Chapter 16: Investments in Financial Assets

A company's net assets increase when ___(a)___ and decrease when ___(b)___

(a) increase when it earns net income (b) decrease when it declars dividends or incurs a net loss

Trading Securities

A debt investment that a company intends to hold only for the short term. --> Generally a company classifies securities as trading when it plans to actively buy and sell securities with the objective of generating a gain on the sale

Bond

A promissory note, a form of borrowing by which a company raises capital today in exchange for a contractual obligation to pay bondholders (the lenders) the principal amount (face value) and interest in the future.

Fair Value Option for Reporting Investments

Companies can elect to value most types of financial assets and obligations at fair value. Improves financial reporting by enabling entities to offset volatility in reported earnings.

Effective Interest Method

Computes interest revenue by multiplying the historical market rate of interest by the carrying value of the debt investment at the beginning of the period

Unrealized gain or loss

If the company holds the securities, then the change in the fair value is the unrealized gain or loss

Classification of Debt Securities

Management classifies debt securities into one of three portfolio categories at acquisition: 1. Held-to-maturity 2. Trading securities 3. Available-for-sale securities

There are three possible levels of influence:

No significant influence, signficiant influence, and control

Long-term notes receivable

Notes receivable with a maturity date longer than a year from the balance sheet date (or operating cycle, if longer)

Control

Typically gained by an investor company holding more than 50% of the voting shares of the investee companyx

Equity Method

Under the equity method, the investor recognizes the increases and decreases in the economic resources of the investee. The investor initially reports the investment account at cost and thereafter reports any events that affect the book value of the investee's retained earnings in the carrying value of its investment account and financial statements.

Amortized cost

original cost less the unamortized amount of the premium or discount. Any discount or premium is amortized to income subsequent to the date of acquisiton and over the bond term. -->amortized cost is a more relevant value than fair value for securities held until maturity

When the company sells the securities, it also reports any....

realized gains or losses in net income!!!

An investee's fair value often does not equal the reported book value of its net assets at the date of acquisition for a variety of reasons, including:

--> differences between the fair values and book values of assets such as inventory or PPE --> unreported intangible assets such as brands that can be identified --> unreported goodwill

The fair value adjustment account can have a debit or credit balance depending on whether the company recognizes unrealized gains or losses, respectively:

1) If the fair value at the end of the year is greater than the amortized cost of the debt investment, the fair value adjustment (FVA) account will have a debit balance 2) If the fair value at the end of the year is less than the amortized cost of the debt investment, the FVA will have a credit balance

FVO: IFRS -- IFRS stipulates that a company can use the fair value option for financial assets when doing so results in relevant information because either:

1. A company has a documented risk management or investment strategy that prescribes it will manage and evaluate its performance on the fair values and changes in fair values of financial assets and/or liabilities 2. The fair value option ensures consistently measuring liabilities or assets and gains or losses on them on the same basis. That is, the FVO eliminates or significantly reduces accounting mismatches from measuring liabiliites and assets on different bases.

Under IFRS, a note receivable to be amortized must meet two criteria:

1. Be held within a business model whose objective is to hold it to collect contractual cash flows. 2. Satisfy the SPPI contractual cash flow characteristics test.

Dividends reduce the investment account and are not recorded as income for several reasons:

1. Dividends received on investments accounted for under the equity method are a return of an investment, not a return on investment. 2. The decision to distribute investee dividends in influenced by the investor. As a result, this is not an objective transation, and the investor should not recongize this event as income. 3. Because the investor recognizes its share of investee's net income or loss on the income statement, recognizing dividends as income would double count a portion of the investee's earnings on the investor's income statement.

There are two primary effects of the discount amortization:

1. Increases the interest revenue so that the corporation's effective rate of return is brought up higher than the market rate 2. Reduces the discount and increases the carrying value of the note receivable until the carrying value is brought up to its face value on the maturity date.

Accounting for investments in debt and equity securities in debt and equity securities:

1. Is the investment a debt security or an equity security? 2. If the investment is a debt security, how long does management intedn to hold the investment? 3. If the investment is an equity security, how much control does the investor have over the investee company? 4. If the investment is an equity security, is the fair value readily determinable?

Investments in debt securities commonly change fair value. The portfolio classification determines:

1. The valuation of the security on the balance sheet (at amortized cost or at fair value) 2. If carried at fair value, where changes in fair value are reported (in earnings or other comprehensive income)

Face value

Also known as the par value, the amount that the issuer will pay the bondholder at maturity

Bonds can be purchased at a ___ or a ____

Bonds can be purchased at their par value, at a discount (a price below par), or at a premium (price above par). In all cases, bonds are priced such that their yield will be the same as the market rate of interest, which is also called the effective interest rate, for a similar amount of risk.

When an equity investment with no significant influence has no readily determinable value ...

Companies report these at estimated fair value with unrealized gains and losses in net income. Realized gains and losses on disposal are also reported in net income. However, a company can elect, on a security-by-security basis to report an equity security without a readily determinable fair value at cost with an adjustment for changes resulting from observable price changes for similar securities of the same issuer. The amount of the adjustment should account for the difference in the two securities, and is reported in net income with any realized gains and losses.

Held to maturity Securities

Debt securities where a company has both the positive intent and ability to hold a debt investment until it matures. --> Positive intent is not just the absence of the intent to sell: The company must actually plan on holding the debt security to maturity. If the company's intent to hold the instrument is uncertain, then it should not classify the security as held to maturity.

Amount amoritzed formula

Discount/Premium Amortization = Effective Interest Revenue - Cash Interest Received

Available-for-sale securities

If a debt security is not classified as held to maturity or trading, then it is classified as an available-for-sale security

Realized gain or loss

If the company actually sells the securities, the realized gain or loss is the change in the fair value.

Debt Security

Investment in the notes or bonds payable issued by another company

Investments in Equity Securities

Investments in the common or preferred shares of another ocmpany

Companies recognize interest revenue on HTM debt investments using----

THE EFFECTIVE INTEREST METHOD

Equity subsequent adjustments depend on whether:

The book value of net assets of the investee EQUALS its fair value at the date of the acuqisition, or if it's DIFFERENT.

Significant influence

The investor company has the ability to exert influence over operating and financial policy decisions of the inestee company even though it does not legal control the investee company, generally holding 20 to 50% of the company's stock

No significant influence

The investor lacks the ability to participate in the decisions of the investee company.

Investor (equity security)

The party purchasing the equity security may receive returns in the form of dividends, which are distributions (often cash) that the investee (the party that issued the equity security) pays to the investor. In addition, the investor could eventually sell the investment for an amount higher than its purchase price and earn a gain on disposal.

FAIR VALUE OPTION --- What does it mean for a) trading securities + equity investments without sig. influence? b) held to maturity, AFS debt isntruments, and equity investments with significant influence

a) nothing, because these are already reported at fair value with gains and losses reported in net income, so FVO does not change these investments b) these will change substantiallly.

Stated Interest Rate

determines the amount of interest that bondholders will receive in cash

A company reports AFS (available for sale securities) at

fair value and includes unrealized gains or losses in OCI

An investor reports changes in fair value of trading securities in ----

net income!

Yield

the actual return that the investors will receive

When electing the fair value option at initial recognition...

the company reports the asset on the balance sheet at fair value and reports all unrealized gains and losses in net income

When a note's interest rate EQUALS the market rate .... ....

the face value of the note equals its present value, and periodic payments are computed using the time value of money techqniques.

When a note's interest rate is LESS THAN the market interest rate..... ....

the face value of the note will NOT equal its present value. the difference between the note's face value and present value is a discount on the note. the note's PV is therefore the value of its future cash flows discounted at the market rate of interest the discount represents deferred interest revenue to be earned over the life of the note. Companies amortize the discount to interest revenue over the loan term using the effective interest method.

Historical market rate

the interest rate used to value the investment at the date of the acquistion

The appropriate accounting method for equity investments depends on....

the investor's level of influence over the investee company.

Companies initially measure long-term notes receivable at ....

the present value of future cash flows at the historical market rate of interest when issued. They are subsequently reported at amortized cost on the balance sheet.