Accounting Clinic III

Prepared by: Nir Yehuda

With contributions by Stephen H. Penman Columbia University

Why do Firms Hold Debt and Equity Securities?

To invest idle funds (usually in debt securities)

As part of their operational plan (usually equity securities)

In an investment portfolio where investments are bought or sold As a permanent investment in affiliates and subsidiaries

Classifying Debt and Equity Securities by their Accounting Treatment

Debt Equity

Held to Maturity Available for Sale Trading

Less than 20% ownership

Available for Sale Trading

Greater than 20% ownership

Go to clinic V

What are Marketable Securities?

Debt securities Equity securities representing less then 20% interest in another corporation For the accounting for equity securities with greater than 20% ownership go to Accounting Clinic V

Classifications of Marketable Securities

Debt securities are classified into one of three categories:
held-to-maturity available-for-sale trading.

Equity securities (representing less then 20% ownership) are classified into one of two categories:
available-for-sale trading.

The appropriateness of the classification should be reassessed at each reporting date.

Held-to-Maturity Debt Securities

Investments in debt securities should be classified as held-to-maturity only if the reporting enterprise has the positive intent and ability to hold those securities to maturity. An enterprise should not classify a debt security as held-to-maturity if it intends to hold the security for only an indefinite period.

Held-to-Maturity Debt Securities The Accounting Rule

Held to maturity are measured at their historical cost. If debt were purchased at a discount or premium over par value, the discount of premium is amortized to the income statement.

The Effective Interest Rate Method

The effective interest rate is the internal rate of return or yield to maturity at the time of issue. Under the effective interest rate method, the interest expense for a period is calculated as the effective interest rate times the bonds book value at the beginning of the period. Thus, under this method, the implied interest rate is constant.

Trading Securities and Available-forSale Securities (both Debt and Equity)

Investments in debt securities (not classified as held-to-maturity) and equity securities that have readily determinable fair values should be classified as either:
Trading available-for-sale

Trading Securities
Securities that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time) should be classified as trading securities. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.

Available-for-Sale Securities
Investments not classified as trading securities (nor as held-to-maturity securities) should be classified as available-for-sale securities.

Reporting Changes in Fair Value Unrealized

Unrealized holding gains and losses for trading securities should be included in earnings. Unrealized holding gains and losses for availablefor-sale securities (including those classified as current assets) should be excluded from net income and reported as a net amount in other comprehensive income within shareholders' equity until realized.

Reporting Changes in Fair Value Realized

Dividend and interest income, including amortization of the premium and discount arising at acquisition, should be included in net income (for all securities). Realized gains and losses should be included in net income (for all securities).

Financial Statement Presentation

An enterprise that presents a classified statement of financial position should report all trading securities as current assets and should report individual held-to-maturity securities and individual available-for-sale securities as either current or noncurrent, as appropriate.

Statement of Cash Flows

Cash flows from purchases, sales, and maturities of available-for-sale securities and held-tomaturity securities should be classified as cash flows from investing activities and reported gross for each security classification in the statement of cash flows. Cash flows from purchases, sales, and maturities of trading securities should be classified as cash flows from operating activities.

Example : Marketable Equity Securities Journal Entries

Alexis Co. purchased 100 common shares of Ball Co. on February 1, 2004, for $500,000. The market value of the shares on December 31, 2004, was $560,000. Alexis Co. sold these shares on June 30, 2005, for $600,000. Give the journal entries to record this transaction assuming:
the shares are classified as trading securities the shares are classified as available for sale securities

If the shares were classified as trading securities

February 1, 2004 Marketable Securities Cash December 31, 2004 Marketable Securities Unrealized Holding Gain on Trading Securities

500,000
500,000

60,000
60,000

The unrealized gain is reported in the income statement

June 30, 2005 Cash Marketable Securities Realized Gain on Sale of Trading Securities

600,000
560,000 40,000

The realized gain is reported in the income statement

If the shares were classified as available for sale securities

February 1, 2004 Marketable Securities 500,000 Cash December 31, 2004 Marketable Securities 60,000 Unrealized Holding Gain on Available for sale Securities 500,000

60,000

The unrealized holding gain is reported in other comprehensive income

June 30, 2005 Cash Marketable Securities Realized Gain on Sale of Trading Securities

600,000 500,000 100,000

The realized gain is reported in the income statement

At December 31, 2005 the security adjustment account had a debit balance of $60,000 ($560,000$500,000). The adjustment entry is as follows: Unrealized Holding Gain on Available for sale Securities Marketable Securities 60,000 60,000

To remove the unrealized gain from shareholders equity.

Example : Different Accounting Treatments for Marketable Equity Securities

Wonder Corporation has the following portfolio of marketable equity securities:
Dividends received 2003 $1,000 1,600 800 $3,400 Market Value on Dec. 31, 2003 $19,000 25,000 12,000 $56,000 Dividends received 2004 $1,200 800 400 $2,400 Market Value on Dec. 31, 2004 $17,500 $17,500 Selling Price on June 30, 2004 $28,500 10,500 $39,000

Cost in
Security A B C 2003 $16,000 20,000 15,000 $51,000

A. Assume that these securities represent trading securities.

How much income would be recognized during 2003 and 2004? How would these securities be presented on the balance sheet on December 31, 2003 and 2004?

B. Assume that these securities represent available for sale securities by Wonder Corporation. How would your answer to part A change?

Solution
A. Trading Securities
Income Statement: Dividend Revenue (the total in the dividend column) Unrealized Holding Gain (Loss): 2003: ($56,000 - $51,000) 2004: ($17,500 - $19,000) Realized Holding Gain $39,000 ($12,000 + $25,000) Balance Sheet: Current Assets: Marketable Securities 2003 2004 $3,400 $2,400

5,000 (1,500) -$8,400 2,000 $2,900

$56,000

$17,500

B. Securities Available for Sale

2003 Income Statement: Dividend Revenue Realized Holding Gain: [$39,000 ($15,000 + $20,000)] $3,400 -$3,400 2004 $2,400 4,000 $6,400

B. Securities Available for Sale

2003 Balance Sheet: Current Assets: Marketable Securities Shareholders Equity: Net Unrealized Holding Gain (Loss) on Securities Available for Sale: ($56,000 - $51,000) ($17,500 - $16,000) 2004

$56,000

$17,500

5,000 --

-(1,500)

Disclosures About Securities

FASB Statement No. 115 requires the following disclosures each period:
The aggregate market value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost for debt securities held to maturity and debt and equity securities available for sale The proceeds from sales of securities available for sale and the gross realized gains and gross realized losses on those sales

Disclosures About Securities

The change during the period in the net unrealized holding gain or loss on securities available for sale included in a separate shareholders equity account The change during the period in the net unrealized holding gain or loss on trading securities included in earnings

Controversy Surrounding the Accounting for Marketable Securities

The accounting for marketable securities has been controversial. The accounting issues are as follows:
Whether to report the investments at historical cost or at market value on the balance sheet date If reported at market value, when to record the gain/loss from the change in market value in the income statement
Each period? Only when the firm disposes of the investments?

Keep in mind
We have seen that there are two measurement basis for recording securities:
Amortized cost Market value

Which method gives us the a better estimate of the value of the securities?

Amortized cost is based on the historical cost measurement rule and avoids manipulation in the financial statements. But historical cost does not capture any change in value since acquisition. Market prices give the change in value since acquisition. But (fair) market values can be biased if market values are estimated. Actual market prices can be bubble prices which are not fair value.