Accounting for Investment Securities

Transcription

1 738 APPENDIX E Accounting for Investment Securities TYPES OF INVESTMENT SECURITIES A financial investment occurs when one entity provides assets or services to another entity in exchange for a certificate known as a security. The entity that provides the assets and receives the security certificate is called the investor. The entity that receives the assets or services and gives the security certificate is called the investee. This appendix discusses accounting practices that apply to securities held by investors. There are two primary types of investment securities: debt securities and equity securities. An investor receives a debt security when assets are loaned to the investee. In general, a debt security describes the investee s obligation to return the assets and to pay interest for the use of the assets. Common types of debt securities include bonds, notes, certificates of deposit, and commercial paper. An equity security is obtained when an investor acquires an ownership interest in the investee. An equity security usually describes the rights of ownership, including the right to influence the operations of the investee and to share in profits or losses that accrue from those operations. The most common types of equity securities are common stock and preferred stock. In summary, investment securities are certificates that describe the rights and privileges that investors receive when they loan or give assets or services to investees. Transactions between the investor and the investee constitute the primary securities market. There is a secondary securities market in which investors exchange (buy and sell) investment securities with other investors. Securities that regularly trade in established secondary markets are called marketable securities. Investee companies are affected by secondary-market transactions only to the extent that their obligations are transferred to a different party. For example, assume that Tom Williams (investor) loans assets to American Can Company (investee). Williams receives a bond (investment security) from American Can that describes American Can s obligation to return assets and pay interest to Williams. This exchange represents a primary securities market transaction. Now assume that in a secondary-market transaction Williams sells his investment security (bond) to Tina Tucker. American Can Company is affected by this transaction only to the extent that the company s obligation transfers from Williams to Tucker. In other words, American Can s obligation to repay principal and interest does not change. The only thing that changes is the party to whom American Can makes payments. An investee s financial statements are not affected when the securities it has issued to an investor are traded in the secondary market. The fair value, also called market value, is the amount that the investor would receive if the securities are sold in an orderly transaction. More specifically, the fair value is based on the amount that would be collected (an exit value) from the sale of an asset as opposed to the cost necessary to acquire a comparable asset. For a more detailed definition of fair value see FASB Statement No Whether securities are reported at fair value or historical cost depends on whether the investor intends to sell or hold the securities. Generally accepted accounting principles require companies to classify their investment securities into one of three categories: (1) held-to-maturity securities, (2) trading securities, and (3) available-for-sale securities.

2 Appendix E 739 Held-to-Maturity Securities Since equity securities representing ownership interests have no maturity date, the held-to-maturity classification applies only to debt securities. Debt securities should be classified as held-to-maturity securities if the investor has a positive intent and the ability to hold the securities until the maturity date. Held-to-maturity securities are reported on the balance sheet at amortized historical cost. 1 Trading Securities Both debt and equity securities can be classified as trading securities. Trading securities are bought and sold for the purpose of generating profits on the short-term appreciation of stock or bond prices. They are usually traded within three months of when they are acquired. Trading securities are reported on the investor s balance sheet at their fair value on the investor s fiscal closing date. Available-for-Sale Securities All marketable securities that are not classified as held-to-maturity or trading securities must be classified as available-for-sale securities. These securities are also reported on the investor s balance sheet at fair value as of the investor s fiscal closing date. Two of the three classifications, therefore, must be reported at fair value, which is a clear exception to the historical cost concept. Other exceptions to the use of historical cost mea sures for asset valuation are discussed in later sections of this appendix. REPORTING EVENTS THAT AFFECT INVESTMENT SECURITIES The effects on the investor s financial statements of four distinct accounting events involving marketable investment securities are illustrated in the following section. The illustration assumes that the investor, Arapaho Company, started the accounting period with cash of $10,000 and common stock of $10,000. EVENT 1 Investment Purchase Arapaho paid $9,000 cash to purchase marketable investment securities. This event is an asset exchange. One asset (cash) decreases, and another asset (investment securities) increases. The income statement is not affected. The $9,000 cash outflow is reported as either an operating activity or an investing activity, depending on how the securities are classified. Since trading securities are shortterm assets that are regularly traded for the purpose of producing income, cash flows from the purchase or sale of trading securities are reported in the operating activities section of the statement of cash flows. In contrast, cash flows involving the purchase or sale of securities classified as held to maturity or available for sale are reported in the investing activities section of the statement of cash flows. The only difference among the three alternatives lies in the classification of the cash 1 Debt securities are frequently purchased for amounts that are more or less than their face value (the amount of principal due at the maturity date). If the purchase price is above the face value, the difference between the face value and the purchase price is called a premium. If the purchase price is below the face value, the difference is called a discount. Premiums and discounts increase or decrease the amount of interest revenue earned and affect the carrying value of the bond investment reported on the balance sheet. The presentation in this section of the text makes the simplifying assumption that the bonds are purchased at a price equal to their face value. Accounting for discounts and premiums is discussed in Chapter 10.

3 740 Appendix E outflow reported on the statement of cash flows, as shown in the following statements model: Event No. Type Assets 5 Liab. 1 Equity Rev. 2 Exp. 5 Net Inc. Cash Flow Cash 1 Inv. Sec. 1 Held (9,000) 1 9,000 5 NA 1 NA NA 2 NA 5 NA (9,000) IA 1 Trading (9,000) 1 9,000 5 NA 1 NA NA 2 NA 5 NA (9,000) OA 1 Available (9,000) 1 9,000 5 NA 1 NA NA 2 NA 5 NA (9,000) IA EVENT 2 Recognition of Investment Revenue Arapaho earned $1,600 of cash investment revenue. Investment revenue is reported the same way regardless of whether the investment securities are classified as held to maturity, trading, or available for sale. Investment revenue comes in two forms. Earnings from equity investments are called dividends. Revenue from debt securities is called interest. Both forms have the same impact on the financial statements. Recognizing the investment revenue increases both assets and stockholders equity. Revenue and net income increase. The cash inflow from investment revenue is reported in the operating activities section of the statement of cash flows regardless of how the investment securities are classified. Event No. Assets 5 Liab. 1 Equity Rev. 2 Exp. 5 Net Inc. Cash Flow Cash 5 Ret. Earn. 2 1,600 5 NA 1 1,600 1,600 2 NA 5 1,600 1,600 OA EVENT 3 Sale of Investment Securities Arapaho sold securities that cost $2,000 for $2,600 cash. This event results in recognizing a $600 realized (actual) gain that increases both total assets and stockholders equity. The asset cash increases by $2,600 and the asset investment securities decreases by $2,000, resulting in a $600 increase in total assets. The $600 realized gain is reported on the income statement, increasing net income and retained earnings. The $600 gain does not appear on the statement of cash flows. Instead, the entire $2,600 cash inflow is reported in one section of the statement of cash flows. Cash inflows from the sale of held-to-maturity and available-for-sale securities are reported as investing activities. Cash flows involving trading securities are reported as operating activities. These effects are shown below. Event Rev. or Exp. or No. Type Assets 5 Liab. 1 Equity Gain 2 Loss 5 Net Inc. Cash Flow Cash 1 Inv. Sec. 3 Held 2,600 1 (2,000) 5 NA NA ,600 IA 3 Trading 2,600 1 (2,000) 5 NA NA ,600 OA 3 Available 2,600 1 (2,000) 5 NA NA ,600 IA

4 Appendix E 741 EVENT 4 Market Value Adjustment Arapaho recognized a $700 unrealized gain. After Event 3, the historical cost of Arapaho s portfolio of remaining investment securities is $7,000 ($9,000 purchased less $2,000 sold). Assume that at Arapaho s fiscal closing date, these securities have a fair value of $7,700, giving Arapaho a $700 unrealized gain on its investment. This type of gain (sometimes called a paper profit) is classified as unrealized because the securities have not been sold. The treatment of unrealized gains or losses in the financial statements depends on whether the securities are classified as held to maturity, trading, or available for sale. Unrealized gains or losses on securities classified as held to maturity are not recognized in the financial statements; they have no effect on the balance sheet, income statement, and statement of cash flows. Even so, many companies choose to disclose the market value of the securities as part of the narrative description or in the footnotes that accompany the statements. Whether or not the market value is disclosed, held-to-maturity securities are reported on the balance sheet at amortized cost. Investments classified as trading securities are reported in the financial statements at fair value. Unrealized gains or losses on trading securities are recognized in net income even though the securities have not been sold. In Arapaho s case, the $700 gain increases the carrying value of the investment securities. The gain increases net income, which in turn increases retained earnings. Unrealized gains and losses have no effect on cash flows. Investments classified as available-for-sale securities are also reported in the financial statements at fair value. However, an important distinction exists with respect to how the unrealized gains and losses affect the financial statements. Even though unrealized gains or losses on available-for-sale securities are included in the assets on the balance sheet, they are not recognized in determining net income. 2 On Arapaho s balance sheet, the $700 gain increases the carrying value of the investment securities. A corresponding increase is reported in a separate equity account called Unrealized Gain or Loss on Available-for-Sale Securities. The statement of cash flows is not affected by recognizing unrealized gains and losses on available-for-sale securities. The effects of these alternative treatments of unrealized gains and losses on Arapaho s financial statements are shown here: Event Rev. or Exp. or No. Type Assets 5 Liab. 1 Equity Gain 2 Loss 5 Net Inc. Cash Flow Inv. Sec. 5 Ret. Earn. 1 Unreal. Gain 4 Held NA 5 NA 1 NA 1 NA NA 2 NA 5 NA NA 4 Trading NA NA NA NA 4 Available NA 1 NA NA 2 NA 5 NA NA FINANCIAL STATEMENTS As the preceding discussion implies, the financial statements of Arapaho Company are affected by not only the business events relating to its security transactions but also the accounting treatment used to report those events. In other words, the same economic events are reflected differently in the financial statements depending on whether the 2 Statement of Financial Accounting Standards No. 130 permits companies to report unrealized gains and losses on available-for-sale securities as additions to or subtractions from net income with the result being titled comprehensive income. Alternatively, the unrealized gains and losses can be reported on a separate statement or as part of the statement of changes in stockholders equity.

5 742 Appendix E EXHIBIT E.1 ARAPAHO COMPANY Comparative Financial Statements Income Statements Investment Securities Classified as Held Trading Available Investment revenue $ 1,600 $ 1,600 $ 1,600 Realized gain Unrealized gain 700 Net income $ 2,200 $ 2,900 $ 2,200 Balance Sheets Held Trading Available Assets Cash $ 5,200 $ 5,200 $ 5,200 Investment securities, at cost (market value $7,700) 7,000 Investment securities, at market (cost $7,000) 7,700 7,700 Total assets $12,200 $12,900 $12,900 Stockholders equity Common stock $10,000 $10,000 $10,000 Retained earnings 2,200 2,900 2,200 Unrealized gain on investment securities 700 Total stockholders equity $12,200 $12,900 $12,900 Statements of Cash Flows Held Trading Available Operating Activities Cash inflow from investment revenue $ 1,600 $ 1,600 $ 1,600 Outflow to purchase securities (9,000) Inflow from sale of securities 2,600 Investing Activities Outflow to purchase securities (9,000) (9,000) Inflow from sale of securities 2,600 2,600 Financing Activities* Net decrease in cash (4,800) (4,800) (4,800) Beginning cash balance 10,000 10,000 10,000 Ending cash balance $ 5,200 $ 5,200 $ 5,200 *The $10,000 capital acquisition is assumed to have occurred prior to the start of the accounting period. securities are classified as held to maturity, trading, or available for sale. Exhibit E.1 displays the financial statements for Arapaho under each investment classification alternative. The net income reported under the trading securities alternative is $700 higher than that reported under the held-to-maturity and available-for-sale alternatives because unrealized gains and losses on trading securities are recognized on the income statement. Similarly, total assets and total stockholders equity are $700 higher under the trading and available-for-sale alternatives than they are under the held-to-maturity category because the $700 unrealized gain is recognized on the balance sheet for those two classifications. The gain is not reported on the income statement for available-for-sale securities; it is reported on the balance sheet in a special equity account called Unrealized

6 Appendix E 743 EXHIBIT E.2 Recognition of Cash Flow from Unrealized Gains Purchase or Sale Investment Types of Types of Revenue Reported on and Losses on the of Securities Category Securities Recognized Balance Sheet at Income Statement Classified As Held to maturity Debt Interest Amortized cost No Investing activity Trading Debt and equity Interest and dividends Market value Yes Operating activity Available for sale Debt and equity Interest and dividends Market value No Investing activity Gain on Investment Securities. The statements of cash flows report purchases and sales of trading securities as operating activities while purchases and sales of available-for-sale and held-to-maturity securities are investing activities. Exhibit E.2 summarizes the reporting differences among the three classifications of investment securities. Alternative Reporting Practices for Equity Securities If an investor owns 20 percent or more of an investee s equity securities, the investor is presumed able, unless there is evidence to the contrary, to exercise significant influence over the investee company. Investors owning more than 50 percent of the stock of an investee company are assumed to have control over the investee. The previous discussion of accounting rules for equity securities assumed the investor did not significantly influence or control the investee. Alternative accounting rules apply to securities owned by investors who exercise significant influence or control over an investee company. Accounting for equity investment securities differs depending on the level of the investor s ability to influence or control the operating, investing, and financing activities of the investee. As previously demonstrated, investors who do not have significant influence (they own less than 20 percent of the stock of the investee) account for their investments in equity securities at fair value. Investors exercising significant influence (they own 20 to 50 percent of the investee s stock) must account for their investments using the equity method. A detailed discussion of the equity method is beyond the scope of this text. However, be aware that investments reported using the equity method represent a mea sure of the book value of the investee rather than the cost or fair value of the equity securities owned. Investors who have a controlling interest (they own more than 50 percent of the investee s stock) in an investee company are required to issue consolidated financial statements. The company that holds the controlling interest is referred to as the parent company, and the company that is controlled is called the subsidiary company. Usually, the parent and subsidiary companies maintain separate accounting records. However, a parent company is also required to report to the public its accounting data along with that of its subsidiaries in a single set of combined financial statements. These consolidated statements represent a separate accounting entity composed of the parent and its subsidiaries. A parent company that owns one subsidiary will produce three sets of financial statements: statements for the parent company, statements for the subsidiary company, and statements for the consolidated entity. EXERCISES Exercise E1 Identifying asset values for financial statements Indicate whether each of the following assets should be valued at fair market value (FMV), lower of cost or market (LCM), or historical cost (HC) on the balance sheet. For certain assets, historical cost may be called amortized cost (AC.)

7 744 Appendix E Asset FMV LCM HC/AC Supplies Land Trading securities Cash Held-to-maturity securities Buildings Available-for-sale securities Office equipment Inventory Exercise E2 Accounting for investment securities Norris Bros. purchased $36,000 of marketable securities on March 1, On the company s fiscal year closing date, December 31, 2009, the securities had a market value of $27,000. During 2009, Norris recognized $10,000 of revenue and $2,000 of expenses. a. Record a 1, 2, or NA in a horizontal statements model to show how the purchase of the securities affects the financial statements, assuming that the securities are classified as (1) held to maturity, (2) trading, or (3) available for sale. In the Cash Flow column, indicate whether the event is an operating activity (OA), investing activity (IA), or financing activity (FA). Record only the effects of the purchase event. Event No. Type Cash 1 Inv. Sec. 5 Liab. 1 Equity Rev. 2 Exp. 5 Net Inc. Cash Flow 1 Held 2 Trading 3 Available b. Determine the amount of net income that would be reported on the 2009 income statement, assuming that the marketable securities are classified as (1) held to maturity, (2) trading, or (3) available for sale. Exercise E3 Effect of investment securities transactions on financial statements The following information pertains to Butler Supply Co. for Purchased $100,000 of marketable investment securities. 2. Earned $10,000 of cash investment revenue. 3. Sold for $30,000 securities that cost $25, The fair value of the remaining securities at December 31, 2011, was $89,000. a. Record the four events in a statements model like the following one. Use a separate model for each classification: (1) held to maturity, (2) trading, and (3) available for sale. The first event for the first classification is shown as an example. Held to Maturity Event Unreal. Rev. or Exp. or No. Cash 1 Inv. Sec. 5 Liab. 1 Ret. Earn. 1 Gain. Gains 2 Loss 5 Net Inc. Cash Flow 1 (100,000) 1 100,000 5 NA 1 NA 1 NA NA 2 NA 5 NA (100,000) IA

8 Appendix E 745 b. What is the amount of net income under each of the three classifications? c. What is the change in cash from operating activities under each of the three classifications? d. Are the answers to Requirements b and c different for each of the classifications? Why or why not? Exercise E4 Preparing financial statements for investment securities Wright, Inc., began 2012 with $100,000 in both cash and common stock. The company engaged in the following investment transactions during 2012: 1. Purchased $20,000 of marketable investment securities. 2. Earned $600 cash from investment revenue. 3. Sold investment securities for $14,000 that cost $10, Purchased $7,000 of additional marketable investment securities. 5. Determined that the investment securities had a fair value of $22,000 at the end of Use a vertical statements model to prepare income statements, balance sheets, and statements of cash flow for Wright, Inc., assuming the securities were (a) held to maturity, (b) trading, and (c) available for sale. Exercise E5 Differences among marketable investment securities classifications Complete the following table for the three categories of marketable investment securities: Recognition of Cash Flow from Unrealized Gains Purchase or Sale Investment Types of Types of Revenue Value Reported on and Losses on the of Securities Is Category Securities Recognized Balance Sheet Income Statement Classified as Held to maturity Debt Interest Amortized cost No Investing activity Trading Available for sale Exercise E6 Effect of marketable investment securities transactions on financial statements The following transactions pertain to Harrison Imports for 2007: 1. Started business by acquiring $30,000 cash from the issue of common stock. 2. Provided $90,000 of services for cash. 3. Invested $35,000 in marketable investment securities. 4. Paid $18,000 of operating expense. 5. Received $500 of investment income from the securities. 6. Invested an additional $16,000 in marketable investment securities. 7. Paid a $2,000 cash dividend to the stockholders. 8. Sold investment securities that cost $8,000 for $14, Received another $1,000 in investment income. 10. Determined the market value of the investment securities at the end of the year was $42,000. Use a vertical model to prepare a 2009 income statement, balance sheet, and statement of cash flows, assuming that the marketable investment securities were classified as (a) held to maturity, (b) trading, and (c) available for sale. (Hint: Record the events in T-accounts prior to preparing the financial statements.)

9 746 Appendix E Exercise E7 Comprehensive horizontal statements model Woody s Catering experienced the following independent events. 1. Acquired cash from issuing common stock. 2. Purchased inventory on account. 3. Paid cash to purchase marketable securities classified as trading securities. 4. Recorded unrealized loss on marketable securities that were classified as trading securities. 5. Recorded unrealized loss on marketable securities that were classified as available-for-sale securities. 6. Recorded unrealized loss on marketable securities that were classified as held-to-maturity securities. 7. Wrote down inventory to comply with lower-of-cost-or-market rule. (Assume that the company uses the perpetual inventory system.) 8. Recognized cost of goods sold under FIFO. 9. Recognized cost of goods sold under the weighted-average method. a. Show the effect of each event on the elements of the financial statements using a horizontal statements model like the following one. Use 1 for increase, 2 for decrease, and NA for not affected. In the Cash Flow column, indicate whether the item is an operating activity (OA), investing activity (IA), or financing activity (FA). The first transaction is entered as an example. Event Rev. or Exp. or No. Assets 5 Liab. 1 Equity Gain 2 Loss 5 Net Inc. Cash Flow 1 1 NA 1 NA NA NA 1 FA b. Explain why there is or is not a difference in the way Events 8 and 9 affect the financial statements model.