Chapter 12: Investments

Professor May Zhang

Learning Opportunities
1. Demonstrate how to identify and account for debt investments classified for
reporting purposes as held-to-maturity, trading and available-for-sale
securities.
2. Demonstrate how to account for equity investments that lack significant
influence
3. Demonstrate how to account for equity investments accounted for under
the equity method.
4. Explain the adjustments made in the equity method when the fair value of
the net assets underlying the investment exceeds their book value.
5. Explain how electing the fair value option affects accounting for
investments.

Investments

Financial instruments:
Equity securities Debt securities
• Common stock • Bonds
• Preferred stock • Notes
Objective:
• To earn a return from the dividends or interest the securities
pay or from increases in the market prices of the securities

• To develop ongoing affiliations with the companies whose

securities are acquired
 Investment in Debt Securities

Investment in Debt Securities: Bond

} A bond indenture describes the specific promises

bond issuers made to bondholders.
} Specified date when the bond matures (maturity
date)
} Face amount paid to investors on maturity
(principal)
} Cash interest paid to investors (coupon) during
the term of the bond
CHAPTER 12 Looks at things from the
BONDHOLDERS’ perspectives!
Accounting for Investment in Bonds: Determining
Bond Price

Present value of the Present value of the

Bond
principal payable at periodic cash interest
price = maturity
+ payments*

Discounted at the market rate

*Principal × Stated rate (coupon rate)

• Bond prices are typically stated in terms of a percentage of face amounts

• Example: A price quote of 98 means a $1,000 bond will sell for $980; a
bond priced at 101 will sell for $1,010

Determining Bond Price (continued)

Bonds will sell for more than face amount (at a discount) or less than
face amount (at a premium), depending on how the stated interest
rate compares with the prevailing market or effective rate of interest.

Stated (coupon)
Interest rate > Market rate sold at Premium

Stated (coupon)
Interest rate = Market rate sold at Par

Stated (coupon) >

Market rate sold at Discount
Interest rate
 Bonds Purchased at a Discount-Semiannual interest
On January 1, 2023, Masterwear Industries issued $700,000 of 12% bonds,
dated January 1. Interest of $42,000 is payable semiannually on June 30 and
December 31. The bonds mature in three years. The market yield for bonds of
similar risk and maturity is 14%. The entire bond issue was purchased by United
Intergroup, Inc.

Calculation of the Price of the Bonds

Interest $ 42,000 × 4.76654 = $200,195

Principal $700,000 × 0.66634 = 466,438
Present value (price) of the bonds $666,633
Present value of an ordinary Present value of $1: n
annuity of $1: n = 6, i = 7% = 6, i = 7%

Semiannual: n = 6 (3 × 2); i = 7% (14% ÷ 2)

Bonds Purchased at a Premium--Semiannual interest

On January 1, 2023, Masterwear Industries issued $700,000 of 12% bonds,
dated January 1. Interest of $42,000 is payable semiannually on June 30 and
December 31. The bonds mature in three years. The market yield for bonds of
similar risk and maturity is 10%. The entire bond issue was purchased by United
Intergroup, Inc.

Calculation of the price of the bonds

Interest $ 42,000 × 5.07569 = $213,179

Principal $ 700,000 × 0.74622 = 522,354
Present value (price) of the bonds $735,533

Present value of an ordinary annuity of $1: n = 6, i = 5%

Present value of $1: n = 6, i = 5%
 ASU 2016-01: (Effective for fiscal years beginning after
December 15, 2017)

Key difference among the reporting approaches is how we account for

unrealized holding gains and losses

Held to Maturity Securities

On January 1, 2023, Matrix Inc. purchased as an investment $1,000,000, of 10%,
10-year bonds, interest paid semi-annually. Matrix has the positive intent to keep
this investment to maturity. The market rate for similar bonds is 12%. Let’s look at
the calculation of the present value of the bond issue.

Present
Amount PV Factor Value
Interest $ 50,000 × 11.46992 = $573,496
Principal 1,000,000 × 0.31180 = 311,805
Present value of bonds $885,301

PV of ordinary annuity of $1, n = 20, i = 6%

PV of $1, n = 20, i = 6%
Held to Maturity Securities
Partial Bond Amortization Table
Interest Interest Discount Unamortized Carrying
Date Payment Revenue Amortization Discount Value
1/1/23 $ 114,699 $ 885,301
6/30/23 $ 50,000 $ 53,118 $ 3,118 111,581 888,419
12/31/23 50,000 53,305 3,305 108,276 891,724
6/30/24 50,000 53,503 3,503 104,772 895,228
12/31/24 50,000 53,714 3,714 101,059 898,941
January 1, 2023 (Investment Purchase)
Investment in bonds 1,000,000
Discount on bond investment 114,699
Cash 885,301

June 30, 2023 (Received 1st coupon)

Cash (stated rate × face amount) 50,000
Discount on bond investment 3,118
Interest (investment) revenue 53,118

Held to Maturity Securities

This investment would appear on the

June 30, 2023, balance sheet as follows:

Investment in bonds $ 1,000,000

Less: Discount on bond investment 111,581
Book value (amortized cost) $ 888,419

$114,699 - $3,118 = $111,581 unamortized discount

Held to Maturity Securities
On December 31, 2023, the fair market value of the bonds are 899,000.
On January 5, 2024, all the bonds are sold for $900,000 cash.
Interest Interest Discount Unamortized Carrying
Date Payment Revenue Amortization Discount Value
1/1/23 $ 114,699 $ 885,301
6/30/23 $ 50,000 $ 53,118 $ 3,118 111,581 888,419
12/31/23 50,000 53,305 3,305 108,276 891,724
6/30/24 50,000 53,503 3,503 104,772 895,228
12/31/24 50,000 53,714 3,714 101,059 898,941
December 31, 2023 (received 2nd coupon)
Cash 50,000
Discount on bond investment 3,305
Interest (investment) revenue 53,305
January 5, 2024 (Early sale of investment)
Cash 900,000
Discount on bond investment 108,276
Investment in bonds 1,000,000
Gain on sale of investment 8,276

Trading Securities (TS)

} Investments in debt or equity securities acquired

principally for the purpose of selling them in the near
term
} Active buying and selling of securities
} Holding period generally is measured in hours and days rather
than months or years
} Typically reported among the investor’s current assets
} Fair value information is more relevant, so
} Carried at fair value on the balance sheet, and
} Unrealized holding gains and losses are included in net
income in the period in which fair value changes
Adjust Trading Security Investments to Fair Value

Assuming the Matrix bonds are trading securities and have a fair value of
$899,000 as of December 31, 2023, the table shows the calculation of the
balance in the fair value adjustment account that is required on that date.

December 31,2023

Security Amortized Fair Value FV Adj Bal

Cost
Matrix $891,724 $899,000 $7,276

Journal Entry – Dec 31, 2023 Debit Credit

Fair value adjustment 7,276
Unrealized holding gain—NI 7,276

Sale of Trading Security Investments

Assuming that Matrix sold the bonds for $900,000 on January 5, 2024.

1. Adjust trading securities to fair value (2024)

January 5, 2024
Security Amortized Cost Fair Value FV Adj Bal
Matrix 891,724 $900,000 $8,276

Fair Value Adjustment

Beginning balance on 12/31/23 $7,276

Adjustment needed to update fair value ?

Balance needed on date of sale $8,276

Journal Entry – Jan 5, 2024 Debit Credit

Fair value adjustment 1,000
Unrealized holding gain—NI 1,000
 Sale of Trading Security Investments (Continued)
Assuming that Matrix sells the bond for $900,000 on January 5, 2024.
2. Record the sale transaction
January 5, 2024

Security Amortized Fair Value FV Adj Bal

Cost
Matrix $891,724 $900,000 $8,276

Journal Entry – Jan 5, 2024 Debit Credit

Cash 900,000
Discount on bond investment 108,276
Investment in Matrix bonds 1,000,000
Fair value adjustment 8,276

Financial Statement Presentation:

Trading Securities
} Income statement and statement of
comprehensive income:
} Gains and losses are included in the income statement in the
periods in which fair value changes, regardless of whether they
are realized or unrealized
} Do not affect other comprehensive income (OCI)
} Balance sheet:
} Investments in trading securities are reported at fair value,
typically as current assets
} Cash flow statement:
} Cash flows from buying and selling trading securities are
classified as operating activities
Debt Investments Classified as Available-for-Sale
Securities
} Available-for-sale (AFS) securities aren’t held for trading
or designated as held to maturity
} The investment is available for sale
} Reported in balance sheet at fair value
} Unrealized gains and losses are not included in net income but
reported in statement of comprehensive income as other
comprehensive income (OCI)

Adjust AFS Security Investments to Fair Value

Assuming the Matrix bonds are AFS securities and have a fair value of
$899,000 as of December 31, 2023, the table shows the calculation of the
balance in the fair value adjustment account that is required on that date.

December 31,2023

Security Amortized Fair Value FV Adj Bal

Cost
Matrix $891,724 $899,000 $7,276

Journal Entry – Dec 31, 2023 Debit Credit

Fair value adjustment 7,276
Unrealized holding gain—OCI 7,276
Sale of AFS Investments
Assuming that Matrix sold the bonds for $900,000 on January 5, 2024.

1. Adjust AFS securities to fair value (2024)

January 5, 2024
Security Amortized Cost Fair Value FV Adj Bal
Matrix 891,724 $900,000 $8,276

Fair Value Adjustment

Beginning balance on 12/31/23 $7,276

Adjustment needed to update fair value ?

Balance needed on date of sale $8,276

Journal Entry – Jan 5, 2024 Debit Credit

Fair value adjustment 1,000
Unrealized holding gain—OCI 1,000

Sale of AFS Investments (continued)

Assuming that Matrix sells the bond for $900,000 on January 5, 2024.

2. Reverse previous fair value adjustments

January 5, 2024

Security Amortized Fair Value FV Adj Bal

Cost
Matrix $891,724 $900,000 $8,276

Journal Entry – Jan 5, 2024 Debit Credit

Reclassification adjustment—OCI 8,276
Fair value adjustment (account balance) 8,276
Sale of AFS Investments (concluded)

3. Record the sale transaction

January 5, 2024

Security Amortized Fair Value FV Adj Bal

Cost
Matrix $891,724 $900,000 $8,276

Journal Entry – Jan 5, 2024 Debit Credit

Cash 900,000
Discount on bond investment 108,276

Investment in Masterwear bonds 1,000,000

Gain on AFS investment—NI 8,276

Financial Statement Presentation: AFS

} Income statement and statement of
comprehensive income:
} Gains and losses are shown in OCI in the periods in which
changes in fair value occur
} Those amounts are reclassified out of OCI and recognized in
net income in the periods in which securities are sold
} Balance sheet:
} Investments in AFS securities are reported at fair value
} Unrealized holding gains and losses become part of AOCI in
shareholders’ equity, and are reclassified out of AOCI in the
periods in which securities are sold
} Cash flow statement:
} Cash flows from buying and selling AFS securities are
classified as investing activities
Fair Value Option (FVO—HTM & AFS)

The election is optional but irrevocable on the date of

investment purchase. Under FVO:
} HTM and AFS investments are shown in the balance
sheets at fair value
} Unrealized gains and losses are recognized in net income
in the period in which they occur
} Purchases and sales of investments are likely to be
classified as investing activities

Fair Value Hierarchy: Input companies use to

determine fair value
 Investment in Equity Securities

Investments in Equity Securities

Extent of Investor Influence Reporting Method

Lack of significant influence

(usually < 20% equity ownership) Fair Value (Trading Securities)

Equity method
Significant influence
(usually 20% - 50% equity ownership)

Consolidation
Has control
(usually > 50% equity ownership)
Accounting for equity investments that Lack
significant influence over the investee

Example:
The following events during 2023 and 2024 pertain to United
Intergroup’s investment in the common stock of Arjent, Inc.:
July 1, 2023 Purchase Arjent, Inc., common stock for
$1,500,000
December 31, 2023 Recognize investment revenue for a
$75,000 cash dividend received from
Arjent
December 31, 2023 Record a fair value adjustment to
recognize a decline in the value of the
Arjent stock investment to $1,450,000
January 5, 2024 Sell the Arjent stock for $1,446,000

Lacks Significant Influence (continued)

Purchase Investments
Journal Entry – July 1, 2023 Debit Credit
Investment in Arjent stock 1,500,000
Cash 1,500,000

Recognize Investment Revenue

Journal Entry – Dec 31, 2023 Debit Credit
Cash 75,000
Dividend revenue 75,000
Lacks Significant Influence (continued)
Adjust • Fair value of Arjent stock: $1,450,000
investments to
fair value December 31, 2023
Security Cost Fair Value FV Adj Bal
Arjent $1,500,000 $1,450,000 $(50,000)

Fair Value Adjustment

Beginning balance 0
Adjustment needed to update fair value ?
$50,000
Balance needed December 31, 2023

Journal Entry – Dec 31, 2023 Debit Credit

Unrealized holding loss—NI 50,000
Fair value adjustment 50,000

Lacks Significant Influence (continued) : Sell the Investment at

$1,446,000 on 1/5/2024…
Step 1. Adjust securities to fair value (2024)
Security Cost Fair Value FV Adj Bal
Arjent $1,500,000 $1,446,000 $(54,000)
Fair Value Adjustment
Beginning balance 1/1/2024 $50,000
?
Balance needed 1/5/2024 $54,000

Journal Entry – Jan 5, 2024 Debit Credit

Unrealized holding loss—NI 4,000
Fair value adjustment 4,000

Step 2. Record the sale

Journal Entry – Jan 5, 2024 Debit Credit
Cash 1,446,000
Fair value adjustment 54,000

Investment in Arjent stock 1,500,000

 When the Investor Has Significant Influence—The
Equity Method

} Significant influence usually is assumed to exist if the

investor owns between 20% and 50% of the investee’s
voting shares
} If more than 50%, the investor has control
} What does significant influence mean?
} Decisions can be swayed in the direction the investor desires
} Investment is accounted for by the equity method

A Single Entity Concept of the equity method

Under the equity method . . .

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.

Affected by further Adjustments

Equity Method—Purchase of Investment
United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash.
Book Value on Arjent’s Fair Value at Time of
Account Financial Statement United’s Investment

Buildings (10-year remaining useful

life, no salvage value) $800,000 $ 2,000,000
Land 700,000 1,000,000
Other net assets 600,000 600,000

Net assets 2,100,000 3,600,000

Goodwill 1,400,000
Total fair value of Arjent = $5,000,000
× 30%
Other information: $1,500,000 purchase
Arjent’s 2023 net income: price
$600,000
Arjent’s 2023 dividends: $250,000
Journal Entry Debit Credit
Investment in Arjent stock 1,500,000
Cash 1,500,000

Equity Method—Recognizing share of the investee’s net

income/loss
Book Value on Arjent’s Fair Value at Time of
Account Financial Statement United’s Investment

Buildings (10-year remaining useful

life, no salvage value) $800,000 $ 2,000,000
Land 700,000 1,000,000
Other net assets 600,000 600,000

Net assets 2,100,000 3,600,000

Goodwill 1,400,000
Total fair value of Arjent = $5,000,000
× 30%
Other information: $1,500,000 purchase
Arjent’s 2023 net income: price
$600,000
Arjent’s 2023 dividends: $250,000
Journal Entry Debit Credit
Investment in Arjent stock 180,000
Investment revenue 180,000
 Equity Method—Receiving dividends
Book Value on Arjent’s Fair Value at Time of
Account Financial Statement United’s Investment

Buildings (10-year remaining useful

life, no salvage value) $800,000 $ 2,000,000
Land 700,000 1,000,000
Other net assets 600,000 600,000

Net assets 2,100,000 3,600,000

Goodwill 1,400,000
Total fair value of Arjent = $5,000,000
× 30%
Other information: $1,500,000 purchase
Arjent’s 2023 net income: price
$600,000
Arjent’s 2023 dividends: $250,000
Journal Entry Debit Credit
Cash 75,000
Investment in Arjent stock 75,000

Equity Method—Adjustments for Additional Depreciation

Book Value of 30% asset
Cost basis of United’s
Account on Arjent’s Financial
Investment
Statement
Buildings (10-year remaining useful
life, no salvage value) $240,000 $600,000
Land 210,000 300,000
Other net assets 180,000 180,000
Net assets 630,000 1,080,000
Goodwill 420,000 (to balance)
Fair value (price) of 30% of Arjent = $1,500,000

Other information:
Arjent’s 2023 net income: $600,000
Arjent’s 2023 dividends: $250,000 (600,000-240,000) ÷ 10 yrs.

Journal Entry Debit Credit

Investment revenue 36,000
Investment in Arjent stock 36,000
 Equity method--No Adjustments for Land or Goodwill
} Land:
} Land is not depreciated
} Difference between the fair value and book value of the
land would not cause higher expenses
} Goodwill:
} Unlike most of the other intangible assets, goodwill is
not amortized
} Acquiring goodwill will not cause higher expenses

Equity Method--Reporting the Investment on the

Balance Sheet

The fair value of the investment shares at the end of the reporting
period is not reported when using the equity method.

The balance of United’s 30% investment in Arjent at December 31,

2023, is calculated as:

Investment in Arjent Stock

Purchase price 1,500,000

Share of income 180,000 36,000 Depreciation adjustment
75,000 Dividends

1,569,000
Equity Method: Mid-Year Adjustment

} When the investment is acquired in mid-year:

} Only recognize the investor’s share of the year’s activity
} Example: If United purchased 30% of Arjent on October 1 and
Arjent reported a $600,000 Income on December 31:
Investment in Arjent Stock

Cost 1,500,000
Share of income
Depreciation adjustment
(3/12 × $180,000) 45,000
9,000 (3/12 × $36,000)
Dividends
18,750 (3/12 × $75,000)

1,517,250