Investments in Debt and Equity Securities

Chapter 14 Lecture Notes

 

Companies have many reasons for investing in the debt and equity securities of other companies. Five of the most common reasons are:

  1. As a safety cushion, to maintain a large enough liquid investment balance to tide the company over an emergency.
  2. To meet cyclical cash needs (for companies in highly seasonal businesses).
  3. Return on investments, especially for companies primarily engaged in investment, but also to a lesser degree for any company with idle cash to invest.
  4. To gain influence over the decisions of the company being invested in.
  5. To gain complete control over another company. When one company owns more than 50% of another company, the financial statements of the first company must combine the financial performance of the other company (its subsidiary) with its own performance as if the two companies were one single company.

 

Debt securities have a maturity value representing the amount to be repaid, a fixed or variable interest rate, and a maturity date, when repayment of the debt is due. Equity securities represent ownership in a company and typically carry the right to collect dividends and to vote on corporate matters.

 

FASB Statement No. 115, issued in 1993, requires financial statements to classify investment securities according to management’s intent in holding the securities. Each class requires different accounting treatment. The four classes are:

1.      Held-to-Maturity, debt securities only, intended to be held until they mature.

2.      Available-for-Sale, held as a store of excess cash rather than for trading or for influence or control, but not intended to be held to maturity. This is the default classification.

3.      Trading, held for short-term trading purposes in the hope of a rise in price.

4.      Equity method, equity securities only, purchased with the intent of gaining influence or control over the operations of the investee.

 

The different accounting treatments are as follows (Exhibit 14-8. page 831):

 

Class of Securities

Types of Securities

Disclosure on the Balance Sheet

Treatment of Temporary Changes of Value

Held to Maturity

Debt

Amortized cost

Not recognized

Available for Sale

Debt and Equity

Fair market value

Reported in stockholders’ equity

Trading

Debt and Equity

Fair market value

Reported on the income statement

Equity method

Equity

Historical cost adjusted for changes in the net assets of the investee

Not recognized

 

The reasons for the different accounting treatments reflect the differing purposes for which the securities are held. Thus neither equity-method securities nor securities being held to maturity are held to be sold, so that changes in their value are not relevant. Trading securities and available-for-sale securities are intended to be sold if their price rises high enough: therefore the fair market value is of interest to users of the financial statements. However, available-for-sale securities, unlike trading securities, are not expected to be sold in the current accounting period; consequently the unrealized gains or losses are reported through Accumulated Other Comprehensive Income directly in the Stockholders’ Equity section of the balance sheet, rather than passing through the income statement into Retained Earnings.

 

The purchase of debt and equity securities is recorded at cost as with other assets. In the case of debt securities, a minor complication occurs when the security is bought between interest payment dates: then accrued interest must be recognized separately from the investment cost. The interim accrued interest is debited as Interest Receivable and credited to Interest Revenue when received (asset approach). Alternatively, under the revenue approach, the accrued interest paid at the time of purchase may be debited immediately to Interest Revenue and then credited when received; this approach is usually more convenient. See page 832 for an example. In either approach, the interest revenue recognized for the period is the interest earned, not the interest received.

 

The recognition of revenue from investment securities depends on various factors according to the class of securities: interest rates for trading or available-for-sale debt securities; interest rates and amortization of premium or discount for debt securities held to maturity; dividends declared for equity securities held as trading or available-for-sale securities; or income earned by investee and percentage of ownership for equity-method securities.

 

Amortization of premium or discount could be performed for trading and available-for-sale debt securities, but this is not normally done, because the value of the asset is set to the current market value at the end of the accounting period anyway. At acquisition any premium or discount is simply netted with the face value. See page 834.

 

For held-to-maturity debt securities, amortization of premium or discount is calculated using an amortization table to allow interest revenue and amortization to be recorded separately. This ensures that carrying value of the security equals the maturity value on the maturity date. See page 835.

 

 Recognition of revenue from equity securities depends on the degree of influence or control exercised by the investor over the investee. When the degree of influence or control is sufficiently high, as indicated by representation of the investee’s board of directors, by interchange of managerial personnel, by investee’s technological dependence on the investor, or by extent of ownership (50% of common stock, or less than 50% if the remaining ownership is widely held and no significant blocks of shareholders are consistently united in their ownership). These criteria are outlined in APB Opinion No. 18, issued in 1971. The APB recognizes that judgment is required and sets 20% of ownership as a presumptive level for significant influence. FASB has addressed the issue in FASB Interpretation No. 35 (1981) and is considering adding more presumptive conditions for significant influence. See page 836.

 

When control exists, the financial statements of parent company and subsidiary must be consolidated in addition to use of the equity method of accounting. Inter-company transactions are eliminated. FASB Statement of Financial Accounting Standards No. 94 (1987) has tightened up consolidation. Exceptions formerly allowed have been eliminated. FASB is currently considering expanding the concept of control to encourage consolidation of subsidiaries for which parent companies have control with less than 50% of ownership. See page 837.

 

Ownership interest

Control or degree of influence

Accounting method

Applicable standard

More than 50%

Control

Equity method and consolidation procedure

APB Opinion No. 18

20 to 50%

Significant influence

Equity method

APB Opinion No. 18

Less than 20%

No significant influence

Account for as trading or available for sale

FASB Statement No. 115

 

Revenue for trading and available-for-sale equity securities consists only of dividends declared. Under the equity method, the investment account is periodically adjusted to reflect changes in the underlying net assets of the investee. A proportionate share of investee earnings, after deducting preferred stock dividends declared by the investee, increases the account, a proportionate share of investee losses, and dividends received by the investor decrease it. See page 838.

 

Exhibit 14-10 on page 839 illustrates the difference between the equity method and revenue recognition using FASB Statement No. 115.

 

When the purchase price of a company acquired by another company differs from the recorded book value of the underlying net assets of the acquired company, the purchase price must be allocated among the assets acquired as explained in Chapter 10. Any part of the purchase price that cannot be so allocated is recorded as goodwill. Goodwill may be negative if the purchase price is less than the total fair value of the net assets acquired. Then the adjusted values are used to determine the depreciation and amortization charges. Corresponding adjustments to the investee’s reported income may be required when only a portion of the investee’s stock is purchased. See pages 840 – 1.for the details.

 

Joint ventures are accounted for using the equity method.  This is a form of off-balance-sheet financing. The liabilities of the joint venture offset the assets on the balance sheets of the owner companies which do not have to report them as liabilities of their own, although in effect they have jointly borrowed the money.

 

 Changes in the current market value of trading and available-for-sale debt and equity securities are recorded in a Market Adjustment account. Unrealized gains and losses are reported as gains or losses on the income statement (trading securities) or in an equity account: Accumulated Other Comprehensive Income (available-for-sale securities). See pages 842 – 845 for an extensive worked example. This treatment is new: formerly only declines in value and their subsequent recoveries were reported in the financial statements. Temporary changes in held-to-maturity and equity-method securities are not recognized.

 

Deciding whether a decline in market value of a security is “other than temporary” calls for professional judgment. If it is, the loss in value should be credited through the investment account rather than through a market adjustment account and charged against current income, regardless of the classification of the security. See page 846. SEC Staff Accounting Bulletin No. 59 provides some guidance for the accountant: the following criteria should be considered in determining whether a decline in value is “other than temporary”

 

The sale of an investment security requires the carrying value to be removed from the books and the difference between the carrying value and the cash received to be recorded as a realized gain or loss. In addition, in the case of debt securities an entry is required to record interest earned to the date of the sale and to amortize any premium or discount. See pages 847-8.

When a portion of an investment securities portfolio is sold during the year, care must be taken to distinguish properly between realized and unrealized gains and losses. Realized gain/loss is the difference between the selling price and the original cost of the securities. Unrealized gain/loss is the amount needed to adjust the end-of-year market adjustment account to its appropriate balance. See the example on page 848 – 9. The interpretation of unrealized gain or loss can be quite difficult, but at least one can be sure that the sum of the realized and unrealized gains and losses is equal to the total economic return on the portfolio for the year.

 

The classification of a security, reflecting as it does management’s intentions regarding the purpose and length of time for which it is to be held, is subject to change. Should this happen, recognition of previously unrecognized changes in value must be made to ensure that securities are recorded at their value on the date of the reclassification. This also ensures that the category change cannot be used to hide unrealized losses. Pages 850 – 852 treat the changes between the classes described in FASB Statement No. 115. Transactions to and from the equity method are covered in the Web Material Associated with chapter 14. Generally, the security being reclassified is accounted for at its fair value at the time of the transfer, as required by FASB Statement No. 115. This fair value will generally differ from the historical cost, at which the security is being maintained on the books. The historical cost is removed from the old category, the current fair value is entered in the new category, and the difference is treated in one of several manners depending on the categories involved in the reclassification. Exhibit 14-13 summarizes the accounting.

Transferred

Treatment of Changes in Value not Previously Recognized

Treatment of Previously Recognized Changes in Value

From trading

Recognized in current period net income

 Not to be reversed.

To trading

Recognized in current period net income

 

From held to maturity to available for sale

Recognized in a stockholders’ equity account.

 

From available for sale to held to maturity

Recognized in a stockholders’ equity account and amortized using the effective interest method over the remaining life.

 

 

See pages 850 – 852 for details and a worked example.

 

The classification of investment securities affects the statement of cash flows. Purchases and sales of available-for-sale, held-to-maturity and equity-method securities are reported in the Investing Activities section. Purchases and sales of trading securities are reported in the Operating Activities section. When the indirect method is used to compute operating cash flow, adjustments must be made for unrealized gains and losses of trading securities. Also a special adjustment must be made to Operating Activities cash flows associated with equity-method securities to take account of the difference between cash received as dividends and the income reported from the investment. See pages 853 – 854.

 

Realized gains and losses on the sale of investment securities are reported in the income statement in the period of the sale, as Other Revenues and Expenses or as Net Investment Income. Unrealized gains and losses on trading securities are also reported as Other Revenues and Expenses. Unrealized increases and decreases in the value of available-for-sale securities are reported as other comprehensive income and accumulated in the Stockholders’ Equity section of the balance sheet.  Appropriate presentation of individual securities on the balance sheet depends on the intent of management. Trading securities are short term by definition and are presented as current assets. Held-to-maturity securities are always noncurrent assets unless they mature with a year. Available-for-sale securities are presented as current or noncurrent according to the intentions of management.  FASB Statement No. 115 requires the following additional disclosures in the notes to the financial statements.

 

Examples are shown of note disclosures for Berkshire Hathaway and Well Fargo. See pages 855-859.

The IASB issued IAS 39 in December 1998 covering accounting for investment securities and derivatives. Minor adjustments to IAS 39 were made in December 2003. The key provisions relating to investment securities accounting are that all financial assets and liabilities are to be measured initially at cost; subsequently, financial assets are to be re-measured at fair value, except for held-to-maturity debt securities and financial assets whose fair value cannot be reliably determined; financial liabilities are to be re-measured  after acquisition at the original recorded amount less repayments and amortization; and finally, unrealized gains and losses may be reported either entirely in periodic net income or else in net income for trading securities and as part of equity for “non-trading” securities. Thus the only significant difference between IAS 39 and FASB Statement No.115 is in the reporting of unrealized gains and losses; and even there, the FASB method is an allowable option under IAS 39.

 

Impairment of a loan is the most common example of a problem in accounting for a security resulting from the lack of a tradable market value. FASB Statement No. 114, issued in 1993, addresses this issue. Loans receivable are to be carried at cost valuation unless evidence exists of a probable impairment. Impairment exists when based on current information and events it is probable that a creditor will be unable to collect all amounts (including both principal and interest) due according to the contractual terms of the loan agreement. Measurement of impairment is at the present value of expected cash flows discounted at the loan’s effective interest rate. A valuation allowance account is cr4eated and the estimated loss is charged to Bad Debt Expense. In the case of a troubled debt restructuring, the interest rate to be used is based on the original contract rate, not the rate specified in the restructuring agreement. See pages 862 – 863 for a worked example.

 

Thanks to Allen Kyle for preparing these review notes.