CH 12: Investments
Amortized Cost equals
(Face amount less unamortized discount, or plus unamortized premium)
FVTNI Securities
(fair value through net income) are investments in equity securities for which the investor lacks significant influence
Classification of Investment Securities
-Debt Securities -Equity Securities
When the investor lacks significant influence over the investee, the investment is classified in one of three categories:
-Held to maturity securities (debt) -Trading securities (debt) or FVTNI (equity) -Available for sale securities (debt) *each type of investment has its own reporting method. however, regardless of the investment type, investors can elect the "fair value option"
Securities classified as "Available for sale"
-Investments in debt securities only that are not for active trading and not to held to maturity are classified as available for sale (AFS)
Securities classified as "trading" (debt) or FVTNI (equity) - presentation on the cash flow statement
-cash flows from buying and selling these securities are classified as operating or investing based on the nature and purpose for which the securities were acquired -it may be classified as investing activities if they are not held for sale in the near term
Securities classified as "trading" (debt) or FVTNI (equity) - Presentation on the income statement and statement of comprehensive income
-fair value changes are included in the income statement in the periods in which they occur -these investments do not affect other comprehensive income
Impairment of Debt Investments for AFS debt investments
-if company plans to sell the investment before fair value recovers, they will recognize in net income an amount of impairment loss equal to the entire difference between amortized cost and fair value -If they do not think the investment will be sold before fair value recovers, only credit loss will be recognized in net income and noncredit loss will be recognized in OCI
HTM Discount and Premium
-if the bonds pay interest at a rate that is lower than the market requires, they will trade at a discount -if the bonds pay interest at a rate that is higher than the market requires, they will trade at a premium -Discounts and premiums are amortized to interest revenue
Securities Classified as "Held-to-Maturity"
-only a debt security can have this classification because unlike a share of stock, debt has a maturity date -if the investor has the "positive intent and ability" to hold debt securities to their scheduled maturity date -HTM securities are initially recorded at cost (premium or discount) -after their purchase, the bonds are carried on the balance sheet at amortized cost, and not adjusted for changes in the fair value of the securities
Securities classified "available for sale" - Presentation on the 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 the periods in which securities are sold
Different motivations for investing:
-to earn a return on temporarily idle cash -to secure certain operating or financing arrangements with another company
Transfer Between reporting categories
-when debt security is purchased, investor assigns it to one of the three reporting classifications - HTM, TS, or AFS; at each reporting date, the appropriateness of the classification is reassessed
Changing from another method to the equity method
-when the investor's ownership level increases to the point where they can exert significant influence, the investor should change to the equity method -the previous method is discounted and the balance in the investment account at the date of change is used as the starting balance for applying equity method and the investor adds the cost of acquiring the additional interest in the investee to the current basis of the investor's previously held interest -a disclosure not describing the change is required
3 Categories for Debt Securities
1. Held-to-Maturity 2. Trading 3. Available-for-Sale
3 Categories for Equity Securities
1. No influence (below 20% holding) - FVTNI (trading) 2. Significant Influence (between 20% and 50% holding) - Equity Method 3. Controlling Interest (above 50% holding) - Consolidation Method
How can significant influence be overcome?
1. The investee challenges the investor's ability to exercise significant influence through litigation or other methods 2. the investor surrenders significant shareholder rights in a signed agreement 3. the investor is unable to acquire sufficient information about the investee to apply the equity method 4. the investor tries and fails to obtain representation on the board of directors of the investee
Under the fair value option:
1. the investment is carried at fair value and 2. unrealized gains and losses are included in income 3. for HTM and AFS investments, the investment is classified on the balance sheet as trading 4. for equity method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated
Fair value option
GAAP allows companies to choose a "fair value option" for HTM, AFS, and equity method investments -the fair value option election is made for each individual security and is irrevocable
However, unlike trading securities, for AFS security, unrealized gains and losses that result from change in fair values are...
NOT included in net income (rather they are included in other comprehensive income (OCI) and accumulated and reported as a separate component of shareholders' equity called accumulated other comprehensive income (AOCI)
Under the equity method when the cost of investment exceeds the book value of the underlying net assets acquired...
additional adjustments to both the investment account and investment revenue might be needed: -Excess of price paid for the investment over the proportionate share of the book value is allocated to: 1. identifiable tangible and intangible assets that are depreciated/amortized over their respective useful lives; investment income is reduced by this additional expense 2. any additional excess is treated as goodwill which is not amortized
Remember that under the equity method we do NOT
adjust the investment to its fair market value each year as we do for trading and available for sale securities
Credit Losses are due to..
anticipated reduction in cash flows from default on interest or principal payments
Trading Securities
are investments in debt securities acquired principally for the purpose of selling them in the near future term for the purpose of profiting from short-term price changes
Securities classified "available for sale" - Presentation on cash flow statement
cash flows from buying and selling AFS securities typically are classified as investing activities
Impairment of Debt Investments for HTM debt investments
companies will recognize bad debt the same way they recognize it for any other note receivables with debit to bad debt expense and credit to allowance account
Available for sale securities initially are recorded at...
cost included any brokerage fees -same as for trading securities, for AFS securities when a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value -they adjustments are typically recorded in an account called fair value adjustment account, but could also be made directly to the investment account
Trading and FVTNI Securities are initially recorded at.....
cost 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 "market to market" -these adjustments are typically made to a fair value adjustment account, but could also be made directly to the investment account
What is significant influence?
if an investor owns between 20% and 50% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee because by voting theses shares as a block, decisions often can be swayed in the direction of the investor desires
Under the equity method on the balance sheet
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 a loss) -decreased by dividends paid
Securities classified "available for sale" - Presentation on the 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
What should an investment be initially recorded at?
it should be recorded at cost including incidental costs such as brokers' fees
Noncredit losses are..
other reduction in fair value of investment such as those due to changes in general economic conditions
The unrealized holding gains and losses for trading and FVTNI securities are....
reported as a part of net income
Securities classified as "trading" (debt) or FVTNI (equity) - Presentation on the balance sheet
securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders' equity
Under the equity method on the income statement
the investor recognizes investment income in an amount equal to the investor's percentage share (based on share ownership) of the net income earned by the investee, instead of the amount of that net income it receives as cash dividends
When a security is reclassified between two reporting categories...
the security is transferred at its fair value on the date of transfer; -any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred (exception: transfer from trading)
Following the acquisition, the appropriate accounting for an investment depends on:
the type of the investment and its classification
Has significant influence
usually 20%-50% equity ownership you use equity method
Lack of significant influence
usually less than 20% equity ownership you use FVTNI method
Has Control
usually more than 50% equity ownership you use consolidation method
When the investment is acquired in mid-year
when an investment is acquired sometime after the beginning of the year, the journal entires would be modified to include the appropriate fraction of each of the amounts recorded
Changing from the 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 -the carrying value of the investment at the date of transfer becomes the cost basis under the new method