Chapter 12: Investment notes

Debt instruments accounts for four events

1. Purchasing the debt investment 2. Receiving interest (often semiannually) 3. Holding the bonds during periods in which the bonds' fair value changes 4. Either selling bonds before maturity or receiving the principal payment at their maturity date

Equity instruments accounts for four events

1. Purchasing the equity security 2. Receiving dividends (for some equity securities) 3. Holding the investment during periods in which the investment's fair value changes 4. Selling the investment

Differences between TS and HTM

1. Trading securities are written up or down to their fair value, or "marked to market", in the B/S 2. Corresponding unrealized holding gains and losses on trading securities are included in net income in the I/S DURING the period that fair value changes

Consolidated financial statements report

1. the acquired company's assets at their fair value on the date of acquisition rather than their book values on the investee's balance sheet 2. goodwill for the EXCESS of the acquisition price over the fair value of the identifiable net assets acquired.

HTM financial statement presentation

B/S: Investments are reported at amortized cost, less any allowance for credit losses (impairments). Fair values disclosed in the notes. I/S: Realized gains and losses shown in NI in period sold. Unrealized holding gains and losses disclosed in notes. CFS: Cash flows from buying and selling HTM typically are classified as investing activities. Interest received is an operating activity.

AFS financial statement presentation

B/S: Investments in AFS are reported at fair value, either current or LT investments. Unrealized holding gains and losses become part of AOCI in SE, and are reclassified out of AOCI when sold. I/S: AFS gains and losses are shown in OCI in which fair value changes, those amounts are reclassified out of OCI and recognized in net income when sold. CFS: Cash flows from buying and selling AFS are classified as investing activities. Interest received is classified as operating activities.

TS financial statement presentation

B/S: Investments in TS are reported at fair value, typically current assets. I/S: TS gains and losses are included in NI in which fair value changes, regardless of whether they are realized or unrealized. CFS: Cash flows from buying and selling TS are classified as operating activities because the financial institutions that routinely hold TS consider them as part of their normal operations.

Transfers from AFS to HTM

Don't write off any existing unrealized gain or loss in AOCI, but amortize it to NI over the remaining life of the security

The holding period for trading securities generally measures is measured in _________ and ______ rather than months or years.

Hours; days

Transfers from TS to either HTM/AFS

Include in current NI any unrealized gain or loss that occurred in the current period prior to the transfer.

Transfers from either HTM/AFS to TS

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

Interest received (paid) vs. interest revenue (expense)

Interest received is the (face amount x stated rate x time factor) and reflected on CFO. Interest revenue is the (outstanding balance at the beginning of the period x market rate x time factor) reflected on I/S

______ relates to _________ in the same way that NI relates to RE.

OCI; AOCI

Fair value adjustment

a valuation account that when added to the amortized cost of the investment yields fair value; use of this account enables a company to maintain a record of its amortized cost of AFS and TS securities

Fair value option

allows companies to report specified financial assets and liabilities at fair value

Hedging arrangement

an investment intended to reduce earnings volatility by offsetting changes in the fair value of assets with changes in the fair value of liabilities

Effective interest method

calculates interest revenue by multiplying the outstanding balance of the investment by the relevant interest rate

To account for the sale of TS, the company needs to (1) update the _______________ _______ of the bonds to _______ ______ and record any unrealized holding gains and losses in NI, and (2) record the ______of _______and _________ the amounts associated with the investment from relevant B/S accounts as well as the fair value adj account.

carrying value; fair value; receipt of cash; remove

AFS falls in the middle of HTM and TS. For example, a company may not be planning to trade the debt investment actively, but the investment is available to sell if _______ ________ arise or the ___________ is particularly favorable.

cash needs; market

Consolidated financial statements

combination of the separate financial statements of the parent and subsidiary each period into a single aggregate set of financial statements, as it there were only one company, after first eliminating any amounts that are shared by the separate financial statements to avoid double counting

>50%; method used

controls the investee; consolidation

All equity investments are recorded initially at ________.

cost

Trading securities are recorded at ________ when they are purchased, and any discount or premium is __________ to interest revenue over time as periodic interest payments are received. However, trading securities are written up or down to their ________ ________, or "marked to market", in the B/S.

cost; amortized; fair value

All investment securities are initially recorded at __________. That is, the total amount paid for the investment, including any other fees. This amount is reflected as the ___________ _________ of the bonds.

cost; present value

Trading securities are typically reported among the investor's ___________ assets.

current

Equity investments for which the investor has no significant influence are classified as either ___________ or ____________ in the B/S.

current; noncurrent

Unrealized holding losses and realized losses are _________ whereas unrealized holding gains and realized gains are _________.

debited; credited

Trading securities

debt securities the investor (usually a financial institution) acquires principally for the purpose of selling in the near term

Increased by the investor's percentage share of the investee's NI (or ____________ by its share of loss)

decreased

Decreased by the investor's percentage share of the investee's _________ paid.

dividends

<20%; method used

does not have significant influence; fair value through NI

Significant influence

effective control is absent but the investor is able to affect the operating and financial policies of the investee (usually is the case when the investor holds between 20% and 50% of the investee's voting shares)

Financial instruments

equity and debt securities

Changes in ________ ________ 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 long-term or short-term securities.

fair value

Equity investments are adjusted to their _______ _______ at each reporting date.

fair value

The investor adjusts its share of the investee's net income to reflect revenues and expenses associated with differences between the _______ __________ and the ________ _________ of the investee's assets and liabilities that existed at the time the investment was made.

fair value; book value

Unrealized holding gains and losses

gains and losses that arise from holding an investment during a period in which its fair value changes

20%-50%; method used

has signifcant influence; equity method

If the market rate of interest rises after a bond is purchased, the market will compute the present value of cash flows provided by the bond using that _______ rate, so the fair value of the bond _________ and the bond suffers an _____________ ___________ ________.

higher; falls; unrealized holding loss

Building/equipment or other depreciable assets recorded at higher values, deprecation expense will be _______ during their remaining useful lives. Likewise, recorded amount if inventory is increased, cost of goods sold will be ____________.

higher; higher

As the investee earns additional net assets (income), the investor's share of those net assets ____________. Likewise, when the investee pays out assets (dividends), the investor's share of the remaining net assets ____________.

increases; decreases

Accounting for equity investments considers the extent to which the investor can __________ the activities of the investee.

influence

The election of the fair value option for AFS and HTM securities is ____________.

irrevocable

The investor makes no adjustment for ______ and _____________ because those two items are not depreciable/amortizable and therefore results in no income effect.

land; goodwill

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

less; increases

If the market rate of interest falls after a bond is purchased, the market will compute the present value of cash flows provided by the bond using that _______ rate, so the fair value of the bond _________ and the bond enjoys an _____________ ___________ ________.

lower; rises; unrealized holding gain

If the bond is purchased at a premium, _______ cash is received each period than the effective interest earned by the investor, so the paid difference __________ the outstanding balance of the investment.

more; decreases

The fair value of the investment shares at the end of the reporting period is not reported when using equity method, rather reported at its original cost and the increase/decrease in its percentage share of _____ _________ which also includes the ______________ _____________.

net assets; depreciation adjustment

When a trading security is sold, all of the gain/losses already has been included in _____ _______, so no additional gain/loss is recognized. The HTM approach recognizes gains/losses only when they are realized upon sale.

net income

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

next; reduce; next

Equity investments held with an intent for short-term profit are treated as ___________ activities whereas other current and long-term equity investments are classified as _______________ activities in the CFS.

operating; investing

The fair value of a fixed-rate investment moves in the _____________ direction of market interest rates and accounting for these changes depends on the ________________ of the debt investment.

opposite; classification

For AFS, unrealized holding gains and losses are recorded in __________ ____________________ _________, and then only include realized gains and losses in ________ _________ in the period sold.

other comprehensive income; net income

CFS presentation for equity investments using equity method:

purchase/sale of the investment in reported in CFI and receipt of dividends is classified under CFO

When an AFS investment is sold, accumulated unrealized gains and losses are removed from AOCI using a _____________ entry.

reclassification

The purchase of the debt instrument and receipt of interest payments are handled the ______ ______ regardless of how the debt investment is classified (eg. ________________________________). The last two events are accounted for ________________.

same way; HTM, AFS, or TS; differently

Subsidiary

the investee

Parent

the investor

Amortizing the differential

the process of expensing some of the difference between the price paid for the investment and the book value of the investment (difference between NI reported by the investee and what the amount would have been if consolidation procedures had been followed)

Choosing the fair value option for HTM and AFS investments means accounting for them like ________ securities.

trading

Held-to-maturity (HTM): definition, treatment of unrealized holding gains and losses, and amount carried in the B/S

used for debt for which the investor has the "positive intent and ability" to hold to maturity; not recognized; amortized cost

Available-for-sale (AFS): definition, treatment of unrealized holding gains and losses, and amount carried in the B/S

used for debt that does not qualify as HTM or TS; recognized in OCI; fair value

Trading (TS): definition, treatment of unrealized holding gains and losses, and amount carried in the B/S

used for debt that is held in an active trading account for immediate resale; recognized in NI; fair value

Equity method

used when the investor can't control, but can significantly influence the investee. Under the equity method, the investor recognizes in its own I/S its proportionate share of the investee's income

Control

usually an investor can control the investee if it owns more than 50% of the investee's voting shares

A bond sold at premium

when the stated rate is higher than the market rate, investors are willing to purchase the the bond for more than its maturity value

A bond sold at discount

when the stated rate is lower than the market rate, investors are willing to purchased the bond only at an amount less than its maturity value