Investments in Debt & Equity Securities
If AFS securities are transferred to trading, any related unrealized holding gain or loss
is removed from AOCI and recognized in earnings.
Factors to consider regarding an investor's significant influence over an investee (PERMIT)
-Participation in policy-making processes -Extent of ownership in relation to the concentration of other shareholdings -Representation on the board of directors -Material intra-entity transactions -Interchange of managerial personnel -Technological dependency
The fair value option cannot be applied to the following items:
1. An investment in a subsidiary or variable interest entity that will be consolidated 2. Deposit liabilities of depository institutions 3. Financial assets or financial leases recognized under lease arrangements 4. Financial instruments classified as an element of shareholders' equity 5. Obligations or assets related to pension plans, post-employment benefits, stock option plans, and other types of deferred compensation
Under IFRS the equity method of accounting is used for both joint operations and joint ventures. Joint ventures involve both shared control and rights to the arrangement's net assets. Joint operations involve shared control but no rights to the arrangement's net assets, and are accounted for with an equity method approach known as
A.Joint equity. B.Proportionate consolidation. C.Allocated equity. D.Shared value through profit and loss. Answer - B. Proportionate consolidation
Moss Corp. owns 20% of Dubro Corp.'s preferred stock and 80% of its common stock. Dubro's stock outstanding at December 31, Year 1, is as follows: 10% cumulative preferred stock$100,000; and Common stock 700,000 Dubro reported net income of $60,000 for the year ended December 31, Year 1. Assume that Moss does not elect the fair value option to report the investment in Dubro. What amount should Moss record as equity in earnings of Dubro for the year ended December 31, Year 1?
An investor's share of the income of a company in which it holds a 20% or greater investment is referred to as the investor's equity in earnings of the investee. The investor's share of the investee's earnings should be computed after deducting the investee's cumulative preferred dividends (whether declared or not). In this case, the income available to common stockholders is $50,000 [$60,000 income − (10% × $100,000 total pref. div.)], so Moss Corp.'s equity in earnings is $40,000 (80% ownership × $50,000). Since $40,000 is not one of the answer choices, apparently the candidate is expected to include the preferred dividend revenue of $2,000 [20% ownership × ($100,000 × 10% total pref. div.)] on the income statement in the equity in earnings line item. The answer, therefore, is $42,000. Equity in earnings $40,000 Less: Dividend revenue 2,000 Answer: $ 42,000
On January 1, Year 1, Peabody Co. purchased an investment for $400,000 that represented 30% of Newman Corp.'s outstanding voting stock. For Year 1, Newman reported net income of $60,000 and paid dividends of $20,000. At year end, the fair value of Peabody's investment in Newman was $410,000. Peabody elected the fair value option for this investment. What amount should Peabody recognize in net income for Year 1 attributable to the investment?
Answer: $16,000 In this scenario, because Peabody Co. elects the FV option, $16,000 of income ($6,000 dividends + $10,000 unrealized holding gain) will be recognized, calculated as follows: 30% of cash dividends (30% × $20,000)$6,000Holding gain from increase in FV ($410,000 − $400,000)10,000Total income$16,000
On January 1, 20X3, Point, Inc. purchased 10% of Iona Co.'s common stock. Point purchased additional shares bringing its ownership up to 40% of Iona's common stock outstanding on August 1, 20X3. During October 20X3, Iona declared and paid a cash dividend on all of its outstanding common stock. Point uses the equity method to account for its investment in Iona. How much income from the Iona investment should Point's 20X3 income statement report?
Answer: 40% of Iona's income for August 1 to December 31, 20X3 only. When changing from the cost to the equity method, the investor simply prospectively applies the equity method. The equity method only becomes effective August 1, when Point became a 40% owner of Iona.
Available-for-sale (AFS) securities are initially recorded at cost but carried at fair value (ie, market value).
Any changes in fair value for each period due to market risk are classified as unrealized holding gains or losses and reported in other comprehensive income (OCI).
Available-for-sale debt securities are carried at fair value (FV).
Any decline in FV due to credit risk is reported as a credit loss expense in income. The security is reported at FV on the balance sheet using a contra account.
When a bond is purchased at a discount, the carrying value will be lower than the face amount of the bond.
As a result, a bond purchased between interest dates at a discount has a carrying amount that is lower than both the cash paid to the seller and the face amount of the bond.
When classified as held to maturity, bonds are originally recorded at cost with any discount or premium being amortized as an adjustment to income.
As a result, the bonds are reported at amortized cost.
Each period, unrealized gains and losses resulting from fluctuations in the fair value of available-for-sale securities must be evaluated to determine what portion, if any, is due to credit risk (ie, credit losses reported on the income statement) and to market risk.
Changes in the fair value related to market risk are reported as unrealized holding gains or losses in other comprehensive income.
Antonio Corp. has a portfolio of marketable debt securities that it does not intend to sell in the near term. Antonio elects the fair value option for reporting its financial assets. How should Antonio classify these securities, and how should it report its noncredit-related unrealized holding gains and losses?
Classify as: Available for Sale (due to their intent to hold) Unrealized G/L reported: income from continuing ops
If the investor elects the fair value (FV) option, the investment is reported at FV at the end of each accounting period.
Dividends received and unrealized holding gains (losses) and realized gains (losses) are recognized in net income. The investor's share of the investee's income is ignored.
The equity method is used to record investments when the investor has the ability to exercise significant influence over the operating and financial policies of the investee (ie, holds 20-50% of the investee's stock).
Dividends received reduce the investment account; the investor's share of the investee's net income (even though not actually received) is reported on the investor's income statement.
When the equity method is used to account for investments, any excess purchase price over the investor's share of the carrying value of net assets is allocated to specifically identified assets. If the purchase price exceeds the fair value of the net assets, goodwill is also recorded.
Example calculation at acquisition (30% stake): - Purchase price $200k - Birk's share of net assets ($500k × 30%) (150k) - Total excess purchase price $50k - Attributed to assets [($600k − $500k) × 30%] (30k) = Attributed to goodwill $20k
The equity method is used when an investor can exercise significant influence over an investee.
Generally, significant influence is ownership of 20% to 50% of the voting stock of the investee; however, the degree of influence is a matter of professional judgment that considers both quantitative and qualitative factors.
Under IFRS an equity investment is considered an investment in an associate if the investor has significant influence over the investee. Significant influence is indicated by?
Having the power to participate in the decisions of the investee Under both GAAP and IFRS, the equity method is applied when an entity has the ability to exercise significant influence over the investee. Under IFRS, that is considered to be the case when the investor has the power to participate in the decisions of the investee.
Changes in the fair value of AFS debt investments due to credit risk are recognized on the income statement.
However, changes in fair value due to market risk are unrealized gains and losses and are instead recognized as OCI (net of taxes).
Unrealized gains (losses) from changes in fair value of available-for-sale debt securities must be evaluated to determine what portion is due to credit risk (reported in earnings) and what portion is due to market risk (reported in other comprehensive income).
If management intends to sell the security, the loss is realized and recognized in net income.
How to treat a dividend received from ownership of preferred stock...
More than 20% ownership of preferred stock cannot give an investor significant influence because it is nonvoting stock. If an investor has influence due to other causes (eg, major customer or supplier), the equity method may be used. When the equity method is used for preferred stock, the income reported is equal to allocated dividends (ie, treated like less than 20% ownership).
Factors to consider regarding an investors significant influence over an investee (PERMIT)
Participation in policy-making processes Extent of ownership in relation to the concentration of other shareholdings Representation on the board of directors Material intra-entity transactions Interchange of managerial personnel Technological dependency
the equity method is used when the investor can exercise significant (but not controlling) influence over the operating and financial policies of the investee.
Significant influence implies the investor and investee are so connected that to faithfully represent the relationship, the investor must recognize the investment at cost and reports its proportionate share of the investee's income each period.
When a bond is purchased between interest dates, the amount paid will be the fair market value of the bond, which will be the carrying value at the purchase date, plus interest accruing from the last interest date to the date of purchase.
The carrying amount excludes the interest and will be lower than the amount of cash paid.
AFS securities valuation: an evaluation is performed on each reporting date to determine if the securities are impaired (ie, if FV is less than amortized cost basis).
The entity must determine if the change in the FV is due to credit losses (ie, the investee's inability to pay) or market risk (ie, changes in market conditions).
When an AFS security is sold, the difference between the carrying value (ie, FV) and the proceeds is treated as a realized gain (loss).
The investment, any related valuation account, and the unrealized holding gain (loss) are removed from the books.
For AFS securities: When recording market risk adjustments, asset valuation accounts are used to offset the entry to OCI.
Unrealized holding losses are recorded in AFS securities- unrealized losses, a contra account, and unrealized holding gains are recorded in AFS securities-unrealized gains, an adjunct account.
When an entity reporting under IFRS elects to recognize changes in fair value of an equity instrument in other comprehensive income (OCI) rather than profit or loss, the investment is reported at its fair value on the balance sheet and any increases or decreases are recognized in OCI. This is not the case with impairments, which are recognized in profit or loss.
When an investment for which changes are recognized in OCI increases in fair value, any previously recorded impairment losses are reversed. Any remaining increase is reported in OCI.
In general, the equity method is used to account for investment transactions when the investor has the ability to exercise significant influence over the investee's operations (ie, holds 20%-50% ownership).
When the investor's ownership is less than 20%, the degree of influence is a matter of professional judgment and factors specified by accounting standards (eg, investor serving on board of directors, participating in policy decisions).
The unrealized holding gains (losses) related to market risk from OCI are transferred to accumulated OCI in stockholders' equity
and are not reported in earnings until the securities are sold.
Marketable debt securities that the entity has both the ability and the intent to hold until they mature
are classified as held-to-maturity (classified as noncurrent assets)
Marketable debt securities that are purchased for the purpose of resale in the near future
are classified as trading securities (normally classified as a current asset).
All other investments in marketable debt securities (ie, don't fall into either of the other two categories)
are recognized as available-for-sale debt securities (may be classified as current or noncurrent assets).
When accounting for investments under the equity method, the investor's share of the investee's net income is reported as income. But how are dividends treated?
dividends received are not income but reduce the investment account. Dr: Cash, Cr: Investment
Under the equity method (ie, investor holds 20-50% of investee's stock),
dividends received reduce the investment (asset acct), and the investor's share of the investee's net income (loss) is reported as equity in earnings (income stmt)
When reporting investments at FV, cash dividends received from the investee are reported as income. If an investee declares a stock dividend to existing shareholders, what is the impact?
no income is reported. Instead, the carrying value of the investment is allocated over the increased quantity of shares (ie, adjust the cost basis per share).
Similar to consolidation, under the equity method, when assets or liabilities of the investee are under- or over-valued at the acquisition date
the investor's share of the investee's net income is adjusted to reflect income as if the items had been reported at their fair values on the acquisition date.
When AFS are reclassified as held-to-maturity,
the unrealized holding gain or loss is recognized in OCI and transferred to accumulated OCI, and the balance is amortized over the remaining life of the security.