Investments in Debt and Equity Securities
Among the reasons that companies invest in debt and equity securities of other companies are the following:
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.
Available-for-Sale, held as a store of excess
cash rather than for trading or for influence or control, but not intended to be
3. Trading, held for short-term trading purposes in the hope of a rise in price. May be either debt or equity securities
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):
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 fair value are not so 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. See example on Page 832. In either approach, the interest revenue recognized for the period is the interest earned, not the interest received.
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 example on 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% (to 50%) of ownership as a presumptive level for significant influence.
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. Control exists when the principal company owns more that 50% of the subsidiary. 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.
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 example.
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.
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. 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, Page 850, summarizes the accounting for transfers of securities between categories.
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 non-current assets unless they mature with a year. Available-for-sale securities are presented as current or non-current according to the intentions of management. FASB Statement No. 115 requires certain additional disclosures in the notes to the financial statements (Page 857).
International accounting for investment securities is very similar to GAAP. The major exception is that under IFRS companies can elect to recognize all unrealized gains and losses--both for trading and available-for-sale securities--in net income for the period. As we have previously discussed, under GAAP only unrealized gains and losses can be reported as net income.
Please skip Chapter 14's extended material relating to accounting for the impairment of a loan.