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  1. Investments ACCTG 5120 David Plumlee

  2. Financial Instruments Any contract that • Imposes on a 1st entity on potentially unfavorable terms with 2nd entity an obligation to • deliver cash or other financial instrument to the 2nd entity or • to exchange financial instrument • Conveys to 2nd entity at potentially favorable terms a contractual right to • receive cash or other financial instrument from 1st entity or • to exchange financial instruments

  3. 100% 0% 20% 50% No significant influence Significant influence CONTROL Equity Investments What are the important “ownership” percentages when accounting for an investment in another entity?

  4. 100% 0% 20% 50% cost or fair value (i.e. FASB 115) equity method consolidate Guidelines for Equity Investments How does “ownership percentage” affect accounting for an investment in another entity?

  5. Background - Pre-FASB 115 Prior to FASB 115, what were the concerns about accounting treatment of investments? • Inconsistencies – accounting for debt was either amortized cost orLCM, while equity as LCM • Income manipulation (cherry picking) • BV irrelevant

  6. Scope of FASB 115 To what Investments does FASB 115 apply? • equity securities with no significant influence • debt securities FASB 115 assumes that market value is readily available, what if its is not? Record at cost (equity) or amortized cost (debt)

  7. Classifications Under FASB 115 FASB 115 looks to the intent of management to classify investments, what are the 3 classifications? • Trading securities -- debt or equity securities intended to be actively traded • Held-to-maturity-- debt securities where the entity has both the intent and ability to hold to maturity • Available-for-saleall other debt or equity securities

  8. Held-to-Maturity Securities How are held-to-maturity investments valued on the balance sheet? amortized cost using effective interest method to amortize premium/discount What is considered as income for held-to-maturity investments? Interest including discount/premium amortization; no adjustment for FV

  9. Example - Held to Maturity Jan. 1, 2004: Acme Co. purchases $100,000 face amount, 7% bonds of Olsen Co. for $96,634, and it intends to hold to maturity, Dec. 31, 2007 • Yielding 8% per year when purchased • Interest paid June 30 and December 31 • Acme uses effective interest rate method to amortize discount • FV at December 31, 2004 is $98,000

  10. Journal Entries JE to record purchase at January 1, 2004: held to maturity 96,634 cash 96,634 JE to record income at June 30, 2004: cash (100,000 x 3.5%) 3,500 held to maturity (plug) 365 interest income (96,634 x 4%) 3,865

  11. Journal Entries JE to record income at Dec. 31, 2004: cash (100,000 x 3.5%) 3,500 held to maturity (plug) 380 interest income* 3,880 *(96,634 + 365) x 4% Unrealized gain at 12/31/04 not recorded! fair value 98,000 cost basis 97,379 unrealized gain 621

  12. Available for Sale Securities How are available for sale investments valued on the balance sheet? • Record purchase at cost adjust to fair value at period end • Include unrealized gain/loss in equity not in current year income

  13. Available for Sale Securities What is considered as income for available for sale investments? • Dividend income • Interest received adjusted by premium/discount amortization • Upon sale, realized gains and/or losses proceeds - cost basis

  14. Example - Available for Sale • Jan. 1, 2004: Acme Co. purchases the following: # SharesPriceTotal $ Red Co. stock 5,000 $12 $60,000 Blue Co. stock 1,000 $80 $80,000 • March 1, 2004: $5,000 dividends received from Red. • December 31, 2004 FV: Red Co. ($14 x 5,000) $70,000 Blue Co. ($75 x 1,000) $75,000

  15. Example - Available for Sale • June 15, 2005: 2,500 shares of Red Co. stock sold for $9/share • December 31, 2005 fair values: Red Co. ($9 x 2,500) $22,500 Blue Co. ($78 x 1,000) $78,000

  16. Journal Entries JE to record purchase at January 1, 2004: available for sale 140,000 cash 140,000 JE to record income at March 1, 2004: cash 5,000 dividend income 5,000

  17. Journal Entries December 31, 2004: adjust to FMV fair value 145,000 cost basis -140,000 unrealized gain 5,000 What is the adj. JE? valuation allowance (AFS) 5,000 unreal. gain/loss - B/S 5,000

  18. Calculation for each asset.. Red stock Cost $12/share 60,000 FMV $14/share 70,000 Valuation allowance $10,000 DR Blue stock Cost $80/share 80,000 FMV $75/share 75,000 Valuation allowance $ 5,000 CR Net valuation 5,000 DR

  19. Balance sheet presentation Current assets Investments AFS,at fair value (net) 145,000 PPE etc. XXXX Total AssetsXXX,XXX Total LiabilitiesXXXX Stockholders’ Equity Unrealized gain on AFS securities 5,000 Total stockholders equity XXXX Total Liabilities and S Equity XXX,XXX

  20. Journal Entries JE to record sale of shares at June 15, 2005: sale proceeds (2,500 x $9) 22,500 cost basis (2,500 x $12) 30,000 realized loss on sale (7,500) What is the JE for the sale? cash 22,500 loss on sale 7,500 available for sale 30,000

  21. Journal Entries JE to adjust to FMV at December 31, 2005: fair value 100,500 cost basis (2,500@$12; 1,000@$80)110,000 unrealized loss (9,500) What is the adj. JE? change in valuation allowance: current balance $5,000 debit required balance $9,500 credit unreal. gain/loss - B/S 14,500 valuation allowance (AFS) 14,500

  22. compare compare Calculation for each asset.. Red stock Cost $12/share 30,000 FMV@ 12/31/04 $14/share 70,000 FMV@ 12/31/05 $9/share 22,500 Valuation allowance $ 7,500 CR Blue stock Cost $80/share 80,000 FMV@12/31/04 $75/share 75,000 FMV@ 12/31/05 $78/share 78,000 Valuation allowance $ 2,000 CR Net valuation 9,500 CR

  23. Balance sheet presentation Current assets Investments AFS sec,at fair value (net)100,500 PPE etc. XXXX Total AssetsXXX,XXX Stockholders’ Equity Unrealized gain(loss) on AFS securities (9,500) Total stockholders equity XXXX Total Liabilities and S Equity XXX,XXX

  24. Trading Securities How are Trading Securitiesinvestments valued on the balance sheet? Record purchase at cost adjust to fair value at period end

  25. Trading Securities What is considered as income for Trading Securitiesinvestments? • Dividend income (equity) or interest received (debt) NOT adjusted by premium/discount amortization • Unrealized gains/losses • Upon sale, realized gains and/or losses proceeds - cost basis

  26. Journal Entries The JE are identical to entries for available for sale securities except • Unrealized gains/losses are taken to the income statement • No adjustment to amortize bond discount/premium

  27. Equity method Situations where the investor has “significant influence,” but not control (>20% and < 50% ownership). When do we account for investments using the equity method? What are the important differences in the way we account for these investments? • Dividends paid by investee is recorded as reduction of asset account • Income earned by investee is recorded as income by investor

  28. Journal Entries JE to record purchase at January 1, 2004: Investment in Red Co. 60,000 cash 60,000 JE to record income at March 1, 2004: cash 5,000 Investment in Red Co. 5,000

  29. Investment in Red Co. 15,000 Revenue from investment 15,000 Journal Entries Assume Acme has a 30% ownership and Red’s reported income is $50,000 What is the JE to record Acme’s investment income in 2004? No entry for FMV adjustment!!

  30. Original investment $60,000 Dividends (5,000) Pro Rata Income 15, 000 Balance sheet presentation Current assets Long term investments Inv in Red Co 70,000 PPE etc. XXXX Total Assets XXX,XXX Stockholders’ Equity Total stockholders equity XXXX Total Liabilities and S Equity XXX,XXX

  31. Acme sold 1/2 of its investment in Red Company for $25,000. Equity Method Stock Sale What is the JE to record Acme’s investment sale? Cash 25,000 Loss on sale 10,000 Investment in Red 35,000

  32. Transfers from one category to another How to you account for transfers from Trading to AFS? • FV at date of transfer--new cost basis • Unrealized gains/losses are recognized How to you account for transfers from AFS to Trading? • FV at date of transfer--new cost basis • Unrealized gains/losses are recognized Cannot avoid gains/losses by transferring!

  33. AFS to HTM FV at date of transfer Unrealized gain/loss is amortized over life of security Transfers from one category to another How to you account for transfers from Hold to Maturity to AFS? • FV at date of transfer • Unrealized gain/loss effective at date of transfer How to you account for transfers from AFS to Hold to Maturity?