Chapter 12

INVESTMENTS

2008 The McGraw-Hill Companies, Inc.

Slide 2

Nature of Investments
Bonds and notes (Debt securities) Common and preferred stock (Equity securities)

Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

McGraw-Hill /Irwin

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Reporting Categories for Investments

Reporting Categories for Investments Control Characteristics of the Investment Reporting Method Used by the Investor The investor lacks significant influence over the operating and financial policies of the investee: Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at has the "positive intent and ability" to hold to amortized cost.* maturity. Investment held in an active trading account. Trading securities (TS) - investment reported at fair value with unrealized holding gains and losses included in net income. Other. Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and losses excluded from net income and reported in Other Comprehensive income.* The investor has significant influence over the operating and financial policies of the investee: Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for of the voting stock of the investee. subsequent earnings and dividends of the investee.* The investor controls the investee: The investor owns more than 50% of the voting stock of the investee.

Consolidation - the financial statements of the investor and investee are combined as if they are a single company.

* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
McGraw-Hill /Irwin

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Securities to Be Held to Maturity

On January 1, 2009, Matrix, Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%. Lets look at 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%

McGraw-Hill /Irwin 2008 The McGraw-Hill Companies, Inc.

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Securities to Be Held to Maturity

Partial Bond Amortization Table
Period 1 2 3 4

Interest Payment
50,000 50,000 50,000 50,000

Interest Revenue
53,118 53,305 53,503 53,714

Discount Amortization
(3,118) (3,305) (3,503) (3,714)

Unamortized Discount 114,699 111,581 108,276 104,773 101,059

Carrying Value 885,301 888,419 891,724 895,227 898,941

Date 1/1/09

Description Investment in bonds Discount on bond investment Cash Cash Discount on bond investment Investment revenue

Debit 1,000,000

Credit 114,699 885,301

6/30/09

50,000 3,118 53,118

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.

Slide 6

Securities to Be Held to Maturity

How would this investment appear on the balance sheet after one period of discount amortization?
Investment in bonds Less: Discount on bond investment Book value (amortized cost) $ 1,000,000 111,581 $ 888,419

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

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Securities to Be Held to Maturity

On December 31, 2009 after interest is received by Matrix, all the bonds are sold for $900,000 cash.
Period 1 2 3 4 Interest Payment 50,000 50,000 50,000 50,000 Interest Revenue 53,118 53,305 53,503 53,714 Discount Amortization (3,118) (3,305) (3,503) (3,714) Unamortized Discount 114,699 111,581 108,276 104,773 101,059 Carrying Value 885,301 888,419 891,724 895,227 898,941

Date Description 12/31/09 Cash Discount on bond invetment Investment revenue 12/31/09 Cash Discount on bonds investment Investment in bonds Gain on sale of investment
McGraw-Hill /Irwin

Debit 50,000 3,305

Credit

53,305 900,000 108,276 1,000,000 8,276

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Trading Securities
Adjustments to fair value are recorded: 1. in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 2. as a net unrealized holding gain/loss on the Income Statement. Unrealized Gain Unrealized Loss

Income Statement
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Trading Securities
Matrix, Inc. purchased additional securities classified as Trading Securities (TS) at the end of 2009. The fair value amounts for these securities on December 31, 2009, are shown below. Prepare the journal entries for Matrix, Inc. to adjust the securities to fair value at 12/31/09.

Type TS TS

Name Mining, Inc Ford Motor

No. of Unit Total Fair Gain or Shares Cost Cost Value (Loss) 1,000 $ 42.00 $ 42,000 $ 41,000 $ (1,000) 1,500 15.00 22,500 20,000 (2,500) $ (3,500)

Net Unrealized Holding Loss for TS

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Trading Securities

Date 12/31

Description Net unrealized holding gains and losses-IS Fair value adjustment

Debit 3,500

Credit 3,500

The Net Unrealized Holding Loss is reported on the Income Statement.

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Slide 11

Trading Securities
Unrealized holding gains and losses from trading securities are reported on the income statement.
McGraw-Hill /Irwin

Matrix, Inc. Partial Income Statement For the Year Ended 12/31/09 Income from operations Unrealized holding loss Net income

$ 267,500

(3,500) $ 264,000

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Trading Securities
On January 3, 2010, Matrix sold all trading securities for $65,000 cash.
Date 1/3/10 Description Cash Investment in Ford Motor TS Investment in Mining, Inc. TS Gain on sale of investment Fair value adjustment Net unrealized holding gain or loss I/S Debit 65,000 Credit 22,500 42,000 500 3,500 3,500

12/31/10

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.

Slide 13

Securities Available-for-Sale
Adjustments to fair value are recorded: 1. in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 2. as a net unrealized holding gain/loss in Other Comprehensive Income (OCI), which accumulates in Accumulated Other Comprehensive Income (ACOI).

Unrealized Gain

Unrealized Loss

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Other Comprehensive Income

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Other Comprehensive Income (OCI)

Other comprehensive income: Foreign currency translation gains (losses) Net unrealized holding gains (losses) on investments Minimum pension liability adjustment Deferred gains (losses) from derivatives Less: aggregate income tax expense (benefit) Other comprehensive income $ XX,XXX -3,500 XXX XXX

$ XX,XXX X,XXX $XX,XXX

When we add other comprehensive income to net income we refer to the result as comprehensive income.

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Accumulated Other Comprehensive Income

Unrealized holding gains and losses on available-for-sale securities are accumulated in the shareholders equity section of the balance sheet. Specifically, the account is included in Accumulated Other Comprehensive Income.
Net unrealized holding gains and losses.

Shareholders Equity Common Stock Paid-in Capital in Excess of par Accumulated other comprehensive income Retained earnings Total Shareholders Equity
2008 The McGraw-Hill Companies, Inc.

McGraw-Hill /Irwin

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Securities Available for Sale Example

Now assume the same facts for our Matrix, Inc. example, except that the investment is for available-for-sale securities rather than trading securities.

Type Name AFS Mining, Inc AFS Ford Motor

No. of Unit Total Fair Gain or Shares Cost Cost Value (Loss) 1,000 $ 42.00 $ 42,000 $ 41,000 $ (1,000) 1,500 15.00 22,500 20,000 (2,500) $ (3,500)

Net Unrealized Holding Loss for AFS

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Securities Available for Sale Example

Date 12/31

Description Net unrealized holding gains and losses-OCI Fair value adjustment

Debit 3,500

Credit 3,500

This net unrealized holding gain is reported in other comprehensive income.

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Reclassification Adjustment When AFS Investments are Sold

Event Period 1: hold AFS investment and experience net unrealized loss. Effect on Comprehensive Income OCI for unrealized holding loss. OCI to back out previously recognized unrealized holding loss (so effect on OCI over time is zero) Net income for realized loss Effect on Shareholders' Equity AOCI AOCI (so net effect on AOCI over time is zero)

Period 2: sell AFS investment and realize loss on sale

Retained earnings

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.

Slide 19

Securities Available for Sale Example

On January 3, 2010, Matrix sold all available-forsale for $65,000 cash.
Date 1/3/10 Description Cash Investment in Ford Motor TS Investment in Mining, Inc. TS Gain on sale of investment Fair value adjustment Net unrealized holding gain or loss OCI Debit 65,000 Credit 22,500 42,000 500 3,500 3,500

12/31/10

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.

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Other Than Temporary Impairments

This is called an. . .

Occasionally, an investments value will decline for reasons that are other than temporary.

Impairment in Value

McGraw-Hill /Irwin

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Transfers Between Reporting Categories

Transfers are accounted for at fair value on the transfer date.

Unrealized holding gains or losses at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred.

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Transfers Between Reporting Categories

Transfer from: To: Either of the other Trading Trading Either of the other Held-to-maturity Available-for-sale Available-for-sale Held-to-maturity Unrealized Gain or Loss from Transfer at FMV Include in current net income There is none (already recognized in net income) Report as a separate component of shareholders' in OCI. Don't write-off existing unrealized holding gain or loss. Amortize it to net income over the remaining life of
the security.

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.

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Disclosures
Aggregate Fair Value
Gross realized & unrealized holding gains & losses

Maturities of debt securities

Amortized cost basis by major security type

Change in net unrealized holding gains and losses

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Inputs to fair value estimates

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Investor Has Significant Influence

Reporting Categories for Investments Control Characteristics of the Investment Reporting Method Used by the Investor The investor lacks significant influence over the operating and financial policies of the investee: Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at has the "positive intent and ability" to hold to amortized cost.* maturity. Investment held in an active trading account. Trading securities (TS) - investment reported at fair value with unrealized holding gains and losses included in net income. Other. Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and losses excluded from net income and reported in Other Comprehensive income.* The investor has significant influence over the operating and financial policies of the investee: Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for of the voting stock of the investee. subsequent earnings and dividends of the investee.* The investor controls the investee: The investor owns more than 50% of the voting stock of the investee.

Consolidation - the financial statements of the investor and investee are combined as if they are a single company.

* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings. McGraw-Hill /Irwin

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Investor Has Significant Influence

Extent of Investor Influence Lack of significant influence (usually < 20% equity ownership) Significant influence (usually 20% - 50% equity ownership) Has control (usually > 50% equity ownership) Reporting Method Varies depending on classification previously discussed Equity method Consolidation

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What Is Significant Influence?

If an investor owns 20% 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. The presumption can be overcome if : 1. the investee challenges the investors 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. McGraw-Hill /Irwin 2008 The McGraw-Hill Companies, Inc.

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Equity Method and Consolidation

If a company acquires more than 50% of the voting stock of another company: 1. it controls the company acquired (cannot be outvoted). The parent controls the subsidiary.

2.

for accounting purposes, the parent and subsidiary are considered a single reporting entity. Consolidated financial statements combine the separate financial statements of the parent and subsidiary each period into a single aggregate set of financial statements.

the equity method is sometimes referred to as a one line consolidation, because it shows the investors income and investment as increasing by their portion of the investees income. 2008 The McGraw-Hill Companies, Inc. McGraw-Hill /Irwin

3.

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Equity Method
1.

The investment account is increased by:

Original investment cost. Proportionate share of investee's earnings.

2.

The investment account is decreased by:

Dividends received.

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Equity Method
On January 1, 2009, Matrix, Inc. acquired 45% of the equity securities of Apex, Inc. for $1,350,000. On the acquisition date, Apexs net assets had a fair value of $3,000,000. During 2009, Apex paid cash dividends of $150,000 and reported net income of $1,750,000.
What amount will Matrix, Inc. report on the balance sheet as Investment in Apex, Inc.?

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Equity Method
Date 1/1/09 Description Investment in Apex, Inc. Cash Debit 1,350,000 Credit 1,350,000

$ 3,000,000 Fair value of assets 45% Percentage ownership $ 1,350,000 Fair value of assets purchased

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Equity Method
Date 1/1/09 Description Investment in Apex, Inc. Cash Cash Investment in Apex, Inc. Investment in Apex, Inc. Investment revenue Debit 1,350,000 Credit 1,350,000 67,500 67,500 787,500 787,500

12/31/09

$ $

150,000 Dividends paid 45% Percentage ownership 67,500 Share of dividends

$ $
McGraw-Hill /Irwin

1,750,000 Reported earnings 45% Percentage ownership 787,500 Share of earnings

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Equity Method

Investment in Apex, Inc.

Investment 45% Earnings 1,350,000 787,500 67,500 45% Dividends

Reported amount 2,070,000 If the investee had a loss, the investment account would have been reduced.
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Equity Method
On January 1, 2009, Matrix, Inc. purchase 25% of the common stock of Apex, Inc. for $180,000. At the date of acquisition, the book value of the net assets of Apex was $400,000, and the net fair value of these assets is $600,000. During 2009, Apex paid cash dividends of $40,000, and reported earnings of $100,000.

Fair value of assets Percentage ownership Share of fair value of assets Cost of investment in Apex Excess of cost over fair value
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$ 600,000 25% 150,000 180,000 $ 30,000

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Equity Method
Assume that of the $50,000 excess of the fair value of net assets acquired ($600,000 25% = $150,000) over the book value of those net assets on Apexs balance sheet ($400,000 25% = $100,000), 75% is attributable to depreciable assets with a remaining life of 20 years and the remainder is attributable to land. Matrix uses the straight-line method of depreciation on similar owned assets.
Excess of fair value over book value Amount applicable to depreciable assets Share subject to excess depreciation Remaining useful life of assets in years Additional depreciation expense
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$ 50,000 75% 37,500 20 $ 1,875

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Equity Method
Date 1/1/09 Description Investment in Apex, Inc. Cash Cash Investment in Apex, Inc. Investment in Apex, Inc. Investment revenue Investment revenue Investment in Apex, Inc. Debit 180,000 Credit 180,000 10,000 10,000 25,000 25,000 1,875 1,875

12/31/09

$ 40,000 Dividends paid 25% Percentage ownership $ 10,000 Share of dividends

$ 100,000 Reported earnings 25% Percentage ownership $ 25,000 Share of earnings

Remember, goodwill is not amortized.

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Changing From the Equity Method to Another Method

When the investors level of influence changes, it may be necessary to change from the equity method to another method.

At the transfer date, the carrying value of the investment under the equity method is regarded as cost.
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Changing From the Equity Method to Another Method

Any difference between carrying value and fair value is recorded in a valuation account and is recognized as an unrealized holding gain or loss. After the transfer, the investment is treated as a trading security or a security available for sale, depending on managements intent.

McGraw-Hill /Irwin

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Changing From Another Method to the Equity Method

When the investors ownership level increases to the point where they can exert significant influence, the investor should change to the equity method. At the transfer date, the recorded value is the initial cost of the investment adjusted for the investors equity in the undistributed earnings of the investee since the original investment.

Reported earnings Dividends paid = Undistributed Earnings

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Changing From Another Method to the Equity Method

The original cost, the unrealized holding gain or loss, and the valuation account are closed. A retroactive change is recorded to recognize the investors share of the investees earnings since the original investment.

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Fair Value Option

SFAS No. 159 allows companies to use a fair value option for HTM, AFS and equity method investments.
The investment is carried at fair value. Unrealized gains and losses are included in income.

For HTM and AFS investments, this just amounts to classifying the investments as trading. 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. The fair value option is determined for each individual investment, and is irrevocable.
McGraw-Hill /Irwin 2008 The McGraw-Hill Companies, Inc.

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Financial Instruments & Derivatives

Financial Instruments:
1. Cash.
2. Evidence of an

Derivatives:
1. Value is derived from

ownership interest in an entity. 3. Contracts meeting certain conditions.

other securities. 2. Derivatives are often used to hedge (offset) risks created by other investments or transactions

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Other Investments Appendix A

It is often convenient for companies to set aside money to be used for specific purposes. In the short-term, funds may be set aside for 1. Petty cash funds. 2. Payroll accounts.

In the long-run, funds are often set aside to:

1. Pay long-term debt when it comes due. 2. Acquire treasury stock. Special purpose funds set aside for the long-term are classified as investments.
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Appendix 12A Other Investments

It is a common practice for companies to purchase life insurance policies on key officers. The company pays the premium and is the beneficiary of the policy. If the officer dies, the company receives the proceeds from the policy. Some types of policies build a portion of each premium as cash surrender value. The cash surrender value of such a policy is classified as an investment on the balance sheet of the company.

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Appendix 12B Impairment of a Receivable Due to a Troubled Debt Restructuring

When the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor, the new arrangement is referred to as a troubled debt restructuring. Sometimes a troubled debt is settled in full when the debtor transfers assets or equities to the creditor. The creditor usually recognizes a loss on the settlement. Such a settlement is not considered unusual or infrequent and is not an extraordinary item.

McGraw-Hill /Irwin

End of Chapter 12

McGraw-Hill /Irwin

2008 The McGraw-Hill Companies, Inc.