Nature of Investments

Bonds and notes (Debt securities) Common and preferred stock (Equity securities)

Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

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Reporting Categories for Investments under US GAAP

Reporting Categories for Investments Control Characteristics of the Investment Reporting Method Used by the Investor The investor lacks significant influence over the operating and financial policies of the investee: Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at has the "positive intent and ability" to hold to amortized cost.* maturity. Trading securities (TS) - investment reported at fair Investment held in an active trading account. value with unrealized holding gains and losses included in net income. Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and Other. losses excluded from net income and reported in other comprehensive income.* The investor has significant influence over the operating and financial policies of the investee: Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for of the voting stock of the investee. subsequent earnings and dividends of the investee.* The investor controls the investee: The investor owns more than 50% of the voting Consolidation - the financial statements of the investor stock of the investee. and investee are combined as if they are a single company.
* If the investor elects the fair value option , this type of investment also can be accounted for using the same approach that's used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
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IFRS
Accounting for Investments When Investor Lacks Significant Influence: Until recently, IAS No. 39 was the standard that specified appropriate accounting for investments under IFRS. The primary categories in IAS No. 39 are similar to those in U.S. GAAP, consisting of
FVTPL (similar to TS), HTM, and AFS.

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IFRS (cont.)
IFRS No. 9, issued November 12, 2009, will be required after January 1, 2017 (tentatively decided), and earlier adoption is allowed, so in the time period between 2010 and 2016 either IAS No. 39 or IFRS No. 9 might be in effect for a particular company. Under IFRS No. 9:
Investments in debt securities are classified as either Amortized Cost or FVTPL. Investments in equity securities are classified as either FVTPL or FVTOCI

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U. S. GAAP vs. IFRS

U.S. GAAP permits classification as HTM, AFS, and TS.

Investments in debt securities are classified as either Amortized Cost or FVTPL. Investments in equity securities are classified as either FVTPL or FVTOCI (Fair Value through Other Comprehensive Income).

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Investor Lacks Significant Influence

Reporting Approach Held-to-maturity (HTM): used for debt that is planned to be held for it entire life Trading (TS): used for debt or equity that is held in an active trading account for immediate resale, or for which the fair value option had been elected. Available-for-sale (AFS): used for debt or equity that does not qualify as held-to-maturity or trading. Treatment of Unrealized Holding Gains and Losses Not recognized Investment Reported in the Balance Sheet at Amortized Cost

Recognized in net income and therefore in retained earnings as part of stockholders' equity

Fair Value

Recognized in other comprehensive income, and therefore in accumulated other comprehensive income in shareholders' equity

Fair Value

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Securities to Be Held to Maturity

Investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the positive intent and ability to hold the securities to maturity and classified as held-to-maturity (HTM). They are reported on the balance sheet at amortized cost.

Amortized cost (Face amount less unamortized discount, or plus unamortized premium).

Balance Sheet
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Securities to Be Held to Maturity

On January 1, 2011, Matrix, Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semiannually. The market rate for similar bonds is 12%. Lets look at calculation of the present value of the bond issue.
Amount $ 50,000 1,000,000 PV Factor 11.46992 0.31180 Present Value $573,496 311,805 $885,301

Interest Principal Present value of bonds

= =

PV of ordinary annuity of $1, n = 20, i = 6% PV of $1, n = 20, i = 6%

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Securities to Be Held to Maturity

Partial Bond Amortization Table
Date 1/1/11 6/30/11 12/31/11 6/30/12 12/31/12 Interest Payment $ 50,000 50,000 50,000 50,000 $ Interest Revenue 53,118 53,305 53,503 53,714 Discount Amortization $ 3,118 3,305 3,503 3,714 Unamortized Discount $ 114,699 111,581 108,276 104,772 101,059 Carrying Value $ 885,301 888,419 891,724 895,228 898,941

January 1, 2011 Investment in bonds Discount on bond investment Cash

1,000,000 114,699 885,301

June 30, 2011 Cash (stated rate face amount) Discount on bond investment Investment revenue

50,000 3,118 53,118

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Securities to Be Held to Maturity

This investment would appear on the June 30, 2011, as follows:
June 30, 2011 Investment in bonds Less: Discount on bond investment Book value (amortized cost) $ 1,000,000 111,581 $ 888,419

$114,699 - $3,118 = $111,581 unamortized discount

Unrealized holding gains and losses are not recognized for HTM investments.
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Securities to Be Held to Maturity

On December 31, 2011, after interest is received by Matrix, all the bonds are sold for $900,000 cash.
Date 1/1/11 6/30/11 12/31/11 6/30/12 12/31/12 Interest Payment $ 50,000 50,000 50,000 50,000 $ Interest Revenue 53,118 53,305 53,503 53,714 Discount Amortization $ 3,118 3,305 3,503 3,714 Unamortized Discount $ 114,699 111,581 108,276 104,772 101,059 Carrying Value $ 885,301 888,419 891,724 895,228 898,941

December 31, 2011 Cash Discount on bond investment Investment revenue

50,000 3,305

53,305

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December 31, 2011 Cash 900,000 Discount on bond investment 108,276 Investment in bonds Gain on sale of investment

1,000,000 8,276

Trading Securities
Investments in debt or equity securities acquired principally for the purpose of selling them in the near term. Adjustments to fair value are recorded: 1. in a valuation account called Fair Value Adjustment, or as a direct adjustment to the investment account. 2. as a net unrealized holding gain/loss on the Income Statement.

Unrealized Gain

Unrealized Loss

Income Statement
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Trading Securities
Matrix, Inc. purchased securities classified as Trading Securities (TS) on December 22, 2011. The fair value amounts for these securities on December 31, 2011, are shown below. Prepare the journal entries for Matrix, Inc. to showing the purchase of the securities, and adjust the securities to fair value at 12/31/11.
No. of Shares 1,000 1,500 12/22/11 12/31/11 Unrealized Unit Total Fair Gain or Cost Cost Value (Loss) $ 42.00 $ 42,000 $ 41,000 $ (1,000) 15.00 22,500 20,000 (2,500) $ 64,500 $ 61,000 $ (3,500)

Type TS TS

Name Mining, Inc Toys and Things Totals

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Trading Securities
December 22, 2011 Investment in Mining, Inc. stock Investment in Toys and Things stock Cash
Security Cost Fair Value

42,000 22,500 64,500

Adjustment

Mining, Inc $ 42,000 $ 41,000 Toys and Things 22,500 20,000 Total $ 64,500 $ 61,000 Existing balance in fair value adjustment Change needed in fair value adjustment

$ (1,000) (2,500) $ (3,500) -0$ (3,500)

December 31, 2011 Net unrealized holding gains and losses I/S Fair value adjustment

Reported on the balance sheet as a adjunct account to the investment.

3,500 3,500

The Net Unrealized Holding Loss is reported on the Income Statement.

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Trading Securities
On January 3, 2012, Matrix sold all trading securities for $65,000 cash. Lets record the entry for the sale and the adjustment to the fair value adjustment account.
January 3, 2012 Cash Investment in Mining, Inc. stock T/S Investment in Toys and Things stock T/S Gain on sale of investment December 31, 2012 Fair value adjustment Net unrealized holding gains or losses I/S 65,000 42,000 22,500 500

3,500

3,500

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Financial Statement Presentation

Trading securities are presented on the financial statement as follows:
1. Income Statement and Comprehensive Income Statement: Fair value changes are included on the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income. 2. Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders equity. 3. Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investor that hold trading securities consider them as part of their normal operations.

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Financial Statement Presentation

Presented below are the partial financial statements showing the accounting for TS owned by United:
Income Statement Revenue Expenses Other income (expenses): Interest and dividend income Realized and unrealized gains and losses on investments Total expenses Net income Balance Sheet Assets: Trading securities Statement of Cash Flows (direct method) Operating Activities: Cash from investment revenue Purchase of trading securities Sale of trading securities
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2011 t t 121,664 (16,354) t t

2012 t t -01,057 t t

3,154,943

985,000

117,000 (3,166,633) -0-

-0-02,141,000

Securities Available-for-Sale
Investments in debt or equity securities that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS). Adjustments to fair value are recorded: 1. in a valuation account called fair value adjustment, or as a direct adjustment to the investment account. 2. as a net unrealized holding gain/loss in other comprehensive income (OCI), which accumulates in accumulated other comprehensive income (ACOI).
Unrealized Gain Unrealized Loss

Other Comprehensive Income (OCI)

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Other Comprehensive Income (OCI)

Other comprehensive income: Foreign currency translation gains (losses) Net unrealized holding gains (losses) on investments Minimum pension liability adjustment Deferred gains (losses) from derivatives Less: aggregate income tax expense (benefit) Other comprehensive income $ XX,XXX -12,500 XXX XXX

$ XX,XXX X,XXX $ XX,XXX

When we add other comprehensive income to net income we refer to the result as comprehensive income.

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Accumulated Other Comprehensive Income

Unrealized holding gains and losses on availablefor-sale securities are accumulated in the shareholders equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income (AOCI).
Net unrealized holding gains and losses.

Shareholders Equity Common Stock Paid-in Capital in Excess of par Accumulated other comprehensive income Retained earnings Total Shareholders Equity

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Securities Available for Sale Example

Assume the same information for our T/S example for Matrix, Inc., except that the investments are classified as available-for-sale securities rather than trading securities.
Security Cost Fair Value Adjustment

Mining, Inc $ 42,000 $ 41,000 Toys and Things 22,500 20,000 Total $ 64,500 $ 61,000 Existing balance in fair value adjustment Change needed

$ $ $

(1,000) (2,500) (3,500) -0(3,500)

December 31, 2011 Net unrealized holding gains and losses OCI Fair value adjustment
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3,500 3,500

Financial Statement Presentation

AFS securities are presented on the financial statement as follows:
1. Income Statement and Comprehensive Income Statement: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. 2. Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders equity, and are reclassified out of AOCI in the periods in which securities are sold. 3. Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

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Financial Statement Presentation

Presented below are the partial income statement showing the accounting for AFS of United:
Income Statement Revenue Expenses Other income (expenses): Interest and dividend income Realized net loss on sale of investments Total expenses Net income Other comprehensive income (loss) items: Unrealized holding gains (losses) on investments Reclassification adjustment for net gains (losses) Total 2011 $ t t 121,664 -0t t (16,354) -0(16,354) 2012 $ t t -0(297) t t (5,000) 6,354 1,354

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Financial Statement Presentation

Finally, we have the partial balance sheet and statement of cash flows for the company.
Balance Sheet Assets: Available-for-sale securities Stockholders' equity: Accumulated other comprehensive income Statement of Cash Flows (direct method) Operating Activities: Cash from investgment revenue Investing Activities: Purchase of available-for-sale securities Sale of available-for-sale securities 2011 $ 3,154,943 (16,354) 2012 $ 985,000 (15,000)

117,000 (3,166,633) -0-

-0-02,171,000

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U. S. GAAP vs. IFRS

Until recently, IFRS did not allow transfers out of their fair value through profit and loss classification.

U.S. GAAP also allows transfers out of the trading security category. Reclassifications under U.S. GAAP are rare.

IAS No. 39 now allows transfer of debt investments out of the fair value category into AFS or HTM in rare circumstances. The current financial crisis qualified as one of those circumstances.

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Transfers Between Reporting Categories

Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Securities are transferred at fair market value on the date of transfer.

Transfer from: Either of the other Trading Held-to-maturity Available-for-sale

To: Trading Either of the other Available-for-sale Held-to-maturity

Unrealized Gain or Loss from Transfer at Fair Market Value Include in current net income There is none (recognized in income) Reported as a separate component of shareholders' equity (OCI) Do not write off any existing unrealized holding gain or loss, but amortize to net income over remaining life of the security.

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Impairment of Investments
Occasionally, an investments value will decline for reasons that are other than temporary (OTT).

Impairment in Value

For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an other than temporary decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.
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U. S. GAAP vs. IFRS

Until recently, IFRS did not allow transfers out of the fair value through P&L (FVTPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP).

U.S. GAAP has no prohibition against transfers between categories as long as they can be reasonably justified.

In recent changes, IAS No. 39 allows transfers of debt investments out of the FVTPL category into AFS or HTM in rare circumstances, The 2008, financial crisis qualifies as one of those rare circumstances.

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Financial Statement Presentation and Disclosure

Aggregate Fair Value Gross realized & unrealized holding gains & losses

Maturities of debt securities

Amortized cost basis by major security type

Change in net unrealized holding gains and losses

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Inputs to fair value estimates

Fair Value Hierarchy

GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value.
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Investor Has Significant Influence

Reporting Categories for Investments Control Characteristics of the Investment Reporting Method Used by the Investor The investor lacks significant influence over the operating and financial policies of the investee: Investment in debt securities for which the investor Held-to-maturity (HTM) - investment reported at has the "positive intent and ability" to hold to amortized cost.* maturity. Investment held in an active trading account. Trading securities (TS) - investment reported at fair value with unrealized holding gains and losses included in net income. Other. Securities available-for-sale (AFS) - investment reported at fair value with unrealized holding gains and losses excluded from net income and reported in Other Comprehensive income.* The investor has significant influence over the operating and financial policies of the investee: Typically the investor owns between 20% and 50% Equity method - investment cost adjusted for of the voting stock of the investee. subsequent earnings and dividends of the investee.* The investor controls the investee: The investor owns more than 50% of the voting stock of the investee.

Consolidation - the financial statements of the investor and investee are combined as if they are a single company.

* If the investor elects the fair value option, this type of investment also can be accounted for using the same approach that's used for trading securities, with the investment reported at fair value and unrealized holding gains and losses included in earnings.
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Investor Has Significant Influence

Extent of Investor Influence Lack of significant influence (usually < 20% equity ownership) Significant influence (usually 20% - 50% equity ownership) Has control (usually > 50% equity ownership) Reporting Method Varies depending on classification previously discussed

Equity method
Consolidation

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What Is Significant Influence?

If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if : 1. the investee challenges the investors ability to exercise significant influence through litigation or other methods. 2. the investor surrenders significant shareholder rights in a signed agreement.

3. the investor is unable to acquire sufficient information about the investee to apply the equity method.
4. the investor tries and fails to obtain representation on the board of directors of the investee.
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A Single Entity Concept

Under the equity method . . .
1. The investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.

2. Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is: a) Increased by the investors percentage share of the investees net income (or decreased by its share of a loss). b) Decreased by dividends paid.

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Equity Method
On January 1, 2011, Wilmer, Inc. acquired 45% of the equity securities of Apex, Inc. for $1,350,000. On the acquisition date, Apexs net assets had a fair value of $3,000,000. During 2011, Apex paid cash dividends of $150,000 and reported net income of $1,750,000.
What amount will Wilmer, Inc. report on the balance sheet as Investment in Apex, Inc. on December 31, 2011?

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Equity Method
January 1, 2011 Investment in Apex, Inc. stock Cash 1,350,000 1,350,000
$ 3,000,000 Fair value of net assets 45% Percentage ownership $ 1,350,000 Fair value of assets purchased

2011 Investment in Apex, Inc. stock Investment revenue

$ $ 1,750,000 Reported earnings 45% Percentage ownership 787,500 Share of earnings

787,500 787,500

2011 Cash Investment in Apex, Inc. stock

$ $ 150,000 Dividends paid 45% Percentage ownership 67,500 Share of dividends

67,500 67,500

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Equity Method
Investment in Apex, Inc.
Investment 45% Earnings 1,350,000 787,500 67,500 45% Dividends

Reported amount 2,070,000 If the investee had a loss, the investment account would have been reduced.
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Equity Method
On January 1, 2011, Wilmer, Inc. purchased 25% of the common stock of Apex, Inc. for $180,000. At the date of acquisition, the book value of the net assets of Apex was $400,000, and the fair value of these assets is $600,000. During 2011, Apex paid cash dividends of $40,000, and reported earnings of $100,000.

Fair value of assets Percentage ownership Share of fair value of assets Cost of investment in Apex Excess of cost over fair value
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$ 600,000 25% 150,000 180,000 $ 30,000

Equity Method
The excess of the fair value of net assets over book value of those net assets is 75% is attributable to depreciable assets with a remaining life of 20 years and 25% is attributable to land. Wilmer uses the straight-line depreciation.
Fair value of net assets $ 600,000 Book value of net assets 400,000 Difference 200,000 Percentage of net assets acquired 25% Excess 50,000 Amount attributable to land (25% or excess) 12,500 Amount attributable to depreciable assets 37,500 Remaining life of depreciable assets 20 years Additional depreciation expense per year $ 1,875
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Equity Method
January 1, 2011 Investment in Apex stock Cash 2011 Cash Investment in Apex stock Investment in Apex stock Investment revenue December 31, 2011 Investment revenue Investment in Apex stock
$ 40,000 Dividends paid 25% Percentage ownership $ 10,000 Share of dividends
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180,000 180,000

10,000 10,000 25,000 25,000

1,875
1,875
$ 100,000 Reported earnings 25% Percentage ownership $ 25,000 Share of earnings

Changing From the Equity Method to Another Method

When the investors level of influence changes, it may be necessary to change from the equity method to another method.

At the transfer date, the carrying value of the investment under the equity method is regarded as cost.
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Changing From Another Method to the Equity Method

When the investors ownership level increases to the point where they can exert significant influence, the investor should change to the equity method. At the transfer date, the recorded value is the initial cost of the investment adjusted for the investors equity in the undistributed earnings of the investee since the original investment.

Reported earnings Dividends paid = Undistributed Earnings

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Changing From Another Method to the Equity Method

The original cost, the unrealized holding gain or loss, and the valuation account are closed. A retroactive change is recorded to recognize the investors share of the investees earnings since the original investment.

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Fair Value Option

GAAP allows companies to use a fair value option for HTM, AFS and equity method investments.
The investment is carried at fair value. Unrealized gains and losses are included in income.

For HTM and AFS investments, this amounts to classifying the investments as trading. For equity-method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.

The fair value option is determined for each individual investment, and is irrevocable.
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Fair Value Option: IFRS

International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. Under both IAS No. 39 and IFRS No. 9, companies can elect the fair value option only in specific circumstances.

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Fair Value Option: IFRS (cont.)

For example, a firm could elect the fair value option for an asset or liability in order to avoid the accounting mismatch that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not. Although U.S. GAAP indicates that the intent of the fair value option is to address these sorts of circumstances, it does not require that those circumstances exist.
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