1 Investment in Debt and Equity Securities An electronic presentation by Douglas Cloud by Douglas Cloud Pepperdine University Pepperdine University An.

1

Investment Investment in Debt and in Debt and

Equity Equity SecuritiesSecuritiesAn electronic presentationAn electronic presentation

by Douglas Cloudby Douglas Cloud Pepperdine UniversityPepperdine University

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

chapterchapter 14

2

1. Determine why companies invest in other companies.

2. Understand the varying classifications associated with securities.

3. Account for the purchase of debt and equity securities.

4. Account for the recognition of revenue from investments.

Learning Objectives

ContinuedContinuedContinuedContinued

3

5. Account for the change in value of securities.

6. Account for the sale of investment securities.

7. Record the transfer of securities between categories.

8. Properly report purchases, sales, and changes in value of investment securities in the statement of cash flows.

Learning Objectives


4

9. Explain the proper classification and disclosure of investments in securities.

10. Compare the accounting for securities under U.S. GAAP with the international standard in IAS 39.

Learning Objectives

EXPANDED MATERIAL11. Account for the impairment of a loan

receivable.

5Investment in Debt and Equity Securities—2001

Total Investment Percentage ofTotal Investment Percentage ofCompany (in billions) Total AssetsCompany (in billions) Total Assets

Berkshire Hathaway $69.0 42.4%Microsoft 17.7 34.7Coca-Cola 5.4 24.2Citigroup 160.8 15.3AT&T 24.5 14.8Verizon 10.2 6.0

6Time Line of Business Issues Involved with Investment Securities

DETERMINE purpose of investment

?


CLASSIFY investments

a, b, c


Cloud Corporation

$100 par valuexxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxXxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx.

Cloud Corporation


Good Buy Corporation


PURCHASE securities


Cloud Corporation


Cloud Corporation




EARN AND RECOGNIZE

a return


MONITOR changes in value

Cloud Corporation


Cloud Corporation




+-

+-

+


Cloud Corporation


Cloud Corporation



$10 par valuexxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxXxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx. SELL

securities


Time Line of Business Issues Involved with Investment Securities

TRANSFER securities between

categories

a b c


Time Line of Business Issues Involved with Investment Securities

DISCLOSE status of portfolio at the

end of the period

14Why Companies Invest in Other Companies

Safety Cushion

Cyclical Cash Needs

Investment for a Return


15Why Companies Invest in Other Companies

Purchase for Control

Investment for Influence

16

1. A maturity value, representing the amount to be repaid to the debt holder at maturity.

2. An interest rate that specifies the periodic interest payments.

3. A maturity date, indicating when the debt obligation will be redeemed.

Classification of Investment in Securities

Debt securities typically have the following characteristics:

17

These shares of stock typically carry with them the right to collect dividends and vote on corporate matters.

Equity securities represent ownership in a company.

Equity securities have the potential for significant increases in price.


18

Debt/EquitySecurities

TradingTradingSecurities purchased for salein the near future.

Held-to-Maturity

Held-to-Maturity

Securities purchased with theintent to hold until maturity.

Available-for-sale

Available-for-sale

Securities not classified astrading or held-to-maturity.


19

Available-for-sale

TradingHeld-to-maturity

DebtDebt

Equity Method

EquityEquity


Cost Method

20


These shares of stock typically carry with them the right to

collect dividends and to vote on corporate matters.


These shares of stock typically carry with them the right to

collect dividends and to vote on corporate matters.

Equity Method Securities

21


These are securities purchased with the intent to control or significantly influence the operations of the investee.

These are securities purchased with the intent to control or significantly influence the operations of the investee.

22


At least 20 percent of the outstanding voting stock must

be owned to have this significant influence or control.

At least 20 percent of the outstanding voting stock must

be owned to have this significant influence or control.

Even then, there may be evidence to support the fact

that even a 20 percent investment does not have

significant influence.

Even then, there may be evidence to support the fact

that even a 20 percent investment does not have

significant influence.

23Different Accounting Different Accounting TreatmentsTreatments

Classification of Securities

Types of Securities

Disclosure on the

Balance Sheet

Treatment of Temporary Changes in

Value

Held to maturity Debt Amortized cost Not recognizedAvailable for sale Debt/equity Fair market value Reported in

stockholders’ equity

Trading Debt/equity Fair market value Reported on the income statement

Equity method Equity Historical cost Not recognized adjusted for changes in the assets of the investee

24

Purchases of Debt Securities

On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9%

payable semiannually on January 1 and July 1. The debt securities are classified by the

purchaser as trading securities.

On May 1, Douglas Company purchases $100,000 in U.S. Treasury notes at 104¼, including brokerage fees. Interest is 9%

payable semiannually on January 1 and July 1. The debt securities are classified by the

purchaser as trading securities.

Accrued interest on May 1 is $3,000, calculated as follows:

$100,000 x .09 x 4/12 = $3,000

25


May 1 Investment in Trading Securities 104,250Interest Receivable 3,000

Cash 107,250

Purchase date:

Asset Approach


26


May 1 Investment in Trading Securities 104,250Interest Revenue 3,000

Cash 107,250

Purchase date:

Revenue Approach


27


Receipt of semiannual payment:

July 1 Cash 4,500Interest Receivable 3,000Interest Revenue 1,500

Asset Approach

July 1 Cash 4,500Interest Revenue 4,500

Revenue Approach

28

Purchase of Equity Securities

Purchased 10,000 shares of Dave’s Deli Purchased 10,000 shares of Dave’s Deli common shares at $2 per share.common shares at $2 per share.


Treated as available-for-sale because management has no intention of holding

these securities for a a long period of time and will sell them as soon as it is

economically advantageous

29

Available-for-SaleAvailable-for-Sale

Investment in Available-for- Sale Securities—AB Company 2,000

Cash 2,000


Citty Co. purchased 1,000 shares of AB Citty Co. purchased 1,000 shares of AB Company common shares at $2 per share.Company common shares at $2 per share.Citty Co. purchased 1,000 shares of AB Citty Co. purchased 1,000 shares of AB

Company common shares at $2 per share.Company common shares at $2 per share.

30

Citty Co. purchased 100,000 shares of AB Citty Co. purchased 100,000 shares of AB Company common shares at $2 per share.Company common shares at $2 per share.

Citty Co. purchased 100,000 shares of AB Citty Co. purchased 100,000 shares of AB Company common shares at $2 per share.Company common shares at $2 per share.


Assume that the 100,000 shares purchased represents 20 percent of the

outstanding voting stock of AB Company. This investment gives the investor significant influence over AB

Company.

31



Trading SecuritiesTrading Securities

Investment in Trading Securities— AB Company Common Stock 2,000

Cash 2,000


32

PV of Debt Securities

On January 1, 2004, Silmaril Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable

semiannually on January 1 and July 1. The market rate on bonds of similar quality and

maturity is 8%.

On January 1, 2004, Silmaril Technologies purchased 5-year, 10% bonds with a face value of $100,000 and interest payable

semiannually on January 1 and July 1. The market rate on bonds of similar quality and

maturity is 8%.

33

PV of Debt Securities

Present value of principal:

FV = $100,000; N = 10; I = 4%

$ 67,556Present value of interest payments:

PMT = $5,000; N = 10; I = 4%

40,554Total present value of the bonds

$108,110Investment in Trading Securities 108,100

Cash108,100

34Interest Revenue for Debt Securities (Trading)

When the first interest payment is received from Silmaril, the following

entry would be made:



July 1 Cash 5,000Interest Revenue 5,000

35Interest Revenue for Debt Securities (Held-to-Maturity)





July 1 Cash 5,000Interest Revenue 4,324Investment in Held-to- Maturity Securities 676

$108,110 x .04

36Interest Revenue for Debt Securities (Held-to-Maturity)

When the second interest payment is received, the interest revenue is determined by the yield

times the bond carrying value.

When the second interest payment is received, the interest revenue is determined by the yield

times the bond carrying value.

Jan 1 Cash 5,000Interest Revenue 4,297Investment in Held-to- Maturity Securities 703

$107,434 x .04

37Determining the Appropriate Determining the Appropriate Accounting MethodAccounting Method

0% 20% 50% 100%

No significantinfluence

Significantinfluence

Control

Ownership Percentage

Account for as trading or

available-for-saleEquity method

Equity method and consolidation

procedures


In the absence of persuasive evidence to the contrary,

equity securities are classified as trading or available for sale when ownership is less than

20 percent.

In the absence of persuasive evidence to the contrary,

equity securities are classified as trading or available for sale when ownership is less than

20 percent.

SummarySummary


The equity method is used when ownership is such that the investor has the ability to

significantly influence or control the investee’s operations.

The equity method is used when ownership is such that the investor has the ability to

significantly influence or control the investee’s operations.

SummarySummary


Ownership Interest

Control or Degree of Influence

Accounting Method

Applicable Standard

More than 50% Control Equity method APB Opinion #18and consolidation FASB Exposureprocedures Draft

20% to 50% Significant Equity method APB Opinion #18influence

Less than 20% No Account for as FASB Statementsignificant trading or No. 115influence available for sale

41

AB Company announces dividends of AB Company announces dividends of $0.25 per share. Assume that Citty Co. $0.25 per share. Assume that Citty Co.

owns 1,000 sharesowns 1,000 shares


owns 1,000 sharesowns 1,000 shares

Cash 250Dividend Revenue 250

Revenue for Equity Securities Classified as Trading and AFS

42Revenue for Equity Securities Classified as Trading and AFS


owns 100,000 which represents 50 owns 100,000 which represents 50 percent of the outstanding voting stock.percent of the outstanding voting stock.


owns 100,000 which represents 50 owns 100,000 which represents 50 percent of the outstanding voting stock.percent of the outstanding voting stock.

Cash 25,000Investment in AB Company Stock 25,000

43Revenue for Equity Securities Classified as Trading and AFS

AB Company reports an income of AB Company reports an income of $250,000 for the year. Again, assume $250,000 for the year. Again, assume that Citty Co. owns 50 percent of the that Citty Co. owns 50 percent of the

outstanding voting stock.outstanding voting stock.

AB Company reports an income of AB Company reports an income of $250,000 for the year. Again, assume $250,000 for the year. Again, assume that Citty Co. owns 50 percent of the that Citty Co. owns 50 percent of the

outstanding voting stock.outstanding voting stock.

Investment in AB Company Stock 125,000

Income from Investment in AB Company Stock 125,000

44Equity Method: Purchase For More than Book Value

The net assets of Stewart Inc. was $500,000 at the time Phillips Manufacturing Co.

purchased 40% of the common shares for $250,000 on January 1, 2005. The market

value of the net assets of Stewart Inc. would be $625,000, which is $125,000 more than

the book value. Only $50,000 of this is attributed to depreciable assets.

The net assets of Stewart Inc. was $500,000 at the time Phillips Manufacturing Co.

purchased 40% of the common shares for $250,000 on January 1, 2005. The market

value of the net assets of Stewart Inc. would be $625,000, which is $125,000 more than

the book value. Only $50,000 of this is attributed to depreciable assets.

$250,000 $250,000 ÷ .40÷ .40$250,000 $250,000 ÷ .40÷ .40


The average remaining life of the depreciable assets is 10 years and the

special operating license is to be amortized over 20 years.

The average remaining life of the depreciable assets is 10 years and the

special operating license is to be amortized over 20 years.

Additional depreciation ($50,000 x 0.40)/10 $2,000License amortization ($75,000 x 0.40)/20 1,500

$3,500


Stewart Inc. declared and paid dividends of $70,000 to common stockholders during 2005, and it

reported net income of $150,000 for the year ended December 31, 2005.

Stewart Inc. declared and paid dividends of $70,000 to common stockholders during 2005, and it

reported net income of $150,000 for the year ended December 31, 2005.


Investment in Stewart Inc. Common Stock

Acquisition cost 250,000Share of earnings 60,000

Dividends 28,000Additional depreciation 2,000Additional amortization 1,500

310,000 31,500Balance 278,500

48Accounting for TemporaryChanges in Value of Securities

Classificationof Security

Disclosedat

Report FMV

TradingFair marketvalue

Incomestatement

Held-to-maturity

Amortizedcost

Notrecognized

Available-for-sale

Fair marketvalue

Stockholder’sequity

Change On

49

Eastwood Inc. purchased the following securities on March 23, 2005.

• Trading securities:– Purchase price (Security #1) $ 8,000– Value end of year (#1) $ 7,000– Purchase price (#2) $ 3,000– Value end of year (#2) $ 3,500

• Available-for-sale securities:– Purchase price (#3) $ 5,000– Value end of year (#3) $ 6,100

Accounting for TemporaryChanges in Value of Securities


50

• Available-for-sale securities:– Purchase price (#4) $12,000– Value end of year (#4) $11,500

• Held-to-maturity securities:– Purchase price (#5) $20,000– Value end of year (#5) $19,000



51Accounting for TemporaryChanges in Value of Securities

Investment in Trading Securities 11,000Investment in Available-for-Sale Securities 17,000Investment in Held-to-Maturity Securities 20,000

Cash 48,000

Initial Purchase EntryInitial Purchase Entry


52

December 31, 2005:

Unrealized Loss on Trading Securities 500 Market Adjustment—Trading Securities 500

By the end of the year, the value of By the end of the year, the value of the the trading securitiestrading securities decreased from decreased from

$11,000 to $10,500.$11,000 to $10,500.

By the end of the year, the value of By the end of the year, the value of the the trading securitiestrading securities decreased from decreased from

$11,000 to $10,500.$11,000 to $10,500.



53

December 31, 2005:

Market Adjustment—Available-for-Sale Securities 600

Unrealized Increase/Decrease in Value of Available-for-Sale Securities

600

By the end of the year, the value of By the end of the year, the value of the the available-for-saleavailable-for-sale securitiessecurities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.

By the end of the year, the value of By the end of the year, the value of the the available-for-saleavailable-for-sale securitiessecurities

increased from $17,000 to $17,600.increased from $17,000 to $17,600.


54

FASB No. 115 puts an end to “cherry-picking.”

This is the practice of selectively selling

securities whose prices have increased, while

keeping those that have experienced losses or have maintained their

historical cost.


55

Partial Balance Sheet for Eastwood Inc.Assets

Invest. in trading securities $11,000 Market adjustment—trading sec. (500) $10,500Invest. in available-for-sale sec. $17,000 Market adjustment 600 17,600Invest. in held-to-maturity sec. 20,000$48,100

Stockholders’ EquityAdd unrealized increase in available-for-sale securities $ 600


56

Partial Income Statement for Eastwood Inc.

Other expenses and losses:Unrealized loss on trading

securities $500


57

Sale of Securities

On April 1, 2005, the investment in Silmaril’s debt securities is sold for

$103,000, which includes accrued interest of $2,500. Interest revenue of $2,105

($105,248 x .08 x 3/12) would be recorded. On January 1, the debt securities had a

carrying value of $105,248. The required amortization for the three-months’ premium

between January 1 and April 1 is $395.

On April 1, 2005, the investment in Silmaril’s debt securities is sold for

$103,000, which includes accrued interest of $2,500. Interest revenue of $2,105

($105,248 x .08 x 3/12) would be recorded. On January 1, the debt securities had a

carrying value of $105,248. The required amortization for the three-months’ premium

between January 1 and April 1 is $395.

58

Sale of SecuritiesEntry to record accrued revenue and to amortize premium:Apr. 1 Interest Receivable 2,500

Investment in Held-to Maturity Securities 395Interest Revenue 2,105

Entry to record sale:Apr. 1 Cash 103,000

Realized Loss on Sale of Securities 4,353

Interest Receivable 2,500Investment in Held-to Maturity Securities 104,853

59Transferring SecuritiesBetween Categories

TransferredTreatment of

Change in ValueFrom trading Any unrealized change in value not

previously recognized will be recognized in net income in the current period.

To trading Any unrealized change in value not previously recognized will be recognized in net income in the current period.

From held to maturity to available for sale

Recognize any unrealized change in value in a stockholders’ equity account.



TransferredTreatment of

Change in ValueFrom available for sale to held to maturity

Any unrealized change in value recorded in a stockholders’ equity account is to be amortized over the security’s remaining life using the effective-interest method.

Statement of Financial Standards No. 115, par. 15d

61

Assume:Cost of trading security $3,000Fair market value, end of 2006 3,600Fair market value at transfer

date 3,800

Transferring SecuritiesBetween Categories



Investment in Available-for-Sale Securities 3,800

Market Adjustment--Trading Securities

600 Unrealized Gain on Transfer

of Securities 200

Investment in Trading Securities3,000


Assume:Cost of available-for-sale security

$12,000Fair market value, end of 2006

10,700Transfer from the available-for-sale category to the trading

security category.

Transfer from the available-for-sale category to the trading

security category.


64

Investment in Trading Securities 10,300Market Adjustment--Trading Securities 1,300Unrealized Loss on Transfer

of Securities 1,700Unrealized Increase/Decrease in Value of Available-for- Sale Securities 1,300

Investment in Available-for- Sale Securities 12,000


65

Assume:Cost of held-to-maturity security

20,000Fair market value, Dec. 31, 2006

20,700Record a transfer from held-to-maturity to

the available-for-sale category.

Record a transfer from held-to-maturity to the available-for-sale category.



66

Investment in Available-for- Sale Securities 20,400

Unrealized Increase/ Decrease in Value of Available-for-Sale

Securities400Investment in Held-to-

Maturity Securities 20,000


67

Assume:Cost of available-for-sale

securities$5,000

Fair market value, end of 20066,500

Fair market value at transfer date5,900Record a transfer from available-

for-sale to held-to-maturity.

Record a transfer from available-for-sale to held-to-maturity.



68

Investment in Held-to-MaturitySecurities 5,900

Unrealized Increase/Decrease in Value of Available-for-Sale

Securities 600Investment in Available-for-

Sale Securities 5,000Market Adjustment—

Available-for-Sale Securities 1,500


69Cash Flows from Gains and Losses on Available-for-Sale

Caesh Company began with a $1,000 investment on January 1, 2005.

Cash sales $1,700Cash expenses (1,400)Purchases of investment securities (600)Sale of investment securities (costing $200) 170



The market value of the remaining securities was $500 on December 31, 2005.


Sales $1,700Expenses (1,400

)Operating income $ 300Realized loss on sale of securities (30

) Net income $ 270


Caesh Company will report a $100 unrealized increase in the value of it

available-for-sale portfolio.

This $100 unrealized increase is reported as an increase in

Accumulated Other Comprehensive Income.

This $100 unrealized increase is reported as an increase in

Accumulated Other Comprehensive Income.



The statement of cash flows for Caesh Company for 2005 appear as follows:

Operating activities:Net income $ 270Plus realized loss on sale of securities 30 $ 300

Investing activities:Purchase of investment securities $(600)Sale of investment securities 170 (430)

Financing activities:Initial investment by owner 1,000

Net increase in cash $ 870

73

Classification and Disclosure

• Trading securities– The change in net unrealized holding gain or

loss that is included in the income statement.• Available-for-sale securities

– Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type.

– The proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales and the basis on which cost was determined in computing realized gains and losses.


74

• Available-for-sale securities (continued):– The change in net unrealized holding gain or loss

on available-for-sale securities that has been included in stockholders’ equity during the period.

• Held-to-maturity securities:– Aggregate fair value, gross unrealized holding gains and gross

unrealized holding losses, and amortized cost basis by major security type.

– The company should disclose information about contractual maturities.



75

• Transfers of securities between categories:– Gross gains and losses included in earnings from transfers of

securities from available-for-sale into the trading category.– For securities transferred from held-to-maturity, the company should

disclose the amortized cost amount transferred, the related realized or unrealized gain or loss, and the reason for transferring the securities.


76

The EndThe End

chapter 14

77

1 Investment in Debt and Equity Securities An electronic presentation by Douglas Cloud by Douglas Cloud Pepperdine University Pepperdine University An.

Documents

value of securities

value of investment

sale of investment securities

purchase securities

transfer of securities

purpose of investment

c slide

time line of business