduced by the “extra depreciation” the higher fair value. This would equal 30% x $50 million ÷ 15 years = ? each year for fifteen years.

12 -48 End of Required Course Material The following will be covered in Advanced Accounting Will not be tested on final.

12 -49 Fair Value Option 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.

Financial Instruments and Investment Derivatives 12 -50 Financial Instruments: Investment Derivatives: 1. Cash. 2. Evidence of an ownership interest in an entity. 3. Contracts meeting certain conditions. 1. Value is derived from other securities. 2. Derivatives are often used to “hedge” (offset) risks created by other investments or transactions