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Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield. Chapter 18: Investments. Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas. Part 1 : Investments in Debt Securities. Accounting Guidelines: History.

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Intermediate Accounting, 10th Edition

Kieso, Weygandt, and Warfield

Chapter 18: Investments

Prepared by

Krishnan Ranganathan, Angelo State University,

San Angelo, Texas


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Part 1 :

Investments

in

Debt

Securities

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Accounting Guidelines: History

  • There are two standards involved: APB No. 18 and SFAS 115.

  • Under APB No. 18: Investments are classified as either short term or long term depending on management’s intent, and

  • Valuation is lower of cost-or-market (LCM)

  • SFAS 115 applies to periods beginning after Dec 15, 1993.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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History: continued ---

  • SFAS 115 applies to the following investments:

  • all investments in debt securities

  • investments in equity securities (with less than 20% of voting stock)

  • APB No. 18 applies to other investments in equity securities with voting stock of 20% or more

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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All debt

securities

transactions

Equity securities,

if they are

20% or more

of voting stock

Equity securities

transactions, if

they are less than 20%

of voting stock

20 to 50%

> 50%

Scopes of APB No.18 and SFAS No. 115

Scope: SFAS 115

Scope: APB No. 18

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Debt Securities

Equity Securities

Trading

Available

for Sale

Held to

Maturity

Available

for Sale

Trading

Investment Categories under SFAS 115

SFAS No. 115

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Equity Method

Consolidations

If 20% to 50%

voting stock

If more than 50%

voting stock

APB No. 118: Scope

APB No. 118

applies to

Equity Securities

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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TRADING

Securities

Available

for Sale

Held-to-

Maturity

Record at

fair value

Record at

fair value

Record at

Amortized cost

M.V.changes

recorded as part

of income

M.V.changes

recorded as other

income or as part

of equity

M.V. changes

not recognized

Debt Securities: Types and Reported Amounts

Debt Instruments representing a

CREDITOR relationship

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Held-to-Maturity Debt Securities

  • The operating entity has both:

  • a positive intent to hold the securities, and

  • the ability to hold them to maturity

  • These securities are accounted for at amortized cost, not fair value.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Available-for-Sale Debt Securities

  • These investments are reported at fair value in the balance sheet.

  • Differences between the fair value and amortized cost are reported as unrealized holding gains and losses (part of equity)

  • When realized, gains and losses in fair value are reported as part of net income

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Trading Securities

  • Trading securities are used to generate profits from short term differences in prices.

  • The holding period is usually less than 3 months

  • The securities are reported at fair value

  • Unrealized gains and losses are reported as part of net income

  • Any discount or premium is not amortized.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Debt Securities: Example

  • Investment in debt security: (Issue at a discount)

  • Cost to investing entity: $ 924,183

  • Par value: $ 1,000,000

  • Discount $ 75,817

  • Effective rate of interest: 10%

  • Stated (contractual) rate: 8%

  • Fair value of security:

  • End of year 1 $1,000,000

  • End of year 2 $ 975,000

  • Compute gains or losses for the three types of debt securities

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Given:Investment in Debt Security

Amortization Schedule (Discount Issue)

Carrying Interest Cash Received Amortized

Value (beg)Revenuefor Interestcost (end)

924,183

924,183 92,418 80,000 936,601

936,601 93,660 80,000 950,262

End of year

Fair

Value

(in mil)

1,000,000

975,000

Effective rate = 10%; Stated Rate = 8%; Par = $1,000,000

Investments in Debt Securities: Example

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Add to Trading

Securities in

balance sheet

Report as income

Investments in Debt Securities: Trading Security

Compute gain: FMV less Acquisition cost

$1,000,000 less $924,183 = $75,817

Securities Fair Value (Trading) 75,817

Unrealized Holding Gain

or Loss - Income 75,817

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Report as part

of equity

Add to Trading

Securities in

balance sheet

Investments in Debt Securities: Available-for-Sale Security (year 1)

Determining Unrealized gain or loss:

FMV end of year 1: $1,000,000

Amortized cost end of year 1 $ 936,601

Unrealized gain (year 1): $ 63,399

Securities Fair Value Adjustment 63,399

Unrealized Holding Gain or Loss 63,399

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Debt Securities: Available-for-Sale Security (year 2)

Determining Unrealized gain or loss:

FMV end of year 2: $ 975,000

Amortized cost end of year 2 $ 950,262

Unrealized gain (year 2): $ 24,738

Unreal. g & L: End of year 1: $63,399 credit

End of year 2: $24,738 credit

Reverse $38661 debit

Unrealized Holding Gain or Loss 38661

Securities Fair Value Adjustment 38661

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Debt Securities: Held-to-Maturity Security

  • No entry is needed for fair value adjustment.

  • Fair value changes are not recognized at balance sheet date

  • Show security at amortized cost

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Debt securities: TRANSFERS between categories

  • Concerns:

  • At what value is the security transferred?

  • How are gains and losses accounted for?

  • What is the effect of the gain/loss accounting on income and equity?

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Transfers between Categories (1 of 4)

Type of Measurement Impact of Impact of

Transfer Basis Transfer on Transfer on

Stockholders’ Equity Net Income

Trading Transferred at Unrealized gains or Unrealized gains or

tofair value to losses at date of losses at date of

Available Available for transfer increase transfer are

for Sale Sale category or decrease recognized in income.

and is the new stockholders’

COST basis equity.

of security

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Transfers between Categories (2 of 4)

Type of Measurement Impact of Impact of

Transfer Basis Transfer on Transfer on

Stockholders’ Equity Net Income

From Transferred at The unrealized The unrealized

Available fair value at the gains or losses at gains or losses at

for date of transfer the date of the date of transfer

Sale and becomes transfer increase is recognized

to the new cost or decrease in income

Trading basis of security stockholders’

equity

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Transfers between Categories (3 of 4)

Type of Measurement Impact of Impact of

Transfer Basis Transfer on Transfer on

Stockholders’ Equity Net Income

From Transferred at Unrealized gains or None

Held fair value at losses at date of

to date of transfer transfer increase or

Maturity decrease a separate

to component of equity

Available

for

Sale

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Transfers between Categories (4 of 4)

Type of Measurement Impact of Impact of

Transfer Basis Transfer on Transfer on

Stockholders’ Equity Net Income

From Transferred at The unrealized gain None

Available fair value at or loss (at date of

for date of transfer transfer) is carried

Sale as a separate

to component of equity

Held and is amortized

to over the remaining

Maturity life of the security

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Part 2 :

Investments

in

Equity

Securities

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Equity Securities

  • Equity securities represent ownership interests such as common, preferred, or other capital stock.

  • They include rights to buy and sell the ownership interests

  • Convertible debt and redeemable preferred stock are not equity securities for this purpose

  • The extent of ownership in common stock by an investor in an investee determines the accounting treatment forequity securities.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Equity Interests: Control

Ownership Percentage

0% 20%50% 100%

Little Significant CONTROL

or none

Level of Influence

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investment in Equity Securities: Available for Sale Securities

  • Securities when acquired are recorded at cost

  • Subsequent to acquisition, the investments are valued and reported at fair value

  • Investor does not recognize its proportionate share of investee’s net income, unless dividends are declared by investee.

  • Unrealized holding gains and losses are reported as:

  • part of comprehensive income, and

  • a component of stockholders’ equity

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investment in Equity Securities: Trading Securities

  • The accounting guidelines are the same as for the available for sale securities.

  • Unrealized gains and losses, however, are reported in net income.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Equity Securities: Equity Method Securities

  • A substantive economic relationship is acknowledged between the investor and the investee

  • The investment’s carrying value is increased by investor’s proportionate share of earnings

  • The investment’s carrying value is decreased by:

  • investor’s proportionate share of losses

  • dividends received by investee

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Absence of Significant Influence by Investor: Examples Securities

  • The FASB has provided examples of cases in which significant influence may not exist:

  • Investee opposes investor’s acquisition of stock

  • Investor surrenders significant shareholder rights

  • Investor is unable to obtain needed financial information from investee

  • Investor is unable to obtain representation on investee’s board of directors

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Investments in Equity Securities: Consolidation Securities

  • A voting interest of more than 50% results in a controlling interest

  • The investor is the parent corporation; the investee is the subsidiary corporation.

  • The investor prepares consolidated financial statements for the parent and the subsidiary

  • The investor accounts for the investment on its books by the equity method

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Ownership in Capital Stock Securities

less than

20% of voting

20 - 50% of

voting

more than

50% voting

Available

for Sale

Equity

method

Equity

method

Consolidation

No

Consolidation

Trading

Fair

value

Fair

value

Investments in Equity Securities: Summary

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Equity Securities: Accounting by Category Securities

Category Valuation Unrealized Holding Other Income

Gains and Losses Effects

<20% Fair value Other income and Dividends and

Avail for sale Equity G & L (sale)

<20% Fair value Net income Dividends;

Trading G & L (sale)

20% - Equity Not recognized Proportionate

50% investee’s inc

>50% Consolidate Not recognized Not applicable

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Derivatives in General Securities

  • Derivatives are financial products, used for risk management

  • They are used primarily for purposes of hedging a company’s exposure to:

  • fluctuations in interest rates,

  • foreign currency exchange rates, and

  • commodity prices.

  • Speculators and arbitrageurs in the derivatives market provide liquidity to the market

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Reporting Derivatives in Financials Securities

  • Derivatives are reported as assets and liabilities and at fair value

  • Derivative gains and losses from speculation must be reported in income.

  • Derivative gains and losses from hedging transactions are reported in different ways, depending upon the type of the hedging transaction.

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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Accounting for Fair Value Hedges Securities

  • The derivative in a qualifying fair value hedge is recorded at fair value in the balance sheet

  • The gains and losses (from adjustment to the hedged fair value) are recorded in income

  • The items hedged also are accounted for at fair value

  • Derivatives from cash hedges are accounted for at fair value.

  • The gains and losses from cash hedges are reported as other comprehensive income (in equity)

Intermediate Accounting, 10th Edition, Ch. 18 (Kieso et al.)


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COPYRIGHT Securities

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.


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