978-1259722660 Chapter 12 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

CHAPTER 12

INVESTMENTS

Overview

In this chapter we cover various approaches used to account for investments that companies make

in the debt and equity securities of other companies. An investing company has the option to account

for these investments at fair value, with changes in fair values reported on the income statement.

However, depending on the nature of a debt investment, investors can use alternative accounting

approaches.

In the first part of this chapter we discuss investments in the debt of other companies. Some of

these investments are accounted for at fair value, with changes in fair values reported on the income

statement (trading securities). Others ignore most fair value changes (e.g., held-to-maturity

investments) or include fair value changes only in other comprehensive income (e.g.,

available-for-sale investments).

In the second part of this chapter we cover equity investments. Relatively small equity investments

are accounted for at fair value, with changes in fair value included in net income, similar to trading

securities. Larger investments are accounted for using the equity method—a completely different way

to record and report investments in stock when specific characteristics indicate that the investor can

“significantly influence” the operating and financial policies of the investee. The equity method

ignores fair value changes but includes in the investor’s income their share of the investee’s income.

This chapter concludes the presentation of assets and begins the coverage of financial instruments.

Learning Objectives

LO12–1 Describe the key characteristics of a debt investment and demonstrate how to account for

a purchase and for interest revenue.

LO12–2 Demonstrate how to identify and account for debt investments classified for reporting

purposes as held-to-maturity.

LO12–3 Demonstrate how to identify and account for debt investments classified for reporting

purposes as trading securities.

LO12–4 Demonstrate how to identify and account for debt investments classified for reporting

purposes as available-for-sale securities.

LO12–5 Demonstrate how to identify and account for equity investments classified for reporting

purposes as fair value through net income.

LO12–6 Demonstrate how to identify and account for equity investments accounted for under the

equity method.

LO12–7 Explain the adjustments made in the equity method when the fair value of the net assets

underlying an investment exceeds their book value at acquisition.

LO12–8 Explain how electing the fair value option and how impairment recognition affect

accounting for investments.

LO12–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to

investments.

Instructors Resource Manual 12-1

McGraw-Hill Education.

Lecture Outline

Overview

I. Debt investments can be accounted for as:

A. Held-to-maturity

B. Trading securities

C. Securities available-for-sale

II. Equity investments can be accounted for as:

A. Fair value through net income

B. Equity method

III. So long as the investor lacks control of the investee, the investor can choose the fair value option

and account for an investment similar to how trading securities are accounted for. If the investor

controls the investee, they cannot choose the fair value option, and consolidation is appropriate

(discussed briefly in Part B and more in depth elsewhere in the curriculum).

Part A: Accounting for Debt Investments

I. Securities to be Held-to-Maturity (HTM)

A. A bond or other debt security—unlike a share of stock—has a specified date when it

matures.

B. Changes in fair value of HTM investments are not as relevant to an investor who will hold a

security to its maturity regardless of those changes.

C. If an investor has the “positive intent and ability” to hold the securities to maturity,

investments in debt securities are reported at amortized cost in the balance sheet.

1. All investment securities are initially recorded at cost.

2. Interest is recorded each period as the effective market rate of interest

multiplied by the outstanding balance of the investment.

D. A loss inherent in an “other-than-temporary” impairment of HTM investments is recognized

in earnings even though the security hasn’t been sold.

II. Trading Securities (TS) and Available-for-Sale Securities (AFS)

A. Reported at the fair value of the investment securities on the reporting date.

B. Fair value information is more relevant than for investments to be held-to-maturity.

C. All investment securities are initially recorded at cost.

D. Dividend and interest income from all investment securities is included in earnings.

E. Realized gains and losses are included in earnings.

F. Reporting unrealized holding gains and losses in the financial statements depends on

whether the investments are classified as “securities available-for-sale” or as “trading

securities.”

1. Trading Securities

a. Actively managed in a trading account for the purpose of profiting from

short-term price changes.

b. Classified as either current or noncurrent assets, depending on how long they’re

likely to be held, but usually current.

Instructors Resource Manual 12-2

McGraw-Hill Education.

c. Relatively few investments are classified this way because typically banks and

other financial operations invest in trading securities, but given the fair value

option provided by SFAS No. 159 the prevalence of this classification could

increase.

d. Unrealized holding gains and losses from retaining trading securities during

periods of fair-value change are included in the determination of income.

e. In the period a trading security is sold, only the gain or loss occurring since the

last reporting date is included in income, because the rest was included in

income in prior periods, as an unrealized holding gain or loss. This happens

automatically by the combination of (1) recognizing in income the total gain or

loss realized on sale and (2) updating the fair-value adjustment at the end of the

period to back out from net income the unrealized holding gains and losses that

were recorded in prior periods.

2. Securities Available-for-Sale

a. All investments in debt securities that don’t fit the definitions of the other

reporting categories.

b. Until ASU 2016-1 (adoption required in 2018), equity investments for which the

investor did not have significant influence over the investee could also be

accounted for as AFS.

c. AFS investments are classified as either current or noncurrent assets, depending

on how long they’re likely to be held.

d. Unrealized holding gains and losses from holding AFS securities during periods

of fair-value change are not included in net income (rather, they are included in

other comprehensive income (OCI) and accumulated and reported as a separate

component of shareholders’ equity called accumulated other comprehensive

income (AOCI).

e. In the period an AFS security is sold, the entire gain or loss realized on sale is

included in net income. The sale is accounted for in three parts:

1) The fair-value adjustment is updated to the fair value at time of sale, and

any unrealized holding gain or loss is included in OCI and AOCI.

2) The accumulated unrealized holding gain or loss is reclassified out of

AOCI via OCI.

3) The sale is recorded, with any realized gain or loss recognized and

included in net income.

f. A loss inherent in an “other-than-temporary” impairment of AFS investments is

recognized in earnings even though the security hasn’t been sold.

3. IFRS currently has two standards that apply to these investments:

a. IAS No. 39, until recently the only standard. It has primary categories that are

similar to U.S. GAAP, consisting of “Fair Value through Profit & Loss”

(“FVTPL,” similar to TS), HTM, and AFS.

b. IFRS No. 9

1) Required adoption has been postponed to January 1, 2018, and earlier

adoption is allowed (but still not allowed by the EU).

2) Investments in debt securities are classified as either amortized cost

(accounted for like HTM investments in U.S. GAAP), fair value through

other comprehensive income (“FVOCI,” accounted for like AFS

Instructors Resource Manual 12-3

McGraw-Hill Education.

investments) and fair value through profit or loss (“FVPL,” accounted for

like trading securities). Classification depends on (1) whether the

investment’s contractual cash flows consist solely of payments of principal

and interest (this criterion is called “SPPI”), and (2) whether the business

purpose of the investment is to collect contractual cash flows, sell

investments, or both. If the debt investment qualifies as SPPI and is held

only to collect cash flows, it is classified as amortized cost. If it qualifies

as SPPI and is held both to collect cash flows and potentially be sold, it is

classified as FVOCI. Otherwise it is classified as FVPL.

3) Investments in equity securities are classified as either FVPL or FVOCI. If

the equity investment is held for trading, it must be classified as FVPL, but

otherwise the company can irrevocably elect to classify it as FVOCI.

Realized gains or losses are not reclassified out of OCI, but rather just

transferred to retained earnings.

G. Transfers:

1. U.S. GAAP: a transfer of a security between reporting categories is accounted for at

fair value and in accordance with the new reporting classification.

2. IFRS: Until recently, IFRS did not allow transfers out of the FVTPL classification, but

in October 2008 the European Union responded to the financial crisis by requiring

that the IASB amend IAS No. 39 to allow transfers of debt investments out of the

FVTPL category into AFS or HTM in “rare circumstances,” and indicated that the

current financial crisis qualified as one of those circumstances.

III. The Fair Value Option

A. SFAS No. 159 allows companies to elect to treat HTM or AFS securities similarly to how

we treat trading securities, with the investment shown at fair value on the balance sheet and

unrealized holding gains and losses included in earnings.

B. The fair value option is made for each individual security, and is irrevocable.

C. IFRS has a similar fair value option, but investments have to meet more restrictive criteria

for the fair value option to be allowed.

IV. Impairments

A. If the fair value of an HTM or AFS investment declines below the amortized cost of the

investment, and that decline is deemed to be other-than-temporary (OTT), the company

recognizes an OTT impairment loss in earnings.

B. The specific process for determining whether an investment has an OTT impairment differs

between equity and debt investments.

1. For equity investments, the question is whether the company has the intent and ability

to hold the investment until fair value recovers. If it doesn’t, the company recognizes

an OTT impairment loss in earnings and reduces the carrying value of the investment

in the balance sheet by that amount.

2. For debt investments, the process is more complicated than for equity investments,

both in determining whether an impairment is OTT and in determining the amount of

the impairment to include in earnings.

C. For both equity and debt investments, after an OTT impairment is recognized, the ordinary

Instructors Resource Manual 12-4

McGraw-Hill Education.

treatment of unrealized holding gains and losses is resumed; that is, further changes in fair

value are reported in OCI for AFS investments and not recognized for HTM investments.

D. An in-depth discussion of accounting for OTT impairments is provided in Appendix 12B.

V. Financial Statement Presentation and Disclosure

A. It’s not necessary that a company report individual amounts for the three categories of

investments—held-to-maturity, available-for-sale, or trading—on the face of the balance

sheet as long as that information is presented in the disclosure notes.

B. Investors should disclose the following in the disclosure notes for each year presented:

1. Aggregate fair value

2. Gross realized and unrealized holding gains

3. Gross realized and unrealized holding losses

4. The change in net unrealized holding gains and losses, and

5. Amortized cost basis by major security type.

C. Information about maturities should be reported for debt securities, by disclosing the fair

value and cost.

D. Companies also have to report information about how fair values were determined,

particularly if the fair values are estimated using “level 3” inputs that are less verifiable.

Part B: Accounting for Equity Investments

I. When the Investor Lacks Significant Influence: Fair Value through Net Income

A. ASU 2016-1 changed accounting for small equity investments. Prior to 2018, equity

investments were accounted for as trading securities or AFS securities.

B. Now, if an equity investor lacks significant influence, the investment is accounted for at fair

value, with unrealized holding gains and losses included in net income. That is the same

approach as is used for trading securities.

II. Significant Influence

A. The equity method is used when an investor can’t control, but can “significantly influence”

the investee.

B. Usually an investor can exercise “significant influence” over the investee when it owns

between 20% and 50% of the investee’s voting shares.

C. Under IFRS, companies can either use the equity method or proportionate consolidation for

joint venture.

III. A “One-Line Consolidation”

A. Much like consolidation, the equity method views the investor and investee collectively as a

special type of single entity (as if the two companies were one company).

B. The investor’s ownership interest in individual assets and liabilities of the investee is

represented by a single investment account.

C. The investor recognizes investment income equal to its percentage share (based on share

ownership) of the net income earned by the investee.

D. The investment account subsequently is:

Instructors Resource Manual 12-5

McGraw-Hill Education.

1. Increased by the investor’s percentage share of the investee’s net income (or decreased

by its share of a loss).

2. Decreased by dividends declared.

E. When the cost of an investment exceeds the book value of the underlying net assets

acquired, additional adjustments to both the investment account and investment revenue

might be needed.

1. Both the investment account and investment revenue are adjusted for differences

between net income reported by the investee and what that amount would have been if

consolidation procedures had been followed.

2. Consolidated financial statements report (a) the acquired company’s assets at their fair

market values rather than their book values and (b) “goodwill” for the excess of the

acquisition price over the fair value of the acquired net assets.

a. Increasing asset balances to their fair values usually will result in higher

expenses.

b. Recording goodwill will not result in higher expenses.

IV. Reporting the Investment

A. The investment account is reported at its original cost:

1. Increased by the investor’s share of the investee’s net income (adjusted for additional

expenses like depreciation and amortization).

2. Decreased by the portion of those earnings actually received as dividends.

B. Thus, the investment account represents the investor’s share of the investee’s net assets

initially acquired, adjusted for the investor’s share of the subsequent increase in the

investee’s net assets (net assets earned and not yet distributed as dividends).

V. A Change in Methods

A. When the investor’s level of influence changes, it may be necessary to change from the

equity method to another method.

1. No adjustment is made to the remaining carrying amount of the investment.

2. The equity method is simply discontinued and the new method applied from then on.

B. When the investor’s level of influence changes, it may be necessary to change from another

method to the equity method.

1. No adjustment is made to the remaining carrying amount of the investment.

2. The equity method is applied to the carrying amount of the investment going forward.

VI. The Fair Value Option

A. The investor can elect the fair value option for “significant influence” investments,

recording the investment at fair value and including dividend income and unrealized

holding gains and losses in earnings.

B. The investor needs to clearly indicate the portion of “significant influence” investments that

are reported at fair value as opposed to reported under the equity method.

C. IFRS does not allow the fair value option for most equity method investments.

Decision Makers’ Perspective

A. It is critical that both managers and external decision makers clearly understand the impact

of investment accounting on income and make decisions accordingly.

Instructors Resource Manual 12-6

McGraw-Hill Education.

1. The way we account for an investment has little effect on a company’s cash flows.

2. But, the accounting method affects net income while the investment is being held and

when the investment is sold, and therefore affects calculations of earnings per share

and any rate of return ratios.

3. When analyzing a company’s profitability, lenders and investors should be alert to the

way accounting methods affect reported net income.

4. An analyst should be particularly wary if the method changes from one year to the

next.

B. The equity method actually was designed in part to prevent the manipulation of income that

would be possible if investing corporations that have significant influence over investee’s

recognized income only when received as dividends.

1. The equity method limits that potential way of managing earnings.

2. But the discretion management has in classifying investments creates other potential

abuses.

C. Increasing use of fair values in reporting investments could create concerns about the

reliability of unrealized holding gains and losses that are included in income. Footnote

disclosures about the reliability of the inputs to fair value estimates can be helpful.

Appendix 12A: Other Investments (Special Purpose Funds, Investments in Life Insurance

Policies)

A. Special Purpose Funds

1. Some special purchase funds – like petty cash – are current assets.

2. A special purchase fund can be established for virtually any purpose.

3. Noncurrent special purchase funds are reported within the category “Investments and

funds.”

4. Any investment revenue from these funds is reported as such on the income statement.

B. Investments in Life Insurance Policies

1. Certain life insurance policies can be surrendered while the insured is still alive in

exchange for its cash surrender value.

2. Part of each insurance premium represents an increase in the cash surrender value, so

part of each premium payment – the investment portion – is recorded as an asset.

Appendix 12B: Impairment of Investments

A. Overview provided by Illustration 12B–1.

B. An investment is impaired if its fair value is less than cost (or in the case of debt, amortized

cost). The question is whether the impairment is other-than-temporary (OTT) and if so what

amount is recognized in earnings. That differs according to whether it is debt or equity.

C. For equity, since accounted for as FV through net income, impairments are recognized

automatically.

D. For debt:

1. View the impairment as OTT if one of three conditions hold:

a. The investor intends to sell the investment.

b. The investor believes it is “more likely than not” that the investor will be

required to sell the investment prior to recovering the amortized cost of the

investment less any credit losses arising in the current year.

c. The investor determines that a credit loss exists on the investment.

Instructors Resource Manual 12-7

McGraw-Hill Education.

1) Credit losses reflect expected reductions in future cash flows from

anticipated defaults on interest or principal payments. We calculate credit

losses as the difference between the amortized cost of the debt and the

present value of the cash flows expected to be collected, using a discount

rate equal to the effective interest rate that existed at the date the

investment was acquired.

2) Non-credit losses capture other reductions in fair value.

2. If OTT for the first two reasons, entire impairment is included in earnings, as with

equity.

3. If OTT for the 3rd reason (credit loss exists), include only the credit loss in earnings,

and include the non-credit loss in OCI.

a. From a disclosure perspective, the entire impairment is shown on the income

statement, and then the non-credit loss is backed out.

b. If this is a HTM debt investment, have to amortize the amounts out of OCI for

the remainder of the investment, debiting the fair value adjustment associated

with the investment and crediting OCI each period.

E. Under IFRS (IAS No. 39):

1. Companies recognize OTT impairments if there exists objective evidence of

impairment. Objective evidence must relate to one or more events occurring after

initial recognition of the asset that affect the future cash flows that are going to be

generated by the asset.

2. For an HTM investment, the impairment is calculated as the difference between the

amortized cost of the asset and the present value of expected future cash flows,

estimated at the asset’s original effective rate. So, the impairment is essentially limited

to the amount that would be considered a credit loss in U.S. GAAP.

3. For an AFS investment (debt or equity), the impairment is calculated as the difference

between amortized cost and fair value.

4. All OTT impairments are recognized in earnings (there is no equivalent to recognizing

in OCI any non-credit losses on debt investments).

5. IFRS allows recoveries of impairments to be recognized in earnings for debt

investments, but not for equity investments.

F. Under IFRS (IFRS No. 9, to be adopted by 1/1/2018),

1. Impairment of debt investments is calculated using the expected credit loss (ECL)

model. Under that approach,

a. If the credit risk of a debt investment has not increased, the estimate of credit

losses only considers losses that are expected to arise from a default occurring

within the next twelve months.

b. On the other hand, if the borrower’s credit quality has deteriorated significantly

since inception of the debt, the company also includes credit losses expected to

occur from defaults after twelve months.

2. OTT impairments of equity investments are not recognized under IFRS No. 9.

a. If the investment is classified as FVPL, unrealized holding losses are recognized

automatically in net income.

b. If the investment is classified as FVOCI, realized and unrealized losses are

recognized on OCI and remain in owners’ equity.

Instructors Resource Manual 12-8

McGraw-Hill Education.

Instructors Resource Manual 12-9

McGraw-Hill Education.