CH 12 Investments

Transfer Between Reporting Categories: Fair value option

TS already are accounted for a t fair value, so there is no need to choose the fair value option for them. When a security that qualifies for HTm or AFS treatment is purchased, the investor makes an irrevocable decision about whether to elect the fair value option. Choosing the fair value option for HT and AFS investments just means reclassifying those investments as TS. Unlike most trading securities, purchases and sale of investments accounted for under the fair value option are likely to be classified as investing activities in the statement of cash flows because those investments are not held for sale in the near term and therefore are not operational in nature. Electing the fair value option is irrevocable. Why allow the fair value option? A primary reason for creating the AFS approach was to allow companies to avoid excess earnings vitality that would result from reporting in earnings the fair value changes of only part of a hedging arrangement. The fair value option allows companies to choose whether to use fair value for most types of financial assets and liabilities.

Reporting the Investment

The fair value of investment shares at the end of the reporting periodis not reported using teh ewuity method. The investment account is reported at its original cost, increased by the investor's share of the investee's net income (adjusted for additional expenses like depreciation), and decreased by the portion of those earnings actually recevied as didivideds. The investment account represents the investor's share of the investee's net assets initially acquired, adjusted for the investor's share of the subsequent increase in the investee's net assets.

Comparison of Fair Value and the Equity Method

To record the purchase of an investment, we use identical entries for both approaches. The two approaches differ in whther we record investment revenue when dividends are received and wheter we recognize unrealized holding gains and losses assocaited with changes in the fair value of the investment. The differences in how the two approaches account for unrealized holding gains and losses result in difference book values for the investment at the time the investment is sold, and therefore, result in different realized gains or losses when the investment is sold. Regardless of the approach, the same cash flows occur, and the same total amount of net income is recognized over the life of the investment. thus the question is not how much total net income is recognized, but when that net income is recognized.

Transfer from HTM or AFS to Trading

Include in current net income the total unrealized gain or loss, as if it all occurred in the current period.

No adjustments for land or goodwill

We do not depreciate land. Goodwill is not amortized.

Accounting for Unrealized Holding Gains and Losses When the Investor Lacks Significant Influence: Avaialable for Sale (AFS)

used for debt or equity that does not qualify as held to maturity or trading; unrealized holding gains and losses are recognized in other comprehensive income, and therefore in accumulated other comprehensive income in shareholders' equity; investment reported in the balance sheet at fair value.

Trading Securities:

Trading securities are activiley managed in a trading account for the purpose of proifting from short-term price changes. THey are typically reported among the investor's current assets. Trading securities are initially recorded at cost- the total amount paid for the securities, including any brokerage fees. When a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value, or "Marked to Market." For these investments, fair value information is more relevant than for other assets intended primarily to be used in company operations. If the debt investment is held for active trading, changes in market values, and thus market returns, provide an indication of management's success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in short or long term securities. For that reason it makes sense to report unrealized holding gains and losses on trading securities in net income during a period that fair values change, even though those gains and losses haven't yet been realized through the sale of the securities.

Trading Securities: Adjust Trading Security Investments to Fair Value

Trading securities are adjusted to their fair value at each reporting date. Rather than increasing or decreasing the investemnet account itself, we use a valuation allowance, fair value adjustment, to increase or decrease the carrying value of the investment. At the same time, we record an unrealized holding gain or loss that is included in net income in the period in which fair value changes. pg 661 has a nice table Debit Net unrealized holding gains and losses-I/S and Credit Fair value adjustment (for a loss)

Reporting Categories for Investments: The investor HAS SIGNIFICANT INFLUENCE over the operating and financial policies of the investee.

Typically the investor owns between 20 and 50% of the voting stock of the investee. The Equity method is used; the investment cost is adjusted for subsequent earnings and dividends of the investee.

IFRS

page 670; its probably in the powerpoint

IFRS

page 674

IFRS

pg 672 and 673

Trading Securities: Financial Statement Presentation

We present trading securities in financial statements as follows: -Income Statement and Statement of Comprehensive Income: For trading securities, fair value changes are included in the income statement in the periods in which the occur. Investments in trading securities do not affect other comprehensive income. -Balance Sheet: Investments in trading securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders' equity. -Cash Flow Statement: Cash flows from buying and selling trading securities are typically classified as operating activities because the financial institutions that routinely holding ts consider them as part of their normal operations.

What if conditions change? A change from another method to the equity method

When a change to the equity method is appropriate, the investment account should be retroactively adjusted to the balance that would have existed if the equity method always had been used. As income would have been different, retained earnings would be adjusted as well. Financial statements would be restated to the equity method for each year reported for comparative purposes. Th income effect for years prior to those show in the comparative statements is reported on the statement of retained earnings as an adjustment to beginning retained earnings of the earliest year reported. A disclosure note should also describe the change.

Securities Available-for-Sale:

When a company acquires an investment, not for an active trading account or to be held to maturity, the company classifies its investment as securities available for sale. We report investments in AFS securities in the balance sheet at fair value. Unrealized holding gains and losses on AFS securities are NOT included in net income. Instead, they are reported in the statement of comprehensive income as other comprehensive income.

If an equity method investment is sold

When an equity method investment is sold, a gain or loss is recognized for the difference between its selling price and its carrying amount.

Further Adjustments

When the investor's expenditure to acquire an investmetn exceeds the book value of the underlying net assets required, additional adjustments to both the investment account and investment revenue might be needed. The purpose is to approximate the effects of consolidation without actually consolidating the financial statements. After the date of acquisition, both the investment account and investment revenue are adjusted for differences between net income reported by the investee and what that amount would have been if consolidation procedures had been followed. AKA amortizing the differential because it mimics the process of expensing some of the difference between the price paid for the investment and the book value of the investment.

What if conditions change? A change from equity method to another method

When the investor's level of influence changes, it may be necessary to change from the equity method to another method. When this situation happens, no adjustment is made to the remaining carrying amount of the investment. The equity method is simply discounted and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to fair value on the next set of financial statements.

Securities Available-for-Sale: Financial Statement Presentation

-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 periods in which securities are sold. -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. -Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities. AFS securities are reported at fair value.

When the investment is acquired in mid-year

Changes in the investment account the first year are adjusted for the fraction of the year the investor has owned the investment.

Comprehensive Income

Comprehensive income includes not only net income, but also other changes in equity that don't arise from transactions with owners. It includes net income and Other Comprehensive Income.

Financial Instruments and Investment Derivatives

Derivatives are financial instruments that "derive" their values from some other security or index. The FASB's ongoing financial instruments project is expected to lead to a consistent framework for accounting for all financial instruments.

Trading Securities: Recognize Investment Revenue

Dividend and Investment income are included in net income. For equity securites: debit cash and creidt investment revenue (dividends)

Securities to be Held to Maturity: Sell HTM Investments

A sale is recorded just like nay asset sale, with a gain or loss determined by comparing the cash received with the carrying value of the asset given up. Debit: cash and discount on bond investment Credit: investment in bonds and gain on sale of investments (to balance)

Securities Available-for-Sale: Adjust AFS Investments to Fair Value

AFS securities are adjusted to fair value at the end of each reporting period, which produces an unrealized holding gain or loss due to holding the securities while their fair values change. Fair value changes are not included in net income but instead are recorded as OCI. Account titles are Net unrealized holding gains and losses-OCI and Fair value adjustment

Securities Available-for-Sale: Purchase Investments

All investment securities are initially recorded at cost.

Securities to be Held to Maturity: Purchase of investment

All investment securities are initially recorded at cost. Debit Investment in Bonds (face amount); Credit Discount on bond investment (difference) and Cash (price paid for the bonds)

Trading Securities: Purchase Securities

All investment securities are initially recorded at cost. The journal entry to record the purchase of the bond investment is the same for HTM securities, and to record equity securities, there is only an exchange one asset for another.

A Single Entity Concept: Recording Investment Revenue

As the investee earns additional net assets, the investor's investment in those net assets increases. As the investee prospers, the invetor prospers proportionately. Debit Investment in stock and credit investment revenue (percentage of shares * investee net income)

Transfers between Reporting Categories

At acquisition, an investor assigns debt and equity securities to one of three reporting classifications. At each reporting date, the appropriateness of the classification is reassessed. When a security is reclassified between two reporting categories, the security is transferred at its fair value on the date of the transfer. Any unrealized holding gain or loss at reclassification should be accounted for in a manner hat is consistent with the classification into which the security is being transferred. A transfer of a security between reporting categories is accounted for at fair value and in accordance with the new reporting classification. A disclosure not should describe the circumstances that resulted in the transfer.

A Single Entity Concept: Receiveing Dividends

BEcause investment revenue is recognized as it is earned by the investee, it would be inappropriate to recognize revenue again when earnings are distributed as dividends. WE view the dividend distribution as a reduction of the investee's net assets. Debit Cash; credit investment in stock (% * dividends)

Securities to be Held to Maturity: Amortization Schedule

If a bond is purchased at a discount, less cash is received each period than the effective interest earned by the investor, so the unpaid difference increases the outstanding balance of the investment.

How the Equity Method Relates to Consolidated Financial Statements

If a company acquires more than 50% of the voting stock of another company, it's said to have a controlling interest. Both companies continue to operate as separate legal entities and he subsidiary reports separate financial statements, but the parent company reports consolidated financial statements. In consolidated financial statements, the acquired comapny's assets are included in the financial statements at their fair values as of the date of acquisition, rather than their book values on that date. If the acquisition price is more than the sum of the separate fair values of the acquired net assets, that difference is reported as goodwill. The equity method is in many ways a partial consolidation.

Adjustments for other assets and liabilities

If the fair value of purchased inventory exceeds its book value, we usually assume the inventory is sold in the next year and reduce investment revenue in the next year by the entire difference.

Financial Statement and Disclosure: Disclosure notes

Investors should disclose the following in the disclosure notes for each year presented: aggregate fair value, gross realized and unrealized hold gains/ losses, change in net unrealized holding gains and losses, and amortized cost basis by major security type. Extensive footnote disclosure is provided to help financial statement users assess the quality of fair value measurements and understand where they affect the financial statements.

Financial Statement and Disclosure:

It's not necessary that a company report individual amounts for the three categories of investments on the face of the balance sheet as long as that information is presented in the disclosure notes. On the statement of cash flows, inflows and outflows of cash from buying and selling trading securities are operating activities. But because HTM and AFS securities are not purchased and held principally to be sold in the near term, cash flows from the purchase, sale, and maturity of these securities are considered investing activities. If an investment that normally would be HTM or AFS is classified as trading security because the company elected the fair value option, cash flows may be classified as investing because they are viewed as non-operating in nature.

Reporting Trading Securities in Financial Statements

For ts, fair value changes affect net income in the period in which they occur. Trading securities are reported at fair value in the balance sheet. Cash flows from buying and selling ts are classified as operating activities.

Fair Value Option:

GAAP allows a fair value option with respect to investments that otherwise would be accounted for using the HTM of AFS approaches. Electing the fair value options for those investments requires that they are reclassified as trading securities and accounted for in that manner. Companies can choose the fair value option for "significant influence" investments that otherwise would be accounted for under the equity method. The company makes an irrevocable decision about whether to elect fair value option and can make the election for some investments but not others. These investments are shown on their own line in the balance sheet or combined with other equity method investments with the amount at fair value shown parenthetically. All of the disclosures that are required when reporting fair values as well as some of those that would be required under the equity method still must be provided.

Reporting Categories for Investments: The investor LACKS SIGNIFICANT INFLUENCE over the operating and financial policies of the investee. (Owns less than 20%)

1. Investments in debt securities for which the investor has the "positive intent and ability" to hold to maturity---> reporting method used is Held to Maturity (HTM). The investment is reported at amortized cost. 2. Investments held in an active trading account---> Reporting method used is Trading Securities (TS). The investment is reported at fair value (with unrealized holding gains and losses included in net income). 3. Other---> Reporting method used is Securities available for Sale (AFS). The investment is reported at fair value (with unrealized holding gains and losses excluded from net income and reported in other comprehensive income).

Four critical events that an investor experiences in the life of an investment

1. Purchasing the investment 2. Recognizing investment revenue (interest in the case of debt, dividends in the case of equity) 3. Holding the investment during periods in which the investment's fair value changes (and thus incurring unrealized holding gains and losses since the security has not yet been sold) 4. Selling the investment (and thus incurring realized gains and losses since the security has been sold and the gains or losses actually incurred)

Impairment of Investments: Other-than-temporary impairment loss

Fair value changes for HTM and AFS investments are not typically recognized in earnings. However, there is an exception; if the fair value of an HTM or AFS investment declines below the amortized coast of the investment, and that decline is deemed to be other-than-temporary, the company recognizes an OTT impairment loss in earnings. An OTT impairment loss is recognized in net income even though the security hasn't been sold. For equity investments, the question is whether the company has the intent and ability to hold the investment until fair value recovers. If it doesn't, then the company recognizes an OTT impairment loss in earnings and reduces the carrying value of the investment on the balance sheet by that amount. For Debt investments, the process is more complicated, both in determining whether an impairment is OTT and in determining the amount of the impairment to include in earnings. For both equity and debt investments, after OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

Transfer from Trading to either HTM or AFS

Include in current net income any unrealized gain or loss that occured in the current period prior to the transfer. (Unrealized gains and loses that occurred in prior periods already were included in net income in those periods).

Securities Available-for-Sale: Recognize Investment Revenue

Interest income and dividends on AFS investments are included in net income.

Securities Available-for-Sale: Adjust AFS Investments to fair value

New Changes in the fair value of investments held: the first purpose of the entry is to record in OCI any new unrealized gains or losses associated with investments that have not been sold. Reclassification Adjustment: The second purpose of the journal entry is to remove from OCI any amounts associated with sold investments. For AFS securities, unrealized gains and losses affect OCI and accumulate in AOCI until such time as the investment is sold. read pages 666 and 667 We don't separately record this reclassification. That happens automatically as part of the fair value adjustment entry at the end of the period. We report that reclassification in the statement of comprehensive income.

Transfer from AFS to HTM

No current income effect. Don't write off any existing unrealized holding gain or loss in AOCI, but amortize it to net income over the remaining life of the security (fair value amount becomes the security's amortized cost basis).

Transfer from HTM to AFS

No current income effect. Report total unrealized gain or loss as a separate component of shareholders' equity (in AOCI).

Trading Securities: Sell Trading Securities

Realized gain or loss for the difference between te carrying value and the cash received from selling a trading security is included in net income. When trading securities are sold, unrealized gains or losses that were recorded previously are removed from the fair value adjustment and net income at the end of the accounting period.

Securities to be Held to Maturity: Do Not Recognize Unrealized Holding Gains and Losses for HTM Investments

The fair value of HTM investments will be disclosed in a footnote, but no fair value changes will be recognized in the income statement or balance sheet.

Securities Available-for-Sale: Rationale for AFS Treatment of unrealized holding gains and losses

The big concern is that including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than it really is. Because AFS securities are likely to be held for multiple reporting periods, one could argue that there is sufficient time for unrealized holding gains in some periods to balance out with unrealized holding losses in other periods, so including unrealized holding gains and losses in income would confuse investores by making income appear more volatile than it really is in the long run.

A Single Entity Concept: Purcahse of Investment

The cost principal governs the acquisition of assets.

Securities to be Held to Maturity: Recognize Interest Revenue

The effective interest on debt is the market rate of interest multiplied by the outstanding balance of the debt. The journal entry is a debitto cash (face amount * stated rate) and discount on bond investment (difference); credit to investment revenue (market rate *outstanding balance).

Investor has significant influence:

The equity method can be used when an investor can't control but can significantly influence the investee.

A Single Entity Concept

The equity method views the investor and investee collectively as a special type of single entity. The investor's ownership interest in individual assets and liabilities of the investee is represented by a single investment account. The equity method is sometimes referred to as a "one line consolidation" because it essentially collapses the consolidation approach into single lines in the balance sheet and income statement, while having the same effect on total income and shareholders' equity. The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends. Initially the investment is recorded at cost. The carrying amount of this investment subsequently is increased by the investor's percentage share of the investee's net income (or decreased by its share of net loss), and decreased by dividends paid.

Securities Available-for-Sale: Sell AFS Investments

The receipt of cash is recorded, any accounts that are directly associated with the investment are removed from the balance sheet, and the difference is calculated to determine a realized gain or loss. Realized gain or loss for the difference between carrying value and the cash received from selling a trading security is included in net income. When AFS securities are sold, unrealized gains or losses that were recorded previously are removed from the fair value adjustment and OCI.

Adjustments for additional depreciation

The investor adjusts its share of the investee;s net income to reflect revenues and expenses associated with differences between the fair value and book value of the investee's assets and liabilities that existed at the time the investment was made.

Reporting Categories for Investments: The investor CONTROLS the investee.

The investor owns more than 50% of the investee. The Consolidation method is used; the financial statements of the investor and investee are combined as if they are a single company.

Trading Securities: Adjust Trading Securities to Fair Value

The journal entr to adjust to fair value serves two purposes. 1. It accounts for changes in te fair value of investments that have not been sold. 2. It removes from teh fair value adjustment and net income any unrealized holding gains or lsoses that were recognized in prior periods and that are associated with investments that now have been sold.

Securities to be Held to Maturity: The fair value of a bond changes when market interest rates change.

The market value of a fixed-rate investment moves in the opposite direction of market rates of interest. If market interest rates of interest rise after a fixed-rate security is purchased, the value of the fixed-interest payments declines. So, the fair value of the investment falls. Changes in market value are less relevant to an investor who will hold a security to its maturity regardless of those changes.

Decision Makers' Perspective

The way an investment is accounted for affects net income, investment book value, and the amount of gain or loss recognized in the future when the investment is sold. Managers may structure investments to include only the amount of equity that qualifies for their preferred accounting approach. If investments are not accounted for at fair value, their sale can be timed to recognize gains or losses in particular accounting periods. A concern with fair value accounting is that management has much discretion over fair values, and may not be able to estimate fair values accurately.

Significant Influence

Usually an investor can exercise significant influence over the investee when it owns between 20 and 50% of the investee's voting stock

Consolidated Financial Statements

combine the separate financial statements of the parent and the subsidiary each period in to t a single aggregate set of financial statements as if they were only one company.

Comparison of HTM, TS, and AFS Approaches

see page 669 Illustration 12-10 To record the purchase of an investment and the receipt of investment revenue, we use identical entries in all three approaches. TO record changes inf air value, the entries we use for TS and AFS securities have the same effect on the investment via the fair value adjustment valuation allowance and the same eventual effect on the shareholders' equity. What differs is whether the unrealized gain or loss is recognized in the income statement and then in retained earnings (TS) or recognized in OCI and then in AOCI (AFS). To record the sale of the security, we use identical entries in all three approaches. For TS and AFS securities, the fair value adjustment and unrealized holding gains and losses associated with sold securities are dealt with automatically as part of the next adjustment to fair value. Regardless of approach, the cash flows are the same, and the same total amount of gain or loss is recognized in the income statement. The question is not how much total net income is recognized but when that net income is recognized.

Accounting for Unrealized Holding Gains and Losses When the Investor Lacks Significant Influence: Trading (TS)

used for debt or equity that is held in an active trading account for immediate resale; unrealized holding gains and losses are recognized in net income and therefore in retained earnings as part of shareholders' equity; investment reported in the balance sheet at fair value.

Accounting for Unrealized Holding Gains and Losses When the Investor Lacks Significant Influence: Held To Maturity (HTM)

used for debt that is planned to be held for its entire life; unrealized holding gains and losses are not recognized; investment reported in the balance sheet at amortized cost.