Investments in Marketable Equity and Debt Securities
(SFAS #115, for fiscal years beginning after 12/5/1993)
Reporting Category / Classification CriteriaHeld to Maturity / Debt securities the investor has the positive intent and ability to hold to maturity
Trading Securities / Debt or equity securities
held for immediate resale
Securities Available for Sale
(“catch all”) / Debt or equity securities not classified as either securities held to maturity or trading securities
Debt Securities: (creditor relationship) US Gov. bonds and notes, municipal securities, corp. bonds/notes/paper, convet. debt.
Equity Securities: (ownership interest) common, preferred, or other capital stock, share rights, warrants, and call or put options.
Reporting Categories For Investments
Types of Securities / Characteristics / Reporting Category / Reported at:Debt / Investor has the positive intent and ability to hold to maturity / Held To Maturity / amortized cost
Debt or equity / Held in active trading account for immediate resale / Trading Securities / fair value (with unrealized gains and losses included in earnings)
Debt or equity / Investments not classified in another category / “catch all”
Securities Available for Sale / fair value (with unrealized gains and losses excluded from earnings and reported in shareholders' equity)
Equity / Fair value not determinable and the equity method is not appropriate / Cost
Method / cost
Equity / The investor can “significantly influence” the operating and financial policies of the investee / Equity
Method / cost, adjusted for subsequent growth of the investee
Equity / The investor controls the investee / Consolidation / financial statements are combined as if a single company
INVESTMENTS ACQUIRED TO BE HELD TO MATURITY—DEBT SECURITIES
If an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held to maturity” and reported at amortized cost in the balance sheet.*
Holding gains or losses from market price changes are ignored.
* To calculate the amortized cost, simply make an amortization table for the investment (either bond or note receivable).
If a par note/bond, then amortized cost = face.
investments to be held for an unspecified period of time
(AFS or Trading)
/When an investment is acquired to be held for an unspecified period of time,
/it is reported at the fair value of the investment securities on the reporting date.
American Capital buys and sells both debt and equity securities of other companies as investments. The following transactions during December 2000, pertain to the investment portfolio. The company’s fiscal year-end is December 31.
Investment Revenue
December 18Received cash dividends of $2 million on an investment in ABM Corporation common shares, the only securities in the investment portfolio.
December 18 ($ in millions)
Cash 2
Investment revenue 2
Sale of Investments
December 20Sold the ABM Corporation common shares for $13 million. These were purchased for $12 million.
December 20 ($ in millions)
Cash 13
Investment in ABM Corporation shares 12
Gain on sale of investments 1
PURCHASE OF INVESTMENTS
December 21Acquired two new investments costing:
Millington-Frazier bonds $30 million
Bartlett Corporation common shares 20 million
December 21 ($ in millions)
Investment in Millington-Frazier bonds 30
Investment in Bartlett Corporation shares 20
Cash 50
ADJUSTING INVESTMENTS TO FAIR VALUE
December 31The market prices of the investments are:
Millington-Frazier bonds $33 million
Bartlett Corporation common shares 19 million
December 31 ($ in millions)
Investment in Millington-Frazier bonds 3
Unrealized holding gain on investments ($33 – 30) 3
Unrealized holding loss on investments ($19 – 20) 1
Investment in Bartlett Corporation shares 1
Portfolio Approach: In text, more complex for sales of investments
Securities Fair Value Adjustment (AFS or Trading) 2
Unrealized holding gain on investments ($52 – 50)* 2
☺The way we report unrealized holding gains and losses in the financial statements depends on whether the investments are classified as “securities available for sale”—equity account or as “trading securities.”—directly to IS as other gains/losses.
AVAILABLE FOR SALE
☺All investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified as “available for sale.”
☺Individual securities available for sale are reported as either current or noncurrent assets, depending on how long they’re likely to be held.
☺Investments in securities available for sale are reported at fair value.
☺Holding gains and losses for securities available for sale are reported as a component of shareholders’ equity, rather than as part of earnings.
☺The journal entries to record the cash dividend, the sale of the ABM Corporation common shares, the purchase of the investment securities, and to adjust the investments to fair value at year end would be precisely the same regardless of whether the investments are available for sale or are trading securities.
REPORTING INVESTMENTS IN
SECURITIES AVAILABLE FOR SALE
Balance Sheet
($ in millions)
Assets:
Cash and cash equivalents $xx
Short-term* investments at fair value (cost $50) 52
Accounts receivable xx
. .
. .
Shareholders’ Equity:
. .
. .
Net unrealized holding gain on investments 2
. .
* assumes both securities are intended to be held less than one year; otherwise long-term investments
Selling AFS Securities Previously Adjusted to Fair Value
(1) Assume the Millington-Frazier bonds (AFS) are sold on January 29, 2001, for $34 million. (individual security approach)
January 29, 2001 ($ in millions)
Cash 34
Unrealized Holding Gain on Investments-Millington 3
Gain on sale of investments (plug) 4
Investment in Millington-Frazier bonds ($30 + 3) 33
(2) Assume the market price of Bartlett Corp. common shares has risen by $1 million to the original price American Capital paid for the investment, and the shares are sold on Feb. 13.
February 13, 2001 ($ in millions)
Cash 20
Unrealized Holding Loss on Investments-Bartlett 1
Investment in Bartlett shares ($20 - 1) 19
TRADING SECURITIES
☺Investments in debt or equity securities acquired principally for the purpose of selling them in the near term.
☺Unrealized holding gains or losses on trading securities are reported on the income statement as if they actually had been realized.
☺Relatively few investments are classified this way because only banks and other financial operations invest in securities in the manner and for the purpose necessary to be categorized as trading securities.
☺When securities are actively managed, as trading securities are, with the expressed intent of profiting from short-term market price changes, the gains and losses that result from holding securities during market price changes are appropriate measures of success or lack of success in that endeavor.
Selling Trading Securities Previously Adjusted to Fair Value
(1) Assume the Millington-Frazier bonds are trading securities andare sold on January 29, 2001, for $34 million.
January 29 ($ in millions)
Cash 34
Investment in Millington-Frazier bonds ($30 + 3) 33
Gain on sale of investments 1
(2) Assume the market price of the Bartlett Corporation common shares rises by $1 to the original price American Capital paid for the investment, and the shares are sold on February 13. Assume that investment in Bartlett common shares have always been classified as trading securities.
February 13 ($ in millions)
Cash 20
Investment in Bartlett Corporation shares ($20 – 1) 19
Gain on sale of investments 1
TRANSFERS BETWEEN REPORTING CATEGORIES
When a security is reclassified between two reporting categories, the security is transferred at its fair value at the date of transfer. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred.
1.When a security is transferred into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period.
2.When a security is transferred into the available-for-sale category, any unrealized holding gain or loss should be recorded as a separate component of shareholders’ equity.
3.When a security is transferred into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity.
PRESENTATION AND DISCLOSURE
Trading securities are current assets by definition.
Individual held-to-maturity and available-for-sale securities are either current or noncurrent depending on when they are expected to be sold.
It’s not necessary that a company report individual amounts for the three categories of investments – held to maturity, available for sale, or trading – on the face of the balance sheet as long as that information is presented in the disclosure notes.
Investors should disclose the following in the disclosure notes:
*aggregate fair value
*gross realized and unrealized holding gains
*gross realized and unrealized holding losses
*the change in net unrealized holding gains and losses, and amortized cost basis by major security type
Information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.
REPORTING CLASSIFICATIONS FOR INVESTMENT RELATIONSHIPS
Classification / Reporting MethodThe investor cannot significantly influence the investee / Varies by Reporting Category
(see above)
The investor can significantly influence the operating and financial policies of the investee / Equity Method
The investor controls the investee / Consolidation
THE EQUITY METHOD
We use the equity method when the investor owns less than 51% of the voting shares, and therefore can’t control the investee, but can exercise “significant influence” over the operating and financial policies of an investee.
It should be presumed, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares. The 20-50% rule is not hard-and-fast. There are exceptions. Parent could hold 40% and someone else holds 55%--not significant influence for the 40%. Parent could hold 8% and no one else hold more than 1%--significant influence for the 8%.
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 declared.
I.e., cost is adjusted for subsequent growth of investment.
► The equity method is a partial consolidation. The investor and investee are viewed as a single entity. Unlike consolidation, under the equity method the equity investment is reported in a single investment account (not line by line).
► It is assumed that the fortune of the investee is intertwined with the investor and therefore as the investee’s fortunes change so do the investor’s. The investor owns a portion of the investee’s net assets.
► Cannot do the equity method if you are unable to get enough information about the investee.
EQUITY METHOD
On January 2, 2000, American Capital Corporationpurchased 25% of the outstanding common shares of Embassy Message Corporation for $200 million. The following information is available regarding Embassy Message Corporation:
($ in millions)
Net assetsat acquisition:Fair value $600
Book value 480
2000 net income 100
2000 dividends declared and paid 24
The asset initially is recorded at cost.
($ in millions)
Investment in equity securities (cost of shares) 200
Cash 200
As the investee earns additional net assets, the investment in those net assets increases.
($ in millions)
Investment in equity securities 25
Investment revenue (25% share of $100 million earned) 25
As the investee distributes net assets as dividends, the investment in those net assets declines.
($ in millions)
Cash (25% share of $24 million dividends paid) 6
Investment in equity securities 6
Further Adjustments
When the investor’s expenditure to acquire an investment exceeds the book value of the underlying net assets acquired, additional adjustments to both the investment account and investment revenue may be needed.
Our illustration provides the following information regarding Embassy Message Corporation’s net assets at the time American Capital Corporation pays $200 million for a 25% interest in the company:
($ in millions)
Net assets at acquisition:Fair value $600
Book value 480
Assume the difference between the book value of the net assets and their fair market value is attributable to depreciable assets having a fair market value in excess of their undepreciated cost.
($ in millions)
InvesteeNet AssetsDifference
Net AssetsPurchasedAttributed To:
Cost $200
Goodwill:$50
Fair value:$600 x 25% = $150
Undervaluation
Book value:$480 x 25% = $120 of assets: $30
AMORTIZATION OF ADDITIONAL DEPRECIATION
Assume that the depreciable assets have an average remaining useful life of 10 years. Investment revenue and the investment both would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause:
($ in millions)
Investment Revenue ($30 million ÷ 10 years) 3
Investment in Equity Securities 3
REPORTING THE INVESTMENT
The investment account represents the investor’s share of the investee's net assets initially acquired, adjusted for the investor’s share of the subsequent increase in the investee's net assets (net assets earned and not yet distributed as dividends).
Investment in Equity Securities
______
($ in millions)
Cost 200
Share of income 25
6 Dividends
3 Depreciation
______
Balance 216
A Change from the Equity Method to Another Method
If conditions change and make the equity method no longer appropriate, no adjustments are needed, simply discontinue the equity method and use the new method from then on. The cost basis at time of change is simply the balance in the investment account (mark-to-market from here).
A Change from Another Method to the Equity Method
When a change to the equity method is appropriate,
Retroactive treatment required—the balance in the investment has to be what it would have been if the equity method has been used the entire time. Go back and calculate net income of investee reduced by dividends, then make entry to reflect this balance in investment account.
Investment in equity securities$350,000
Retained earnings (investment revenue) $350,000
Disclosure note and restate the net income for each year reported in the financial statements. Show an adjustment to the beginning of period RE for the earliest period reported on statement.
Equity Method Accounting—Another example
Investment is recorded at cost—then,
The investment is increased (decreased) by a % share of investee’s net income (loss).
The investment is decreased by dividends received from the investee.
Assume that XXX buys 30% of PUD’s voting common shares for $107 million on 1/1/2001. For 2001 PUD reports net income of $10 million ($2 million of which was an extraordinary gain). PUD also declares and pays dividends of $1 million in 2001.
Investment in PUD$107,000,000
Cash $107,000,000
Investment in PUD$3,000,000
Investment Revenue$2,400,000
Investment Gain (EO)600,000
Cash ($1M * 0.30)$300,000
Investment in PUD$300,000
(receipt of dividends reduces XXX’s interest in PUD’s net assets).
Further Complications:
More complicated adjustments have to be made if the investor’s cost to acquire the investment exceeds the book value of the net assets acquired.
Compare fair value of net assets acquired to their book value. If any of the difference is due to “undervaluation” of depreciable assets or inventory, then take additional depreciation over the life of the depreciable assets or additional CoGS the next year. Ignore portion of difference due to “undervaluation” of land. No adjustment for goodwill.
Assume that XXX paid $107M for 30% of PUD. At time of purchase, PUD’s net asset fair market value was $333.3M and book value of identifiable net assets was $300 M. Depreciable assets are “undervalued” by $18M, land by $12M, and inventory by $3.3M. Depreciation is straight-line, with 6 yrs remaining.
InvesteeNet Assets / Net Assets
Purchased
Difference
Cost / $107 M
Fair Value / $333.333 M / $100 M / $7 M Goodwill
Book Value / $300 M / $ 90 M / $5.4M dep.A.
$3.6 M land
$1.0 M inven.
Each year for the next 6 years, recognize $0.9 M in “additional depreciation.”
Investment revenue$900,000
Investment in PUD$900,000
In first year: (to recognize additional CoGS)
Investment revenue$1,000,000
Investment in PUD$1,000,000
************************************************
Reporting the equity investment—at adjusted cost.
The carrying amount in the investment account is the initial cost plus the investor’s portion of undistributed earnings of the investee.
Investee’s net losses result in a reduction of the investor’s investment account. Never reduce the investment account below zero.* If losses would cause this, wait until the subsequent earnings equal losses not recognized during the time equity method was discontinued.
* Reduce below zero if investor is liable for more than the initial investment.
Variation in Earnings by Method
Used to Account for Investments
Situation:Investor Company owns 20% of Investee Company. Investee’s net income is $1 million. Investee distributes one-half its earnings as dividends. (Thus, Investor receives 20% x $1 million x 1/2 = $100,000.) The fair value of Investor’s investment in Investee’s common stock increased by $250,000 during the year.
Which accounting method causes reported income to be highest?
Accounting Method Used:
Trading Security heldEquity
securityfor salemethod
Share of Investee income* $100,000 $100,000 $200,000
Increase in Investee’s fair value** 250,000 0 0
Investor’s investment income $350,000 $100,000 $200,000
*recognized whether received as dividends or not by the equity method; only if received as dividends otherwise
**reported in income for trading securities, component of shareholders’ equity for securities available for sale, and not recognized at all for equity-method investments
CONSOLIDATED FINANCIAL STATEMENTS
If a company has controlling interest (more than 50% of voting stock) in another company, for reporting they are considered as one entity and must prepare consolidated financial statements.
There is now a parent – subsidiary relationship. Both continue to prepare separate financial reports, but the parent must report consolidated financial statements. In short, the process of consolidation removes all of the transactions between parents and subs. (e.g., A/R and A/P). The parent records the acquired company’s net assets at fair market value. If the acquisition price exceeds the fair value, then the difference is called goodwill (an intangible asset).
The investment in a subsidiary is usually accounted for on the parent’s books using the equity method.
Derivatives
Financial instruments that derive their value (cash flows) from some other security or index. The last 10 years has seen an “explosion” in the types of derivatives available in our financial markets. Financial futures, forward contracts, options, and interest swaps are frequently used derivatives.