Accounting Appendix A

trading securities (TS)

- actively traded securities - objective of generating profits on short-term changes in the price of the securities - classified as current assets

a company may invest in the securities of another company in order to:

- earn a return on idle cash (aka a passive) - influence the other company's policies and activities - control the other company's future

available-for-sale securities (AFS)

- excludes debt securities held to maturity - objective of earning a return on funds that may be needed for future operating purposes - classified as current or non-current assets, depending on whether management intends to sell the securities

to measure fair value, the standard recognizes 3 approaches in order of decreasing reliability:

- level 1: quoted prices in active markets for identical assets - level 2: estimates based on other observable inputs (ex: prices for similar assets) - level 3: estimates based on unobservable estimates (the company's own estimates of factors that market participants would consider)

investments in debt securities held to maturity: amortized cost method

- record at cost on acquisition date (minus premium or plus discount) - record interest received and appropriate interest revenue - record principal received at maturity

reporting investments under the equity method

- reported on the balance sheet as a long-term asset, originally at cost - account is increased by the cost of shares that were purchased and the proportional share of affiliate's income - account is decreased by proportional share of affiliate's losses and the cost of shares that were sold and by dividends received from affiliate - no adjustment to fair value at the end of the accounting period - if sold, any gain or loss is reported in the income statement as other income net income of affiliates: if affiliates report positive results of operations for the year, the investor then records investment income equal to its percentage share of the affiliates' net income and increases its asset account Investments in Affiliates (or Associated Companies). If the affiliates report net losses, the investor records the opposite effect dividends paid by affiliates: if the affiliates declare and pay dividends during the year (a financing decision), the investor reduces its investment account and increases cash when it receives its share of the dividends

when performing a purchase price allocation, it is important to remember two points:

- the book values on the acquired company's balance sheet are irrelevant unless they represent fair value - goodwill is reported only if it is acquired in a merger or acquisition transaction

investments in equity securities earn a return from 2 sources:

1.) divided income 2.) price increases - dividends earned are reported as investment income on the income statement and are included in the computation of net income for the period

trading securities

all investments in stocks or bonds that are held primarily for the purpose of active trading (buying and selling) in the near future (classified as short term)

available-for-sale securities

all passive investments other than trading securities and debt held to maturity (classified as either short term or long term)

investments in debt securities are:

always considered passive investments - if the company intends to hold the securities until they reach maturity, the investments are measured and reported at amortized cost - if they are to be sold before maturity, they are reported using the fair value method

unrealized holding gains (losses)

amounts associated with price changes of securities that are currently held and are recorded whenever the fair value of investments changes

on the date of a purchase, a bond may be acquired:

at the maturity amount (at par), for less than the maturity amount (at a discount), or for more than the maturity amount (at a premium) - the total cost of the bond, including all incidental acquisition costs such as transfer fees and broker commissions, is debited to the Held-to-Maturity Investments account

Comparing Trading and Available-forSale Securities

available-for-sale securities: - the balance in net unrealized holding gains and losses is reported as a separate component of stockholders' equity under Accumulated Other Comprehensive Income - it is not reported on the income statement and does not affect net income - at the time of sale, the difference between the proceeds from the sale and the original cost of the investment is recorded as a gain or loss on sale of available-for-sale securities - at the same time, the Investments in AFS Securities and Net Unrealized Gains (Losses) accounts are eliminated trading securities portfolio: - the amount of the adjustment to record net unrealized holding gains and losses is included on each period's income statement - net holding gains increase and net holding losses decrease net income - the amount recorded as net unrealized gains and losses on trading securities is closed to Retained Earnings at the end of the period cash and investments in TS are the only accounts affected on the balance sheet - the difference between the cash proceeds from the sale and the book value (not cost) of the Investments in TS is recorded as a gain or loss on sale of trading securities

what are consolidated statements?

consolidated statements combine two or more companies into a single set of statements - the acquiring company is the parent; the parent company is the company that gains control over the other company - the company acquired is the subsidiary; the subsidiary company is the company that the parent acquires

trading securities are classified as _______________ ____________ on the balance sheet

current assets

available-for-sale securities are classified as ______________ or _________________ ___________ on the balance sheet depending on whether management intends to sell the securities during the next year

current; non-current assets

passive investments are made to:

earn a return on funds that may be needed for future purposes - this category includes both investments in debt (bonds and notes) and equity securities (stock)

if between 20 and 50 percent of the outstanding voting shares are owned, significant influence over the affiliate firm's operating and financing policies is presumed, and the ____________ ____________ is applied.

equity method Under the equity method, the investor records the investment at cost on the acquisition date. Each period thereafter, the investment amount is increased (or decreased) by the proportionate interest in the income (or loss) reported by the affiliate corporation and decreased by the proportionate share of the dividends declared by the affiliate corporation.

an investor may want to exert influence (presumed by owning 20 to 50 percent of the outstanding voting stock) without becoming the controlling shareholder (presumed when owning more than 50 percent of the voting stock):

ex: - a retailer may want to influence a manufacturer to be sure that it can obtain certain products designed to its specifications - a manufacturer may want to influence a computer consulting firm to ensure that it can incorporate the consulting firm's cutting-edge technology in its manufacturing process - a manufacturer may recognize that a parts supplier lacks experienced management and could prosper with additional managerial support

all investment in equity securities, regardless of whether they are classified as current or non-current, trading or available-for-sale, should be measured at ________ _________ with subsequent adjustments recognized in net income

fair value

debt securities should be classified as __________________________ investments if management has the intent and the ability to hold them until maturity

held-to-maturity - these investments in debt instruments are listed at cost adjusted for the amortization of any discount or premium (amortized cost method), not at their fair value

Dividends are not revenue under the equity method. They are treated as a reduction of the _________________ account

investment

investments in stock for significant influence

investments are made with the intent of exerting significant influence over another corporation, and take an active role i.e. investments of 20% or greater up to 50% - significant influence is the ability to have an important impact on the operating, investing, and financial policies of another company

investments in stock for control

investments are made with the intent to exert control over another corporation, i.e. over 50% ownership - control is the ability to determine the operating and financial policies of another corporation - the purpose of investments in stock for control is to achieve vertical integration, horizontal growth, or operational synergy

held-to-maturity investments

investments in debt securities that management has the ability and intent to hold until maturity

investments in affiliates (or associated companies)

investments in stock held for the purpose of influencing the operating and financing strategies of the entity for the long term

the fair value of an asset is the amount that would be received in an orderly sale. to measure fair value, accounting standards recognize the following 3 approaches in order of decreasing reliability:

level 1: quoted prices in active markets for identical assets level 2: estimates based on other observable inputs (ex: prices for similar assets) level 3: estimates based on unobservable estimates (the company's own estimates of factors that market participants would consider)

merger

occurs when one company purchases all of the net assets of another and the acquired company goes out of existence

a merger is when:

one company purchases all of the net assets of another and the acquired company goes out of existence - the acquiring company treats the acquired assets and liabilities in the same manner as if they had been acquired individually - the assets and the liabilities are recorded at fair value on the date of the merger. goodwill, if any, is computed and reported

a consolidation is when:

one company purchases more than 50 percent of the stock of another company - the acquired and acquiring companies continue separate legal existences - consolidated financial statements are prepared - if 100 % of the stock is purchased, the consolidated financial statements look the same as if the companies had been combined into one in a merger

when a company invests cash in securities that are reported on its balance sheet as Investments in Available-for-Sale Securities, it is a ________________ investor

passive however, when the company reports Investments in Affiliates on its balance sheet, it is taking a more active role as an investor

investments in equity securities are:

presumed passive if the investing company owns less than 20 percent of the outstanding voting shares

acquisition method

records assets and liabilities acquired in a merger or acquisition at their fair value on the transaction date - the only method allowed by U.S. GAAP and IFRS for recording a merger or acquisition - requires that the assets and liabilities be recorded on a company's books at their fair value on the date of the merger, so the acquiring company must go through a two-step process, often called the purchase price allocation, to determine how to record the acquisition: 1.) estimate the fair value of the acquired company's tangible assets, identifiable intangible assets, and liabilities 2.) compute goodwill, the excess of the total purchase price over the fair value of the assets minus the liabilities listed in Step 1

passive investments are reported at fair value because of:

relevance and measurability - there are two ways depending on whether they are: - held for sale (available for sale) - held for trade (trading security)

amortized cost method

reports investments in debt securities held to maturity at cost minus any premium or plus any discount

fair value method

reports securities a their current market value (the amount that would be received in an orderly sale)

On January 5th, Graham Holdings acquires for cash 15,000 of the 100,000 outstanding shares of INews at a cost of $10 per share. Graham Holdings has no influence over INews and does not plan to sell the shares in the near future.

should the acquired shares be classified as trading securities or available-for-sale securities? - Graham Holdings does not plan to actively trade the shares. Instead, they will be held to earn a return on invested funds that may be needed for future operations. The shares should be classified as available-for-sale securities.

goodwill:

the amount by which the purchase price exceeds the fair market value of the nets assets acquired - occurs when one company buys another company - only reported as an intangible asset if acquired in a merger or acquisition

goodwill

the excess of the purchase price of a business over the fair value of the acquired business's assets and liabilities

in the case of Graham Holding's unrealizable net gain,

the net unrealized gain balance is reported in the stockholders' equity section of the balance sheet as Accumulated Other Comprehensive Income as a credit balance

in the case of Graham Holding's unrealizable net loss,

the net unrealized loss balance is reported in the stockholders' equity section of the balance sheet as Accumulated Other Comprehensive Income as a debit

the accounting method needed for an investment depends on:

the type of security and the level of ownership

when the investment account is adjusted to reflect changes in fair value, what other account is affected when the asset account is increased or decreased?

unrealized holding gains (losses)

equity method

used when an investor can exert significant influence over an affiliate; the method permits recording the investor's share of the affiliate's income

reasons for acquiring control of another corporation:

vertical integration - a company acquires another at a different level in the channels of distribution horizontal growth - involves companies at the same level in the channels of distribution synergy - the operations of two companies together may be more profitable than the combined profitability of the companies as separate entities