Chapter three

Investments
3.1. Nature and classification of investment

Investments

Different motivations for investing:

 To earn a high rate of return.
 To secure certain operating or financing arrangements with another company.
Companies account for investments based on the type of security (debt or equity) and their intent
with respect to the investment.

3.2 Accounting for debt investment

Debt investments are characterized by contractual payments on specified dates of principal and
interest on the principal amount outstanding. Companies measure debt investments at amortized

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cost if the objective of the company’s business model is to hold the financial asset to collect the
contractual cash flows (held-for-collection).
Amortized cost is the initial recognition amount of the investment minus repayments, plus or
minus cumulative amortization and net of any reduction for uncollectiblity. If the criteria for
measurement at amortized cost are not met, then the debt investment is valued and accounted for
at fair value. Fair value is the amount for which an asset could be exchanged between
knowledgeable willing parties in an arm’s length transaction.
Types of debt securities include:
 U.S. government securities
 Municipal securities
 Corporate bonds
 Convertible debt
 Commercial paper

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Types of debt based on accounting category
 Held – to – maturity securities
 Trading securities
 Available-for-sale securities
Debt Investments—Amortized Cost
Only debt investments can be measured at amortized cost
Example: To illustrate the accounting for a debt investment at amortized cost, assume that
Robinson Company purchased €100,000 of 8 percent bonds of Evermaster Corporation on
January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020, and yield 10
percent; interest is payable each July 1 and January 1. Robinson records the investment as
follows.
January 1, 2015
Debt Investments 92,278
Cash 92,278
Schedule of Interest Revenue and Bond Discount Amortization— Effective-Interest Method

Robinson records the receipt of the first semiannual interest payment on July 1, 2015
July 1, 2015
Cash 4,000
Debt Investments 614

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 Interest Revenue 4,614
Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at
December 31, 2015, as follows.
December 31, 2015
Interest Receivable 4,000
Debt Investments 645
Interest Revenue 4,645

Accounting for Debt Securities by Category

1. Held –to- maturity securities-

Classify a debt security as held-to-maturity only if it has both the positive intent and the ability to

hold securities to maturity. Accounted for at amortized cost not fair value. Amortize premium or
discount using the effective-interest method unless the straight – line method – yields a similar
result.
Example (Held – to – Maturity Securities) On January 1, 2006, Hi and Lois Company
purchased 12% bonds, having a maturity value of $300,000, for $322,744. The bonds provide the
bondholders with a 10% yield. They are dated January 1, 2006, and mature January 1, 2011, with
interest receivable December 31 of each year. Hi and Lois Company uses the effective-interest

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method to allocate unamortized discount or premium. The bonds are classified in the held – to –
maturity category.
Instructions (a) Prepare the journal entry at the date of the bond purchase.
January 1, 2006:
Held – to – Maturity Securities 322,744
Cash 322,744
(b) Prepare a bond amortization schedule.

(c) Prepare the journal entry to record the interest received and the amortization for 2006 &
2007.
December 31, 2006:
Cash 36,000
Held – to – Maturity Securities 3,726
Interest Revenue 32,274
December 31, 2007:
Cash 36,000
Held – to – Maturity Securities 4,098
Interest Revenue 31,902
Available – for – Sale Securities
Companies report available – for – sale securities at fair value, with unrealized holding gains and
losses reported as part of comprehensive income (equity).

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For available for sale securities any discount or premium is amortized.
Example - (Available – for – Sale Securities) assume the same information as in Example above
except that the securities are classified as available-for-sale. The fair value of the bonds at
December 31 for 2006 and 2007 is $320,500 and $309,000, respectively.

Instructions
Prepare the journal entry at date of bond purchase.
January 1, 2006:
Available – for – Sale Securities 322,744
Cash 322,744
Prepare the journal entries to record the interest received and recognition of fair value for 2006.
December 31, 2006:
Cash 36,000
Available – for – Sale Securities 3,726
Interest Revenue 32,274
Securities Fair Value Adjustment – AFS 1,482
Unrealized Holding Gain/Loss 1,482
($320,500 – $319,018 = $1,482)
Prepare the journal entry to record recognition of fair value for 2007.
December 31, 2007:

Unrealized Holding Gain/Loss 7,402

Securities Fair Value Adjustment – AFS 7,402

If company sells bonds before maturity date:

Must make entry to remove the,
 Cost in Available – for – Sale Securities and

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  Securities Fair Value Adjustment accounts.
Any realized gain or loss on sale is reported in the “Other expenses and losses” section of
the income statement.
2. Trading securities
Companies report trading securities at fair value, with unrealized holding gains and losses
reported as part of net income.
Like held –to- maturity debt securities any discount or premium is amortized.
Example (Trading Securities) Pete Sampras Corporation purchased trading investment bonds
for $40,000 at par. At December 31, Sampras received annual interest of $2,000, and the fair
value of the bonds was $38,400.
Instructions
(a) Prepare the journal entry for the purchase of the investment.
(b) Prepare the journal entries for the interest received.
(c) Prepare the journal entry for the fair value adjustment.
Solution
(a).Trading securities 40,000

Cash 40,000
(b).cash 2,000
Interest revenue 2,000
(c). Unrealized Holding Loss – Income 1,600
Securities Fair Value Adj. – Trading 1,600
3.3. Accounting for equity investment
An equity investment represents ownership interest, such as ordinary; preference, or other capital shares.
It also includes rights to acquire or dispose of ownership interests at an agreed-upon or
determinable price, such as in warrants and rights. The cost of equity investments is measured at
the purchase price of the security. Broker’s commissions and other fees incidental to the
purchase are recorded as expense.
The degree to which one corporation (investor) acquires an interest in the shares of another
corporation (investee) generally determines the accounting treatment for the investment
subsequent to acquisition. The classification of such investments depends on the percentage of
the investee voting shares that is held by the investor:
1. Holdings of less than 20 percent (fair value method)—investor has passive interest.

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2. Holdings between 20 percent and 50 percent (equity method)—investor has significant
influence.
3. Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.
Accounting and Reporting for Equity Investments by Category

Investments in Equity Securities

Holding less 20% ownership

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When an investor has an interest of less than 20 percent, it is presumed that the investor has little
or no influence over the investee. Under IFRS, the presumption is that equity investments are
held-for-trading. That is, companies hold these securities to profit from price changes. As with
debt investments that are held-for-trading, the general accounting and reporting rule for these
investments is to value the securities at fair value and record unrealized gains and losses in net
income (fair value method).However, some equity investments are held for purposes other than
trading. For example, a company may be required to hold an equity investment in order to sell its
products in a particular area. In this situation, the recording of unrealized gains and losses in
income, as is required for trading investments, is not indicative of the company’s performance
with respect to this investment. As a result, IFRS allows companies to classify some equity
investments as non-trading. Non-trading equity investments are recorded at fair value on the
statement of financial position, with unrealized gains and losses reported in other comprehensive
income.

* Securities are reported at cost. Dividends are

recognized when received and gains or losses only
recognized on sale of securities.

Because equity securities have no maturity date,

companies cannot classify them as held – to – maturity.
Example Loxley Company has the following portfolio of securities at September 30, 2007, its
last reporting date.

On Oct. 10, 2007, the Fogelberg shares were sold at a price of $54 per share. In addition, 3,000
shares of Los Tigres common stock were acquired at $59.50 per share on Nov. 2, 2007. The Dec.
31, 2007, fair values were: Petra $96,000, Los Tigres $132,000, and the Weisberg common
$193,000.
Prepare the journal entries:

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To record the sale, purchase, and
Adjusting entries related to the trading securities in the last quarter of 2007.

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Portfolio at September 30, 2007:

Solution
October 10, 2007 (Fogelberg):
Cash (5,000 x $54) 270,000
Trading securities 225,000
Gain on sale 45,000
November 2, 2007 (Los Tigres):
Trading securities (3,000 x $59.50) 178,500
Cash 178,500
Portfolio at December 31, 2007

 How would the entries change if the securities were classified as available – for – sale?
The entries would be the same except that the
Unrealized Holding Gain or Loss – Equity account is used instead of Unrealized Holding
Gain or Loss – Income.

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 The unrealized holding loss would be deducted from the stockholders’ equity section rather
than charged to the income statement.
Holdings Between 20% and 50%
An investor corporation may hold an interest of less than 50 percent in an investee corporation and thus
not possess legal control. However, an investment in voting shares of less than 50 percent can still give an
investor the ability to exercise significant influence over the operating and financial policies of an
investee. t. Significant influence may be indicated in several ways. Examples include representation on
the board of directors, participation in policy-making processes, material intercompany transactions,
interchange of managerial personnel, or technological dependency. Another important consideration is the
extent of ownership by an investor in relation to the concentration of other shareholdings. To achieve a
reasonable degree of uniformity in application of the “significant influence” criterion, the profession
concluded that an investment (direct or indirect) of 20 percent or more of the voting shares of an investee
should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to
exercise significant influence over an investee. In instances of “significant influence” (generally an
investment of 20 percent or more), the investor must account for the investment using the equity method.
Equity Method
Under the equity method, the investor and the investee acknowledge a substantive economic
relationship. The company originally records the investment at the cost of the shares acquired but
subsequently adjusts the amount each period for changes in the investee’s net assets. That is, the
investor’s proportionate share of the earnings (losses) of the investee periodically increases
(decreases) the investment’s carrying amount. All dividends received by the investor from the
investee also decrease the investment’s carrying amount. The equity method recognizes that the
investee’s earnings increase the investee’s net assets, and that the investee’s losses and dividends
decrease these net assets.
Example (Equity Method) On January 1, 2007, Pennington Corporation purchased 30% of the
common shares of Edwards Company for $180,000. During the year, Edwards earned net income
of $80,000 and paid dividends of $20,000.
Instructions
 Prepare the entries for Pennington to record the purchase and any additional entries related to
this investment in Edwards Company in 2007.
Investment in Stock 180,000
Cash 180,000

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Investment in Stock 24,000
Investment Revenue (80,000*30%) 24,000
Cash 6,000
Investment in Stock (20,000*30%) 6,000
Holdings of More Than 50%
When one corporation acquires a voting interest of more than 50 percent in another corporation,
it is said to have a controlling interest. In such a relationship, the investor corporation is referred
to as the parent and the investee corporation as the subsidiary. Companies present the investment
in the ordinary shares of the subsidiary as a longterm investment on the separate financial
statements of the parent. When the parent treats the subsidiary as an investment, the parent
generally prepares consolidated financial statements. Consolidated financial statements treat the
parent and subsidiary corporations as a single economic entity. (Advanced accounting courses
extensively discuss the subject of when and how to prepare consolidated financial statements.)
Whether or not consolidated financial statements are prepared, the parent company generally
accounts for the investment in the subsidiary using the equity method.
Financial Statement Presentation
Report trading securities at aggregate fair value as current assets.
Report held – to – maturity and available – for – sale securities as current or noncurrent.
 Aggregate fair value, gross unrealized holding gains, gross unrealized losses, amortized cost
basis by type (debt and equity), and information about the maturity of debt securities.
Disclosures Required under the Equity Method
 Name of each investee and percentage ownership.
 Accounting policies of the investor.
 Difference between amount in the investment account and amount of underlying equity in the
net assets of the investee.
 The aggregate value of each identified investment based on quoted market price (if
available).
 When material, present information concerning assets, liabilities, and results of operations of
the investees.

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 3.4. Impairment value
A company should evaluate every held-for-collection investment, at each reporting date, to determine if
it has suffered impairment—a loss in value such that the fair value of the investment is below its carrying
value. For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor
may suffer a permanent loss. If the company determines that an investment is impaired, it writes down the
amortized cost basis of the individual security to reflect this loss in value. The company accounts for the
write-down as a realized loss, and it includes the amount in net income. For debt investments, a company
uses the impairment test to determine whether “it is probable that the investor will be unable to collect all
amounts due according to the contractual terms.” If an investment is impaired, the company should
measure the loss due to the impairment. This impairment loss is calculated as the difference between the
carrying amount plus accrued interest and the expected future cash flows discounted at the investment’s
historical effective-interest rate.
Note that impairment tests are conducted only for debt investments that are held-for-collection
(which are accounted for at amortized cost). Other debt and equity investments are measured at
fair value each period; thus, an impairment test is not needed.
Example: Impairment Loss
At December 31, 2014, Mayhew Company has a debt investment in Bao Group, purchased at par
for ¥200,000 (amounts in thousands). The investment has a term of four years, with annual
interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate
is 10 percent). This debt investment is classified as heldfor-collection. Unfortunately, Bao is
experiencing significant financial difficulty and indicates that it will be unable to make all
payments according to the contractual terms. Mayhew uses the present value method for
measuring the required impairment loss. Illustration 17-24 shows the cash flow schedule
prepared for this analysis.
Investment Cash Flows

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As indicated, the expected cash flows of ¥264,000 are less than the contractual cash flows of
¥280,000. The amount of the impairment to be recorded equals the difference between the
recorded investment of ¥200,000 and the present value of the expected cash flows, as shown in
the table below
Computation of Impairment Loss

A loss of ¥12,680 is recorded because Mayhew must measure the loss at a present value amount,
not at an undiscounted amount. Mayhew recognizes an impairment loss of ¥12,680 by debiting
Loss on Impairment for the expected loss. At the same time, it reduces the overall value of the
investment. The journal entry to record the loss is therefore as follows.
December 31, 2014
Loss on Impairment 12,680
Debt Investments 12,680
3.5 Transfer between categories
Transferring an investment from one classification to another should occur only when the
business model for managing the investment changes. The IASB expects such changes to be rare.
Companies account for transfers between classifications prospectively, at the beginning of the
accounting period after the change in the business model.
Transfers between Trading and Available – for – Sale
Security transferred at fair value.
Unrealized gain or loss at date of transfer increases or decreases stockholders’ equity.
Unrealized gain or loss at date of transfer is recognized in income.
Transfer from Held – to – Maturity to Available – for – Sale
 Security transferred at fair value.
 Separate component of stockholders’ equity is increased or decreased by the unrealized
gain or loss at date of transfer.
 NO impact of transfer on net income.
Transfer from Available – for – Sale to Held – to – Maturity

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 Security transferred at fair value.
 Unrealized gain or loss at date of transfer carried as a separate component of
stockholders’ equity is amortized over the remaining life of the security.
 NO impact of transfer on net income.

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