Investments (Part 1)

No Significant Influence

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Identify the three possible levels of influence over an investee for accounting purposes.

1. Not significant; 2. Significant influence, but not control; and 3. Control.

Debt Securities

3. Includes - bonds, notes, convertible bonds/notes, redeemable preferred stock. 4. Excludes - common/preferred stock, stock warrants/options/rights, futures/forward contracts.

Investment in Debt Securities

3. The first criterion for a debt security to be classified as Held-to-Maturity (HTM) is that the investor must have the positive ability and intent to hold the security to maturity. By definition only debt securities can be classified as HTM because equity securities do not mature. a. The ability to hold debt to maturity may be evident in prior investments in debt securities and the investor has demonstrated that they hold the security for its entire life. b. The intent to hold the debt to maturity may be evident by demonstrating that the investor does not need the cash associated with this investment. In other words, the investor has sufficient operating cash flows so there is no need to liquidate the investment in order to have enough cash flow for operating activities.

Investment in Debt Securities

4. If the debt security is publicly traded, the investor has the option to account for the debt security at amortized cost or fair value. a. If the investor intends to hold the debt security to maturity and wants to classify the security as held-to-maturity, the debt security must be valued at amortized cost. b. If the debt is classified as HTM, it will be classified as a noncurrent investment until the year the security matures. At that time, the investment will be classified as current. c. If the investor selects the fair value option and records the security at fair market value, the security will be classified as trading or available-for-sale and presented as current or noncurrent depending on how long management intends to hold the debt.

What is the required accounting treatment when an investor has control of an investee?

Treat as a subsidiary and consolidate investee with investor (consolidated statements).

List the criteria for held-for-trading securities.

1. Applies to investments in Debt and Equity; 2. Investor buys for the purpose of selling in the near term.

Equity Securities

1. Includes - common stock, preferred stock (except redeemable), stock warrants, call options/rights, put options. 2. Excludes - debt securities (even convertible debt), redeemable preferred stock, and treasury stock.

Available-for-Sale Investments -- Accounting and Reporting for this Available-for-Sale classification

Accounting and Reporting for this Available-for-Sale classification -- 1. Record Investment at cost a. Cost includes: i. Purchase price (e.g., per security cost); ii. Directly related costs incurred -- brokerage fee, transfer fee, etc.

Trading Investments -- Accounting and Reporting for this Held-for-Trading classification

Accounting and Reporting for this Held-for-Trading classification -- 1. Record Investment at cost. a. Cost includes: i. Purchase price (e.g., per security cost); ii. Directly related costs incurred - brokerage fee, transfer fee, etc.

How is interest earned on held-to-maturity investments reported in the income statement?

As an Other Income item in the income statement.

How are available-for-sale investments reported in the balance sheet?

At fair value (i.e., original cost +/- allowance to adjust to fair value) as either current or non-current asset (based on entity's policy).

Disposition (Sale) of Available-for-Sale Investments:

Disposition (Sale) of Available-for-Sale Investments: a. If Debt Security, first recognize interest income and amortization of Premium/Discount to date of sale. b. Determine carrying value of investment to be sold: i. For Debt and Equity Securities = Fair Value c. Recognize (Realized) Gain or Loss at date of Sale, if any, as difference between sales price and carrying value of investments sold. d. Any related unrealized (holding) gain or loss on securities sold that is in Accumulated Other Comprehensive Income at the date of sale is recognized in income.

If the investor has < 20% ownership

If the investor has < 20% ownership, there is nominal influence over the operating, investing and financing activities of the investee. 1. If the investee is publicly traded, where there is a readily determinable market value for the investee, then the investment is classified as trading or available-for-sale. (These investments are discussed in the lesson "No Significant Influence.") 2. If the investee is not publicly traded, and there is not a readily determinable market value, then the investment is classified as a cost method investment. (The accounting for this type of investment is included in the lessons on "Equity Method.") 3. The balance sheet presentation of current or noncurrent depends on management's intent for holding the security for the short term (typically the trading securities) or long term. AFS securities could be short or long-term.

Where are held-to-maturity investments reported on the statement of cash flows?

Investing Activity.

Investment in Debt Securities

Investment in Debt Securities -- 1. The accounting and reporting of an investment in debt securities depends on: a. How long it is held; b. Whether the debt security is private or public. Debt ownership does not provide any voting rights; therefore, there is no economic influence from debt ownership. The critical criteria for accounting for debt investments are whether the company has the positive ability and intent to hold the debt security to maturity.

List the guidelines for determining no significant influence in an investment.

Investment is: 1. in Debt securities; 2. in Non-voting stock; 3. Temporary in nature; 4. Less than 20% ownership of voting stock.

Available-For-Sale [Mark-to-Market] How Realized Gains and Losses are Reported on the Income Statement

Realized gains and losses are recognized (gain or loss will be difference between selling price and carrying value less any permanent decline in value recognized). Dividends are income.

Held-to-Maturity [No market revaluation] How Realized Gains and Losses are Reported on the Income Statement

Realized gains and losses are recognized in accordance with amortized cost method. No dividends on debt.

What is the basis for general guidelines for determining the level of influence over an investee?

The nature and extent of ownership.

Trading Investments - Overview

This classification includes both debt and equity securities. All investments in this classification must be adjusted to fair value at the balance sheet date. The process for making that adjustment, as well as the required financial statement presentation and accounting for disposal (sale) of Held-for-Trading investments, are also presented.

Available-For-Sale [Mark-to-Market] How Unrealized Holding Gains and Losses are Recorded

Unrealized gains and losses are excluded from earnings - reported as OCI--unless the decline is considered to be "other than temporary" then--recognized in earnings

Accounting and Reporting for this Available-for-Sale classification

Financial Statement Presentation: i. Unrealized Holding Gain/Loss: (1). Report as an item of Comprehensive Income, which is (2). Included in Accumulated Other Comprehensive Income in Shareholders' Equity section of Balance Sheet, net of tax effects. ii. Available-for-Sale Allowance to Balance Sheet as adjustment to carrying value of Investment: Available-for-Sale Investments $200,000 Plus: Allowance to Increase to Fair Value 20,000 Available-for-Sale Investments at Fair Value $220,000 iii. Available-for-Sale Investments in Balance Sheet as Current and/or Noncurrent Asset. Available-for-Sale Investments generally will be classified as noncurrent assets, but those investments within one year (or operating cycle) of disposal will be classified as current assets. iv. Available-for-Sale Investments in Statement of Cash Flows as Investing Activity.

Held-to-Maturity Investments -- Criteria for this classification

Criteria for this classification -- 1. Applies only to investments in Debt securities because only debt has a maturity. 2. Applies when investor has: a. Positive intent to hold the securities to maturity; and b. Ability to hold the securities to maturity. 3. Held-to-Maturity classification is not appropriate if investor may sell due to need for cash or better investment opportunities, or if the debt can be settled (e.g., prepaid) and the investor would not recover all of the recorded investment. 4. Sale of Debt securities before maturity, that meet the following conditions, can be considered held-to-maturity: a. Sale is near enough to maturity date so that interest rate risk is substantially eliminated as a factor in pricing; b. Sale occurs after investor has collected (through periodic payments or prepayment) a substantial portion (at least 85%) of the principal outstanding at acquisition date.

Available-for-Sale Investments -- Criteria for this classification

Criteria for this classification -- 1. Applies to investments in both Debt and Equity securities. 2. Includes all investments in Debt and (qualified) Equity securities not classified as Held-to-Maturity or Trading Investments.

Trading Investments -- Criteria for this classification

Criteria for this classification -- 1. Applies to investments in both Debt and Equity securities; 2. Investor buys and holds for the purpose of selling in the "near term," generally with the objective of generating profits on short-term price changes.

Debt Securities

Debt Securities : Securities representing the right of buyer/holder (Creditor) to receive from the issuer (Debtor) a principal amount at a specified future date and (generally) to receive interest as payment for providing use of funds.

Trading [Mark-to-Market]

Debt and Equity securities bought and held principally for the purpose of selling them in the near term

Available-For-Sale [Mark-to-Market]

Debt and Equity securities not classified as trading or held-to-maturity

Held-to-Maturity [No market revaluation]

Debt securities that the organization has the positive intent and ability to hold to the maturity date

Recognized

1. A recognized gain/loss occurs when a gain or loss related to an investment (or other item) is recorded (recognized) in the financial statements, whether or not the investment has been sold. For example, a gain or loss would be recognized if the change in market value of investment securities is reported in the financial statements before the securities are sold. Note: Recognition is an accounting concept - it means that we have recognized the item on the financial statements.

List the criteria for a held-to-maturity classification.

1. Debt security; 2. Investor has intent to hold to maturity; 3. Investor has ability to hold to maturity.

What amounts should be included in the initial recording of a held-for-trading investment?

1. Purchase price of security; 2. Directly related cost of acquisition, e.g., brokerage fee, transfer fee, etc.

What amounts should be included in the initial recording of a held-to-maturity investment?

1. Purchase price of security; 2. Directly related cost of acquisition, e.g., brokerage fee, transfer fee, etc.; 3. Accrued interest, if any, is not included in the cost of the investment.

How are available-for-sale investments accounted for and reported in financial statements?

1. Recognize interest income (one debt securities)/dividends (on equity securities); 2. Amortize discount or premium, if any, on debt securities; 3. Adjust investment to fair value at balance sheet date with any gain/loss reported as an item of other comprehensive income.

Under what conditions can a debt security sold before maturity be considered held to maturity?

1. Sale is near enough to maturity date so that interest rate risk is substantially eliminated; 2. Sale occurs after investor has collected a substantial portion (at least 85%) of the principal outstanding at acquisition date.

List the investor's considerations in selecting the correct accounting for an investment.

1. The nature of the investment; 2. The extent of the investment; 3. Management's intent.

Disposition (Sale) of Trading Investments

Disposition (Sale) of Trading Investments: 1. If Debt Security, first recognize Interest Income and Amortization of Premium/Discount to date of sale; 2. Determining carrying value of investments to be sold: a. For Debt and Equity Securities = Fair Value 3. Recognize (realized) gain or loss at date of sale, if any, as difference between sales price and carrying value of investments sold.

Investment in Debt Securities

5. If the debt security is privately issued, the investor will usually account for the debt security at amortized cost. a. If the investor intends to hold the debt security to maturity and wants to classify the security as held-to-maturity, the debt security must be valued at amortized cost. b. If the debt is classified as HTM, it will be classified as a noncurrent investment until the year the security matures. At that time, the investment will be classified as current. c. If the investor classifies the debt investment as trading or available-for-sale, the debt should be valued at fair value. This classification will be unlikely because it will be difficult to get a quoted price representing the fair value of private debt (Level 1 valuation). However, it is possible to use this classification; the investor would have to value the private debt using a valuation model and, depending on the extent that the inputs are observable, the debt valuation would be Level 2 or 3.

Realized

A realized gain/loss occurs when an investment (or other item) is sold (or otherwise disposed of). The difference between the cash or other consideration received and the carrying value of the investment is a realized gain or loss. Note: Realization is an economic concept - it means that there is a culmination of the earnings process and cash or other consideration is given or received.

Held-to-Maturity Investments -- Accounting and Reporting for this Held-to-Maturity classification

Accounting and Reporting for this Held-to-Maturity classification -- 1. Record Investment at cost: a. Cost includes: i. Purchase price (e.g., per security cost); ii. Directly related costs incurred - brokerage fee, transfer fee, etc. 2. Carry and Report Held-to-Maturity Investments at Amortized Cost: a. Recognize periodic interest income DR: Cash CR:Interest Income Interest Receivable (accrued interest collected on first interest date, if any) b. Fair Value Option: Normally, temporary changes in the fair value of investments held-to-maturity should not be recognized; however, GAAP permits an investor to elect the fair value option for most financial assets, including debt investments which the investor intends to hold to maturity. c. Report Held-to-Maturity investment in Financial Statements: i. Interest Income or Revenue (including increase/decrease from amortization of discount or premium) ii. Investment Held-to-Maturity (probably net of premium or discount) in Balance Sheet as: (1). Current - if maturity is within one year (or operating cycle) of maturity; (2). Noncurrent - if maturity is not within one year (or operating cycle) of maturity. iii. Investment Held-to-Maturity in Statement of Cash Flows is an Investing Activity.

Securities - Accounted for under the Cost Method

An Equity investment where there is no significant influence and it is a security with no readily determinable market value (privately held)

Securities - Accounted for under the Equity Method

An Equity investment whereby the investor has significant influence over investee--generally >20% voting shares.

What investments are classified as available-for-sale?

Any debt or equity investments not classified as either Held-to-Maturity or Held-for-Trading. The Available-for-Sale category is the default category if an investment in debt or equity does not meet the requirements of either Held-to-Maturity or Held-for-Trading.

Assess Available-for-Sale Investments for Impairment

Assess Available-for-Sale Investments for Impairment. i. The individual securities classified as available for sale are assessed for impairment to determine if a decline in fair value below the amortized cost basis (debt) or cost (equity) is other than temporary using a two-step process: (1). Determine if the fair value of an investment is less than its (amortized) cost; if so, the investment is impaired. (2). Determine if the impairment is other than temporary. ii. If the investment is impaired and the impairment is other than temporary, an impairment loss equal to the difference between the investment's (amortized) cost and its fair value is recognized in current income as a realized loss. (1). The fair value becomes the new (amortized) cost basis of the investment. (2). Subsequent recoveries in fair value would not be recognized.

At what cost are held-to-maturity securities carried and reported?

At amortized cost.

Securities - Accounted for under the Cost Method -- How is security reported on the Balance Sheet

At cost. Cost basis is reduced if there is a liquidating dividend where the dividends declared exceed the investee's profits. Dividends and profits are measured from the date the investee was purchased.

How are held-for-trading investments carried and reported?

At fair value, with changes in fair value reported in current income.

Available-for-Sale Investments -- Carry and Report Securities Available-for-Sale at Fair Value

Carry and Report Securities Available-for-Sale at Fair Value: a. For Debt Securities: i. Recognize periodic interest income. ii. Recognize periodic amortization of Premium or Discount. b. For Equity Securities i. Recognize Dividends received as Dividend Income. c. For both Debt and Equity Securities adjust to Fair Value at Balance Sheet date: i. Determine Fair Value of Available-for-Sale Investments (of this classification) at balance sheet date (only). ii. Determine carrying Value of Available-for-Sale Investments (of this classification) at balance sheet date. iii. Adjusting Available-for-Sale Investments to Fair Value (1). If Fair Value > Carrying Value: (a). Recognize (Unrealized) Holding Gain. (b). Gain is recording in Other Comprehensive Income. (2). If Fair Value < Carrying Value: (a). Recognize (Unrealized) Holding Loss. (b). Loss is recognized in Other Comprehensive Income.

Trading Investments -- Carry and Report Trading Securities at Fair Value

Carry and Report Trading Securities at Fair Value a. For Debt Securities: i. Recognize periodic interest income. b. For Equity Securities: i. Recognize Dividends received as income. c. For Both Debt and Equity Securities, adjust to Fair Value at Balance Sheet date.

What method is used to amortize a premium or discount on a security?

Effective interest method or straight-line method if not materially different.

Equity Method of accounting

Equity method in accounting is the process of treating equity investments, in associate companies. The investor keeps such equities as an asset. The investor's proportional share of the associate company's net income increases the investment (and a net loss decreases the investment), and proportional payment of dividends decreases it. In the investor's income statement, the proportional share of the investee's net income or net loss is reported as a single-line item. Equity accounting is usually applied where the entity holds 20-50% of voting stock, since this implies significant influence on the decisions of the associate by the holding company. Equity accounting may also be appropriate where the holding falls outside this range and may be inappropriate for some entities within this range depending on the nature of the actual relationship between the investor and investee. The ownership of more than 50% of voting stock creates a subsidiary. Its financial statements consolidate into the parent's. The ownership of less than 20% creates an investment position carried at historic book or fair market value (if available for sale or held for trading) in the investor's balance sheet.

If the investor has >50% ownership of an investment

If the investor has >50% ownership of an investment, then the investor controls the investee. An investment of this magnitude creates a Parent / Subsidiary relationship. 1. The default accounting for an investment with >50% ownership is equity method. The Parent company will record its equity investment in the Subsidiary on the Parent company's books. Equity method accounting is discussed more fully in the lessons "Equity Method." 2. In some instances the Parent company can choose to use the cost method to account for its subsidiary. Cost method accounting is discussed more fully in the "Equity Method" lesson. The cost method can be used by the Parent company because the Parent's stand alone financial statements are (typically) not issued on a standalone basis. The Parent must consolidate, and therefore eliminate the investment in the Subsidiary. 3. For financial statement presentation, the Parent must consolidate the Subsidiary and report consolidated financial statements of Parent + Subsidiary. Whether the Parent uses the equity method or the cost method to account for its subsidiary, the consolidated financial statements will be the same. The only difference is what is reported on the Parent's stand alone statements. Not that the Parent's stand alone statements are not in compliance with GAAP - GAAP requires that the Parent present consolidated statements. Consolidation is discussed more fully in the series of lessons on "Consolidations."

If the investor has between 20% to 50% ownership

If the investor has between 20% and 50% ownership, then the investor can significantly influence the operating, investing and financing activities of the investee. Therefore, the investment is accounted for using the Equity Method of accounting. 1. The default accounting for an investment with significant influences is equity method. A detailed discussion of equity method accounting is presented in subsequent lessons. 2. If the investee is publicly traded and there is a readily determinable market value, then the investor has the option to value this investment at fair value. If this option is chosen then the investment is marked-to-market value with the unrealized gains and losses recorded in earnings. Once the investor chooses the fair value option it is irrevocable and the investment continues to be recorded at fair value. 3. Investments with significant influence are usually reported as a noncurrent asset because buying and selling equity shares of this magnitude is relatively difficult to do. For example, if you owned 40% of a publicly traded company, it would be very difficult for you to sell that much stock in one block without severely diluting the selling price.

Where are unrealized holding gains and losses on investments held-for-trading reported?

In income (Income Statement) as part of Income from Continuing Operations.

Securities - Accounted for under the Cost Method -- How Realized Gains and Losses are Reported on the Income Statement

Realized gains and losses are recognized (gain or loss will be difference between selling price and carrying value less any permanent decline in value recognized). Dividends are income. WATCH for liquidating dividends!

Securities - Accounted for under the Equity Method -- How Realized Gains and Losses are Reported on the Income Statement

Realized gains and losses from transactions are recognized for the difference between selling price and the equity basis of the stock. Dividends are NOT income.

Held-to-Maturity [No market revaluation] How is security reported on the Balance Sheet

Reported at amortized cost and grouped with noncurrent assets on the balance sheet

Available-For-Sale [Mark-to-Market] How is security reported on the Balance Sheet

Reported at fair market value, and may be classified as current or noncurrent

Trading [Mark-to-Market] How is security reported on the Balance Sheet

Reported at fair market value, usually a current assets on the balance sheet

Securities - Accounted for under the Equity Method -- How is security reported on the Balance Sheet

Reported in accordance with the Equity Method - if control >50% must consolidate

Equity Securities

Securities representing ownership interest or right to acquire or dispose of ownership interest.

Define "equity securities."

Securities representing ownership or right to acquire ownership interest.

Define "debt securities."

Securities representing the right of the Creditor to receive from the Debtor a principal amount at a specified future date and to receive interest as payment for providing use of funds.

Investment in Equity Securities

The accounting and reporting of an investment in equity securities depends on: 1. How much is owned; 2. How long it is held; 3. Whether the equity security is private or public. Since equity ownership provides voting rights, the level of economic influence is determined by the level of stock ownership. This level of influence is a guide line because there may be other factors that contribute to the investor's ability to exercise significant influence or control.

What amounts are included in a gain or loss recognized on the sale of an available-for-sale investment?

The gain or loss recognized on the sale of an available-for-sale investment includes: 1. The difference between the carrying value of the investment and its selling price; and 2. Any unrealized gain or loss in Accumulated Other Comprehensive Income related to the securities sold.

Securities - Accounted for under the Cost Method -- How Unrealized Holding Gains and Losses are Recorded

There are no unrealized gains and losses because the cost method is not marked-to-market.

Securities - Accounted for under the Equity Method -- How Unrealized Holding Gains and Losses are Recorded

These securities are not adjusted for changes in market value unless the decline is considered to be "other-than-temporary" or the Fair Value Option is selected

Available-for-Sale Investments - Overview

This classification includes all investments in debt and equity securities that are not classified as Held-to-Maturity or Trading, such as, for example, an equity security that the investor intends to hold indefinitely. This section presents the criteria necessary to be classified as Available-for-Sale and the accounting and financial statement reporting for such investments. Like the prior Trading classification, this classification includes both debt and equity securities. Therefore, the details related to both types of securities are not repeated here. The major difference between this lesson and the prior Trading section is that an unrealized holding gain or loss on an investment Available-for-Sale does not go on the income statement, but enters in the determination of Other Comprehensive Income, and subsequently shows up as (part of) Accumulated Other Comprehensive Income in Shareholders' Equity on the Balance Sheet.

Held-to-Maturity Investments

This classification includes only investments in debt securities that the investor intends to hold until the investment matures and has the ability to do so. This lesson presents the criteria necessary to be classified as Held-to-Maturity and the accounting and financial statement reporting for such investments. Coverage includes recognition of a premium or discount at the time of investment, the amortization of a premium or discount, financial statement presentation, and disposition of Held-to-Maturity investments.

Held-to-Maturity [No market revaluation] How Unrealized Holding Gains and Losses are Recorded

Unrealized gains and losses are excluded from earnings--unless the decline is considered to be "other-than-temporary" or the Fair Value Option is selected

Trading [Mark-to-Market] How Unrealized Holding Gains and Losses are Recorded

Unrealized gains and losses are included in earnings in the period they occur

Trading [Mark-to-Market] How Realized Gains and Losses are Reported on the Income Statement]

Unrealized holding gains or losses will already have been recognized, and should not be reversed. Dividends are income.