INVESTMENTS

CHAPTER 17
What you need to know from Ch 17
J/E for purchase/sale +
Accounting Interest Dividends Unrealized Unrealized Realized Net
Gain – Gain – Gain Income
SFVA = 0 SFVA ≠ 0

Bonds
HTM X X
Trading X X X X
AFS X X X X
Equity
Trading X X X X
AFS X X X X
Equity X X X
 I expect to ask questions about these 10 topics
Quiz 2 has 10 questions
1. JE| Purchase HTM security/record interest revenue
2. JE| Unrealized holding gain/loss bond
3. JE | Unrealized holding gain/loss equity
4. Calculate realized gain on income statement year 2
5. JE | Securities Fair Value Adjustment year 2
6. End of year carrying value of equity method security
7. Transfer between categories
8. Impairment of AFS securities
9. Fair Value Option
Homework Practice problems
Exercise
◦ E17-3
◦ E17-4
◦ E17-6
◦ E17-11
◦ E17-21
◦ E17-22

No derivatives
Two types of securities
Three accounting methods each
Investments in Debt
◦ HTM
◦ Trading
◦ AFS

Investments in Equity
◦ Trading
◦ AFS
◦ Equity Method
Debt Securities
The accounting treatment for debt depends how the firm classifies it.

◦ Held-to-Maturity
◦ Positive intent to hold to maturity
◦ Ability to hold to maturity
◦ Trading Securities
◦ Held primarily for sale in near term (financial institutions)
◦ Available for Sale
◦ Not held-to-maturity or trading security
Accounting Rules to Know
To account for each security you need to know appropriate way to
1. Value (on balance sheet)
2. Account for unrealized changes in value
3. Account for interest
4. Account for gain or loss on disposal of the asset

Make sure you know how to account for each of these 4 things for every security
Held-to-Maturity
o Equity has no maturity, does not qualify

o Intend to hold security to maturity

o Ability to hold to maturity

o Valued at (amortized) historical cost

o Changes in market value are ignored
o Interest revenue is recognized each period
Example buy debt security at par
On January 1, 2016 D co. purchased at par a 12% bond having a maturity value of $300,000.
They are dated January 1, 2016, and mature January 1st 2021, with interest paid on January 1st of
each year starting in 2017. These bonds are classified as held to maturity.

Journal entry to purchase the bond

Debt Investments 300,000
Cash 300,000
Held to Maturity bond at par
Record Interest for 2016.

Record receipt of interest on January 1st 2017

Zebart – HTM bond at premium
On January 1, 2016 Zebart a 8% bond having a market value of $1,054,172 and a face value of
1,000,000. The bond is dated January 1, 2016, and mature January 1st 2019, with interest paid
on July 1st and January 1st of each year starting 7/1/2016. These bonds are classified as held to
maturity. The effective interest rate is 6%.

Journal entry to purchase the bond

Zebart – HTM bond at premium
Record Interest receipt for July 1st 2016.
 Zebart – HTM bond at premium
Record Interest for December 31st 2016.

Debt Investments
Zebart – HTM bond at premium
Using the Zebart example, Suppose that interest rates change so that by the end of 2016 the
bond has a market value of 1,010,000.

How does Zebart account for the change in value and how does it affect the balance sheet?
Investment in debt securities –
Available for Sale
◦ When an investment is held not primarily for trading and not held to maturity
it is classified as Available for Sale
◦ Mark to Market Accounting

◦ Interest revenue recorded as income when it is earned

◦ Unrealized gains and losses recorded in Accumulated OCI account

◦ Securities Fair Value Adjustment
Investment in debt securities –
Available for Sale
On January 1st 2019, Elvis purchases a $1,000,000, 5 year 6% bond for
$1,043,295, yielding 5% . The bond pays interest on December 31st of each year.
Elvis intends to sell the bond if interest rates fall.
What is the J/E to record the purchase of the bond
 Investment in debt securities –
Available for Sale
What is the J/E necessary to record interest on December 31st 2019?

if the EOY market value is $1,072,598 (4% market rate of interest)?

1,043,295
What about interest expense in next year?
The bonds should be carried in the books at fair market value for bonds that are
held as trading securities. However, interest should be accounted for as though
the bond is required to be shown on the basis of amortized cost. The premium
paid or discount realized on purchase of the bond should be amortized over the
remaining life of the bond on a yield-to-maturity basis. Such an amortized
premium or discount is added with the interest on the one hand and held
separately in a mark-to-market account on the other. (from text book on
accounting for investments)
 Investment in debt securities –
Available for Sale
On January 1st 2020 Elvis sold the bond for $1,082,000

On balance sheet date, we have a securities fair value adjustment account but no
securities.

1,043,295 Securities Fair Value Adjustment

Available for Sale – debt example 2
On January 1st 2019, Elvis purchases a $100,000, 5 year 8% bond for $92,418, yielding 10% .
The bond pays interest on December 31st of each year. Elvis intends to sell the bond if
interest rates fall.
What is the J/E to record the purchase of the bond
What is the J/E necessary to record interest on December 31st 2019?

if the market value is $90,693 (11% market rate of interest)?

Trading Securities
92,418
Available for Sale – debt example 2
Suppose the firm sells the security for 90,100?

At end of year we test for the appropriate value for the securities fair value adjustment. We have sold
all the securities so it needs to have a zero balance.
Investment in Debt - Trading Securities
Trading Securities are held primarily for sale. Lots of trading.
◦ Day trader would classify his securities as trading securities
◦ Generally held less than 3 months

Interest revenue recorded as income when it is earned

Unrealized gains and losses go into Net Income

◦ This is the only way in which the accounting for trading securities differs from
available for sale securities.
Trading securities - discount
On January 1st 2017, Elvis purchases a $100,000, 5 year 8% bond for $92,418,
yielding 10% . The bond pays interest on December 31st of each year. Elvis
intends to sell the bond if interest rates fall.
What is the J/E to record the purchase of the bond
 What is the J/E necessary to record interest on December 31st 2017?

if the market value is $90,693 (11% market rate of interest)?

Trading Securities
92,418
Investments in Equity Securities
3 types of accounting, depending on how much of the security you own

◦ Fair Value Method

◦ Trading securities
◦ Available for Sale securities
◦ Equity Method
◦ Consolidated statements
Fair Value Method
Available for Sale

Trading
 2017 balance sheet
Stockholders equity
Paid in capital xxx
Retained Earnings xxx
Fair Value Method Example 1 Accumulated OCI <10,000>

1/1/2017 Jade Serpent INC. purchases $500,000 of Target Company shares which is less
than 20% of Target Company's common stock. Jade classifies the security as an available for
sale security

Available for Sale Securities

End of year the security is worth 490,000

 2018 balance sheet
Stockholders equity
Paid in capital xxx
Retained Earnings xxx
Fair Value Method Example 1 (continued) Accumulated OCI 0

On January 3rd 2018, Jade Serpent sells all shares of Target company for
490,000. The price of Target companies stock has not changed since the
end of Jade’s fiscal year end. Jade records the sale as follows.

At end of the year we test for difference between cost and

fair value of our AFS securities. Should be zero.
Unrealized holding gain/loss - OCI
EOY 2017 10,000
4 Winds Company has the following Trading securities on the books
as of December 31st 2017. These shares were all purchased in 2017
Cost Fair Value
1,500 Shares G - Common $ 73,500 $ 69,000
5,000 Shares W - Common 180,000 175,000
400 Shares M - Preferred 60,000 61,600

Total $313,500 $305,600

What is the end of the year adjusting Entry?

Trading securities
On March 1st 2018, the 4 Winds sold 1,500 shares of G at $45, less fees of $200

On April 1st 2018, the 4 Winds purchased 700 shares of E – common at @$75 + fees of $300
Trading securities
End of the 2018 adjusting entry
Cost Fair Value
Securities
5,000 Shares W - Common 180,000 175,000 Fair Value ADJ
700 Shares E - Common 52,800 50,400
400 Shares M - Preferred 60,000 61,600
7,900
Total $292,800 $287,000
Transfer between categories
From To Earnings recognition of prior
period unrealized gains and
losses
Trading Any Already recognized
Not Revised
Any Trading If not already recognized

HTM AFS Unrealized Gain/Loss

Recognized in OCI
AFS HTM Amounts in OCI not reversed
but are amortized in same was
as premium or discount
Equity Method 20 – 50% ownership
When a firm A (call A the investor) owns between 20 and 50% of firm B (call B the
target), A has significant influence on B but not control.

Normal accounting for the investor (A) is the Equity Method

◦ Investor recognizes proportionate share of earnings
◦ Target’s earnings increase the carrying value of the investment
◦ Target’s losses and dividends reduce the carrying value of the investment.

20% is the cutoff

◦ For GAAP this is 20% of shares outstanding
◦ For IFRS this is 20% of shares outstanding + exercisable potential shares
Equity Method
Investors proportionate share of income and loss are recognized as increase or decrease in
asset value.

Example – X co buys 30% of Z company for 180,000. During the year Z earned net income
of $80,000 and paid $20,000 of dividends.

JE for purchase
Equity Method
Received dividends

Z has 80,000 of net income

Fair Value vs. Equity method Example
Fair Value Method - AFS
Make appropriate journal entries assuming that the securities are AFS

On December 31st 2015, X acquired 50,000 shares (20%) of Z for $1,200,000.

Z paid a cash dividend of 0.85 per share on Jun 30th and December 31st of 2016.
Fair Value vs. Equity method Example
Fair Value Method
Z reported net income of $730,000 for 2016.

The fair value of Z’s stock was $27.00 on December 31st 2016.
Fair Value vs. Equity method Example
Equity Method
Make appropriate journal entries assuming that the Equity method is used

On December 31st 2015, X acquired 50,000 shares (20%) of Z for $1,200,000.

Z paid a cash dividend of 0.85 per share on Jun 30th and December 31st of 2016.
Fair Value vs. Equity method Example
Equity Method
Z reported net income of $730,000 for 2016.

The fair value of Z’s stock was $27.00 on December 31st 2016.
What shows up on the 2016 Balance sheet for each of these methods?

Fair Value method Equity method

Available-for-Sale Securities
Including FV adjustment Investment in Z
Purchase
Dividend
Dividend
FV Adj.
Z’s Income
Adjustments under equity method
When price of investment is higher than the target company’s book value of net assets further
adjustments may be needed.
◦ This is an attempt to approximate the income that would have been reported if we had consolidated
financial statements.
◦ “Amortizing the Deferential”
◦ Amortize the difference between the price paid and the book value of the investment.
Amortizing the deferential
The Tillers guild buys 30% of X company for $1,500.
The fair value of X companies net assets is $1,080
Book value of X companies net assets is $630

Investee net Net assets Difference

purchased attributed to
Assets
Cost 5,000 x 30% 1,500 420
Good will
Fair Value 3,600 x 30% 1,080
of Net Assets
Book value of 300
Buildings too
low by
Book Value 2,100 x 30% 630 Land too low by 150
Amortizing the deferential
When X calculates NI it uses book value of assets in its depreciation. But Tillers needs
to use fair value.
If historical cost of X’s buildings is too low by 1,000 and Tillers owns 30% then Tillers
needs to depreciate an additional 300 over the useful life of the assets.
With a useful life of 10 years Tillers needs to record an additional 300/10=30 of
depreciation each year.

No adjustment for good will or land.

CPA exam question – Equity method
S buys 40% of A on 1/2/1 for 400,000. Carrying value of net assets at date of purchase
totaled 900,000. Fair value of carrying amounts were same except for plant and
inventory, for which fair value exceeded their carrying amounts by 90,000 and 10,000,
respectively. Plant has an 18 year life. All inventory is sold in year 1. During Year 1, A
reports net income of 120,000 and paid 20,000 cash dividend.
a. What amount should S report on its income statement from its investment in A for
12/31/1 if it does not elect fair value option.
b. What amount should S report on its 12/31/1 balance sheet for its investment in A.
Investment Income
A’s Net income
Extra Deprecation
Extra COGS
Investment income =

Book value
Investment in A
Amortization of deferential
A’s NI
A’s Divined
EOY Book value of investment
Fair Value Option
Firms have the option to record most securities at fair value.
◦ At each balance sheet date the affected financial assets are marked to market
◦ All changes in value for these securities affect net income.

◦ The option must be made at the date of purchase

◦ If a firm chooses the fair value option for AFS securities or Held to Maturity securities all changes in
market value are run through the income statement.
Equity or fair value?
Dublin Company holds a 30% stake in Club Company which was purchased in 2015 at a cost of
$3,000,000. After applying the equity method, the Investment in Club Company account has a
balance of $3,040,000. At December 31, 2015 the fair value of the investment is $3,120,000.
Which of the following values is acceptable for Dublin to use in its balance sheet at December
31, 2015?
I. $3,000,000
II. $3,040,000
III. $3,120,000

If the firm choose the fair value option what is the end of the year JE?
Equity method simple
On January 1st 2012, Warsong Lumber acquired 5,000 shares (30%) of Silverwing common stock
for $10,000, giving Warsong significant influence. In 2012, Silverwing declared and paid a $0.30
per share dividend and reported $500 of net income. On 12/31/2012 Silverwing common
traded for $2.50 per share.

The carrying value for the investment in Silverwing on Warsong’s 2012 balance sheet is.
◦ Revenue =

◦ Carrying value of investment =

Equity method with amortization
On January 1st 2012, Warsong Lumber acquired 5,000 shares (40%) of Silverwing common stock for
$10,000, giving Warsong significant influence. At that time, the book value of Silverwing’s net assets was
$20,000 and the fair value was 25,000. The difference between the fair value and the book value of
Silverwing’s net assets is attributable to PPE with and useful life of 4 years. In 2012, reported $15,000 of
net income. On 12/31/2012 Silverwing common traded for $2.50 per share.

Investment revenue
Impairment
Each balance sheet date the firm must determine weather its investments have suffered an
impairment that is “other than temporary”

If there is an impairment then the firm writes down the cost basis of the security to its fair value.
This is treated as a realized loss (which means it is recognized on income statement) and can
happen under any accounting method.
Consolidation
When a firm has a controlling interest in a subsidiary and owns more than 50% the financial
statements of the two firms are consolidated.

This can be quite complicated and is not a topic for intermediate accounting.
Equity method - Simple
On 1/1/2016, Windrunner Enterprises pays $1,000,000 to purchase 25% of
Silverpine logging. On 6/30/2016 Silverpine pays a $300,000 dividend. What
journal entry will Windrunner make on that date?
Equity method – w/ amortization
On 1/1/2016, Windrunner Enterprises pays $1,000,000 to purchase 25% of Silverpine logging.
The book value of Silverpine’s net assets was 3,800,000 and the fair market value of the net
assets was 4,000,000. All of the difference was attributable to inventory that will be sold in
2016. Silverpine reports net income of 300,000 in 2016. What journal entries are required for
windrunner at the end of the year?
Equity method – w/ amortization
On 1/1/2016, Windrunner Enterprises pays $1,000,000 to purchase 25% of Silverpine logging.
The book value of Silverpine’s net assets was 3,800,000 and the fair market value of the net
assets was 4,000,000. All of the difference was attributable to PPE with a 5 year useful life.
Silverpine reports net income of 300,000 in 2016. What journal entries are required for
windrunner at the end of the year?
Equity method – w/ amortization
On 1/1/2016, Windrunner Enterprises pays $1,000,000 to purchase 25% of Silverpine logging.
The book value of Silverpine’s net assets was 3,700,000 and the fair market value of the net
assets was 3,900,000. All of the difference was attributable to PPE with a 5 year useful life.
Silverpine reports net income of 300,000 in 2016. What journal entries are required for
Windrunner at the end of the year?