PDF 14 Investments in Debt and Equity Securities - Cengage

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Investments in Debt and Equity Securities

Overview

There are a variety of reasons why companies choose to invest in other companies rather than buy back their own shares or dividend excess cash to shareholders. The accounting for such transactions is frequently as simple as doing basically the opposite of what was done by the company issuing the securities which you learned in the prior two chapters. But there are some major exceptions and issues to be explored.

Based on the kind of security (debt or equity) purchased, the amount of securities held (as a percentage of the available equity securities outstanding in a single company), and the intent with which the security is held, the accounting can defer.

Debt securities can basically be thought of as loaning the issuer money, even when they are purchased on the open market and not directly from the issuer. The number of debt securities held in a single company does not change the accounting, because ownership of the company does not take place by merely loaning money to another company. What can change the accounting with debt securities is intent. Are the held debt securities going to be sold in the near future? Are they not going to be sold in the near future but before maturity? Or are they going to be held until the issuer pays back the face amount? The accounting varies based on which of those three questions gets the "yes."

A similar process is undertaken for equity securities but with an added wrinkle and a key difference. The difference is that equity securities can not be held until maturity because equity securities never mature. There is no fixed date in which a company must buy back common stock from shareholders, unlike the terms with a bond issuance which always have such a date. But there is another question that takes the place of the "Will it be held to maturity?" question, which is, "How much of the other company is owned?" The accounting will differ at three levels: less than 20 percent ownership, 20 percent to 50 percent ownership (significant influence), and over 50 percent ownership (control).

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Significant influence requires the use of the equity method to account for those securities. Control requires consolidated financial statements for the companies. In any event, companies with investments in other companies must disclose significant information about them in notes to the financial statements so that readers of the statements can better understand the composition of the investments listed on the face of them.

Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or "cheat sheet" to the basic concepts and principles that must be mastered.

If after reading this section of the chapter you still don't feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.

The following "Tips, Hints, and Things to Remember" are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 ? Determine why companies invest in other companies.

Why? Companies sometimes have excess cash reserves. These cash surpluses can be planned or mere windfalls from recent operations doing better than expected. Companies then have choices to make. They can dividend the cash to shareholders or they can use the extra cash to support future operations and growth. Sometimes the extra cash isn't immediately needed as the future growth or expansion project is still quarters or years away. Therefore, a company doesn't want to dividend the cash that will be needed or it won't be available when the time comes.

A company doesn't want to just have the cash sit there until it is needed. If the cash is needed in the short term, they may invest the cash into some sort of short-term investment that will yield some interest and cause the cash to grow. However, they may also choose to invest in other companies for the dividends those stocks pay or in the hopes that the stocks will appreciate.

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Finally, a company may be investing in a supplier or a customer with the ultimate objective of controlling the investment's business decisions as well. A significant percentage of the company will likely need to be acquired to meet these ends. That can happen over a short- or long-term purchasing pattern.

LO2 ? Understand the varying classifications associated with investment securities.

How? The following decision flowchart illustrates the steps needed to determine how a security should be classified and reported on the financial statements.

Is it a debt or equity item?

Equity

Will it be sold in the

near future?

(3) Report

Yes changes in value on the

income statement. *

Debt

Is it being held to

maturity?

No

No

(2) Report changes in value in stockholders' equity. *

Yes (1) Report at amortized cost and do not recognize gains or losses for temporary changes in value.

(1) Held-to-maturity securities (2) Available-for-sale securities (3) Trading securities

*Exception: If the investment is in equity securities and more than 20% of the investee company is owned, then the equity method (covered in LO4) is used.

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LO3 ? Account for the purchase of debt and equity securities.

How? Accounting for the purchase of securities is easy if you understand how to account for the issuance of securities. Basically, all that changes here is the entries are flip-flopped. Instead of debiting Cash and crediting a liability or equity account(s), you credit Cash and debit an investment account.

For debt securities purchased on a date other than the date in which interest is paid, interest is also being purchased. You can either debit Interest Receivable or Interest Revenue for the amount of interest that is being obtained with the security. It doesn't matter which so long as you recognize the correct amount of interest revenue for the period between the purchase and the interest receipt by "fixing" the Interest Revenue account balance at the point the cash is owed from the investee.

LO4 ? Account for the recognition of revenue from investment securities.

How? Once again, if you understand the prior chapter on bonds, this learning objective is not difficult. The amount of interest expense that was recognized on bonds by the issuer is going to be the amount of interest revenue recognized on debt securities by the investor.

Under the equity method, the investment account is reduced for dividends received and increased for the portion of income the investee earns multiplied by the ownership percentage. For the second entry, the credit goes to a revenue account which will effectively increase the investor's income and stockholders' equity.

LO5 ? Account for the change in value of investment securities.

How? Held-to-maturity securities are not revalued when they change in value. A gain or loss on these securities takes place only if they are reclassified as "available for sale" or "trading" or if they are actually sold. If they are held to maturity, there will be no gain or loss.

As mentioned in the flowchart on page 14-3, unrealized gains or losses on trading securities are reflected on the income statement (and the investment on the balance sheet is increased/decreased). Unrealized gains or losses on available-for-sale securities are reflected in stockholders' equity with a corresponding increase/decrease in the investment balance.

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LO6 ? Account for the sale of investment securities.

How? When securities are sold, assuming they are sold for an amount different than their book value, an amount is always reported on the income statement. The prior classifications of "available for sale" or "trading" no longer make a difference. Cash (reduced by commissions) receives a debit, the investment is taken off the books with a credit, and the difference is the realized gain or the loss. If the difference is a missing debit, then a loss results. If it is a missing credit, then a gain is recognized. Losses, like expenses, are debits and gains, like revenue, are credits.

LO7 ? Record the transfer of investment securities between categories.

How? Generally, the category in which a security is being transferred to is how it should be recorded. There are two exceptions, as can be seen in Exhibit 14-13 in the textbook. When a security is going from "trading" to another category, any unrealized gains or losses are recognized before the new treatment begins. The second is when a security is going to "held to maturity." The unrealized change in stockholders' equity gets amortized over the time until maturity. In all other situations, previously recognized changes are not reversed or amortized away.

LO8 ? Properly report purchases, sales, and changes in value of investment securities in the statement of cash flows.

How? As you learned in an earlier chapter, the purchase and sale of investment securities are usually investing activities. However, there is one exception: the purchase and sale of trading securities which are considered operating activities.

Unrealized gains and losses do not affect cash and, hence, should not show up in the statement of cash flows. Therefore, if the indirect method is used, gains and losses (both realized and unrealized) should be taken out of net income. The amount of cash that actually went out for a purchase or came in on a sale is what should be reported on the statement of cash flows.

LO9 ? Explain the proper classification and disclosure of investments in securities.

LO10 ? Account for the impairment of a loan receivable.

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