Intermediate accounting 19th by stice stice chapter 14

• Available-for-sale securities are equity securities that are not considered trading securities and are not accounted for using the equity method.. • Trading involves frequent buying an

Intermediate

Accounting

James D Stice Earl K Stice

Investments in Debt and Equity Securities

Chapter 14

19 th

Edition

Why Companies Invest in

Other Companies

• Safety cushion

• Cyclical cash needs

• Investment for a return

• Investment for influence

• Purchase for control

Cyclist Cash Needs

• Some companies operate in seasonal

business environments that need

cyclical inventory buildups requiring

large amounts of cash, followed by lots

of sales and cash collections Examples include:

 Toy stores

 Firework retailers

 Halloween retailers

Investment for Influence

In general, companies can invest in other

companies for many reasons other than to

earn a return Some reasons are:

• to ensure a supply of raw materials

(e.g., Coca- Cola)

• to influence the board of directors

• to diversify product offerings

Purchase for Control

another company to be able to control

operating, investing, and financing

decisions, different accounting treatment is required for that acquisition.

• For accounting purposes, a parent

company is required to report the results of all of its subsidiaries of which it owns more than 50% as if the parent and subsidiaries

Classification of Investment Securities

issued by a company that typically have the following characteristics:

 a maturity value representing the amount

to be repaid to the debt holder at maturity,

 an interest rate that specifies the

periodic interest payments, and

 a maturity date indicating when the debt obligation will be redeemed

• Equity securities represent ownership in a company.

 These shares of stock typically carry with them the right to collect dividends and to vote on corporate matters

 They are an attractive investment

because of the potential for significant increases in the price of the security

Classification of Investment Securities

• Held-to-maturity securities are debt

securities purchased by a company with

the intent and ability to hold those

securities until they mature.

 This category includes only debt

securities because equity securities

typically do not mature.

 The company must have the intention of

holding the security until it matures.

(continued)

Classification of Debt and Equity Securities

• Available-for-sale securities are equity

securities that are not considered trading

securities and are not accounted for using the equity method

• Most of the typical company’s investment

securities are classified as available for sale

Classification of Debt and Equity Securities

• Trading securities are debt and equity securities purchased with the intent of

selling them in the near future.

• Trading involves frequent buying and

selling of securities, generally for the

purpose of “generating profits on

short-term differences in price.”

Classification of Debt and Equity Securities

(continued)

• Equity method securities are equity

securities purchased with the intent of

being able to control or significantly

influence the operations of the investee

• A large block of stock (presumed to be at least 20% of the outstanding stock unless there exists evidence to the contrary)

must be owned to be classified as an

equity method security

Classification of Debt and Equity Securities

The Fair Value Option

• Under the fair value option, a company has the option to report, at each balance sheet date, any or all of its financial assets and

liabilities at their fair values on the balance sheet date

• The election of the fair value option for an

investment security “trumps” the

classification of the security as trading,

available for sale, held to maturity, and

equity method

Classification of Investment Securities According to IFRS

• The classification of investment securities

under IFRS 9 is very similar to the

classification categories under U.S GAAP

• The fair value option for financial assets also exists in IFRS under the provisions of

Purchase of Debt Securities

• On May 1, $100,000 in U.S Treasury notes are purchased at 104¼, including brokerage fees

• Interest is 9%, payable semiannually on

January 1 and July 1 (accrued interest of

$3,000 would be added to the purchase

price)

(continued)

Purchase of Debt Securities

• The debt securities are classified by the

purchaser as trading securities because

management will sell the securities if a change

in the price will result in a profit

• The entries to record the transactions related

to this purchased using the asset approach,

then the revenue approach are shown in the following slides

Purchase of Equity Securities

• Gondor Enterprises purchased 300 shares

of Boromir Co stock at $75 per share plus brokerage fees of $80 (as trading securities) and 500 shares of Faramir Inc stock at $50 per share plus brokerage fees of $30 (as

available-for-sale securities)

• The journal entry to record the purchase is shown on Slide 14-34

(continued)

Purchase of Equity Securities

Investment in Trading Securities—

Computations:

$300 x $75 = $22,500

$500 x $50 = $25,000

Recognition of Revenue from Debt Securities

• Assume that on January 1, 2010, Silmaril

Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable semiannually on January 1 and

July 1 The market rate on similar bonds is 8%.

• The first step is to calculate the market

price of the bonds.

(continued)

Present value of principal:

FV = $100,000; N = 10; I = 4% $ 67,556 Present value of interest payments:

PMT = $5,000; N = 10; I = 4% 40,554

Total present value of the bonds $108,110

Recognition of Revenue from Debt Securities

When interest is received:

Investment in Trading Securities 108,110

When trading securities are purchased:

Interest Revenue for Debt Securities Classified as Trading

Interest Revenue for Debt Securities

Classified as Held to Maturity

To determine the amount of premium to

amortize each period, Silmaril would prepare an amortization table based on the effective-

interest method of amortization

When the first interest payment is received:

Investment in Held-to-Maturity Securities 676

Interest Revenue for Debt Securities

Classified as Held to Maturity

When the second interest payment is received:

Interest Revenue for Debt Securities

Classified as Held to Maturity

Investment in Held-to-Maturity Securities 703

Recognition of Revenue from

Equity Securities

• In those instances where the level of

ownership in the investee is such that the

investor is able to control or significantly

influence decisions made by the investee, the use of the equity method is appropriate

• The ability of the investor to exercise

significant influence over decisions as

dividend distribution and operational and

financial administration may be indicated in several ways, as listed in Slide 14-44

Significant influence may be indicated by decisions affecting:

• Representation on the investee’s board of directors

• Participation in the policy-making process

• Material Intercompany transactions

• Interchange of management personnel

• Technical dependency of investee on investor

• Percentage of outstanding voting stock owned

Recognition of Revenue from

Equity Securities

Determining the Appropriate

Accounting Method

No significant

influence

Significant influence Control

Ownership Percentage Equity method

Equity method and consolidation procedures

Account for as

trading or

available-for-sale

Revenue for Equity Securities Classified

as Trading and Available for Sale

When an investment in another company’s

stock does not involve either a controlling

interest or significant influence, it is classified

as either trading or available for sale Assume that Gondor Enterprises receives the

following dividends from its investees:

The journal entry to record receipt of the

dividends would be:

[(300 × $2.00) + (500 × $3.75) = $2,475]

Revenue for Equity Securities Classified

as Trading and Available for Sale

Revenue for Securities Classified

As Equity Method Securities

• Under the equity method, the investment is

initially recorded at cost.

• The investment account is periodically adjusted

to reflect changes in the underlying net assets of the investee.

 Increased to reflect a proportinate share of the

earnings of the investee or decreased to show any losses reported.

 Preferred dividends declared reduce the

investment account; dividends received also

Revenue for Securities Classified

As Equity Method Securities

BioTech Inc purchased 40% of the outstanding stock of Medco Enterprises on January 1 of the current year by paying $200,000 During the year, Medco reported net income of $50,000 and paid dividends of $10,000

(continued)

Investment in Medco Enterprise Stock:

Investment in Medco Enterprise Stock 200,000

To record the purchase of 40% of

Medco stock.

Recognize a percentage of net income:

Investment in Medco Enterprise Stock 20,000

Income from Investment in Medco

Enterprises Stock ($50,000 × 0.40) 20,000

To record the recognition of revenue

from investment in Medco.

Record receiving a dividend:

Investment in Medco Enterprises Stock 4,000

To record the receipt of dividend on

Medco stock.

Revenue for Securities Classified

As Equity Method Securities

Comparing the Provisions of

FASBS ASC Topics 320 and 323

• To contrast and illustrate the accounting

entries under various methods, assume that Powell Corporation purchased 5,000 shares

of San Juan Company common stock on

January 2 at $20 per share, including

commissions and other costs

• San Juan has a total of 25,000 shares

outstanding Compare the two methods in

Exhibit 14-10 on Slide 14-53

(continued)

Equity Method: Purchase for More than Book Value

• On January 2, 2013, the net assets of Stewart Inc was $500,000 at the time Phillips

Manufacturing Co purchased 40% of the

common shares for $250,000

• Based on the ownership interest, the market

value of the net assets of Stewart Inc would be

$625,000 ($250,000/0.40), which is $125,000 more than the book value Only $50,000 of this

is attributed to depreciable assets The

remaining $75,000 is attributed to a special

• The average remaining life of the depreciable assets is 10 years and the license is to be

amortized over 20 years Phillips Manufacturing

Co would adjust its share of Stewart Inc.’s net income as follows:

(continued)

Additional depreciation ($50,000 × 0.40)/10 $2,000 License amortization ($75,000 × 0.40)/20 1,500

$3,500

Equity Method: Purchase for More than Book Value

Each year for the first 10 years, Phillips would

make the following entry in addition to entries

made to recognize its share of Stewart Inc.’s

income and dividends

Income from Investments in Stewart Inc.

To adjust share of income on Stewart

Inc common stock for proportionate

depreciation on excess of market value

of depreciable property, $2,000, and for

amortization of the unrecorded license,

$1,500.

Equity Method: Purchase for More than Book Value

• After the 10th year, the adjustment would be for

$1,500 until the license amount is fully

amortized

• Stewart Inc declared and paid dividends of

$70,000 during 2013 and reported net income

of $150,000 for the year The investment would

be shown on Phillip’s balance sheet at

$278,500, computed as shown on Slide 14-58

Equity Method: Purchase for More than Book Value

(continued)

Equity Method: Purchase for More than Book Value

The adjustments for additional depreciation

and intangible asset amortization are needed only when the purchase price is greater than

the underlying book value at the date of

Equity Method: Joint Venture

• A joint venture is a form of

off-balance-sheet financing

• Joint ventures are accounted for using the

equity method

• Even if the joint venture does not have a

50%–50% ownership structure, the minority interest will still account for the joint venture using the equity method

(continued)

Equity Method: Joint Venture

Owner A Company and Owner B Company each own 50% of Ryan Julius Company, which does research and marketing for the products of both Owner A and Owner B Ryan Julius has assets of

$10,000 and liabilities of $9,000

Investment in Ryan Julius [($10,000 – $9,000)

Owner A Balance Sheet

Investment in Ryan Julius [($10,000 – $9,000)

Owner B Balance Sheet

Equity Method Accounting

According to IFRS

• Equity method accounting under IFRS is

the same, in all important aspects, as under U.S GAAP.

• The relevant standard is IAS 28

• Under IFRS, the term “associate” is used

for what is called an “equity method

investee” under U.S GAAP.

Eastwood Incorporated purchased five different securities on March 23, 2011 Their fair value is shown as of December 31, 2013.

Accounting for Temporary Changes

in the Fair Value of Securities

Initial Purchase Entry—2013

Initial Purchase Entry—2013

Investment in Trading Securities 11,000

Investment in Available-for-Sale Securities 17,000

Investment in Held-to-Maturity

(continued)Accounting for Temporary Changes

in the Fair Value of Securities

At the end of 2013, the value of the trading

securities decreased from $11,000 cost to

$10,500 fair value As a result, the following

entry would be made:

December 31, 2013:

Unrealized Loss on Trading Securities 500

Trading Securities

Market Adjustment—Available-for-Sale

Unrealized Increase/Decrease in Value

At the end of 2013, the available-for-sale

portfolio had increased from $17,000 to $17,600 This increase in fair value of the securities above their cost would be recorded as follows:

Available-for-Sale Securities

The adjusting entry is as follows:

Market Adjustment—Trading Securities 800

Unrealized Gain on Trading Securities 800

(continued)

Accounting for the Change in

Value of Securities

The account, “Market Adjustment—Trading

Securities” should have a debit balance of $300 The “Before Adjustment Balance” is a 500

credit; a carry over from 2013 The adjusting

entry is as follows:

The balance in Market Adjustment—Trading

Securities would be added to Investment in

Trading Securities and reported on the balance sheet

Accounting for the Change in

Value of Securities

The $800 unrealized gain would be included in the computation of net income for 2014

Available-for-Sale Securities—2014

Available-for-Sale Securities—2014

At the end of 2014, the fair value of the

available-for-sale securities has decreased from

$17,600 to $17,200

Accounting for the Change in

Value of Securities

The adjusting entry is as follows:

Unrealized Increase/Decrease in Value of

Accounting for “Other-Than-Temporary” Declines in the Fair Value of Securities

If a decline in the fair value of an individual

security is judged to be other than temporary,

regardless of whether the security is debt or

equity and regardless of whether it is being

accounted for as a trading, available-for-sale,

held-to-maturity, or equity security, the cost basis

of that security should be reduced by crediting the

investment account

(continued)

Accounting for “Other-Than-Temporary” Declines in the Fair Value of Securities

In Staff Accounting Bulletin No 59, the SEC

staff suggest that one consider the following in

determining whether a decline in fair value is

other than temporary:

• How long has the fair value of the security been below its original cost?

• What is the current financial condition of the

investee and its industry?

• Will the investor’s plans involve holding the

security long enough for it to recover its value?