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Overview
In this chapter we cover various approaches used to account for investments that companies make
in the debt and equity 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 an investment, investors can use alternative accounting approaches.
In the first part of this chapter we discuss investments for which the investor cannot “significantly
influence” the operating and financial policies of the investee. Some of these investments are
accounted for at fair value (trading securities), with changes in fair values reported on the income
statement. 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 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
1. Demonstrate how to identify and account for investments classified for reporting purposes as
held-to-maturity.
2. Demonstrate how to identify and account for investments classified for reporting purposes as
trading securities.
3. Demonstrate how to identify and account for investments classified for reporting purposes as
available-for-sale securities.
4. Explain what constitutes significant influence by the investor over the operating and financial
policies of the investee.
5. Demonstrate how to account for investments accounted for under the equity method.
6. Explain the adjustments made in the equity method when the fair value of the net assets
underlying the investment exceeds their book value.
7. Explain how electing the fair value option affects accounting for investments.
8. Discuss the primary differences between U.S. GAAP and IFRS with respect to investments.
12-2 Intermediate Accounting, 8/e
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Overview (T12-1)
I. If the investor cannot “significantly influence” the operating and financial policies of the
investee, the investment can be accounted for as:
A. Held-to-maturity
B. Trading securities
C. Securities available-for-sale
II. If the investor can “significantly influence” the operating and financial policies of the investee,
the equity method is appropriate (discussed in Part B).
III. So long as the investor lacks control of the investee, the investor can choose the fair value option
and account for the 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, more in depth elsewhere in the curriculum).
Part A: Accounting for Investment Securities for which the Investor Lacks
Significant Influence (T12-2, T12-14)
I. Securities to be Held-to-Maturity (HTM) (T12-3)
A. A bond or other debt security – unlike a share of stock, has a specified date on which 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. (T12-4)
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 (T12-5,6,7,8)
a. Actively managed in a trading account for the purpose of profiting from short-
c. Relatively few investments are classified this way because only 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 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 gains and losses that were
recorded in prior periods.
2. Securities Available-for-Sale (T12-5,9,10,11,12,13)
a. All investments in debt and equity securities that don’t fit the definitions of the
other reporting categories.
b. Classified as either current or noncurrent assets, depending on how long they’re
likely to be held.
c. Unrealized 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)).
d. In the period an AFS security is sold, the entire gain or loss realized on sale is
included in net income. During the fair value adjustment process, the
accumulated unrealized holding gains and losses must be reclassified out of the
fair value adjustment and OCI (and therefore AOCI) to avoid double counting.
(T12-12)
e. 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: (T12-15)
(“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
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.
4) 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. If fair value of equity is not viewed as “readily determinable” (defined as the equity trading
currently on an exchange), and the equity method is not viewed as appropriate, the cost
method is used.
1. Mechanics of the cost method:
a. The security is carried on the balance sheet at cost, with no temporary unrealized
2. Under IFRS:
a. IFRS No. 39: can only use the cost method if can’t reliably measure fair value.
b. IFRS No. 9: cost method is disallowed (but indicates circumstances where cost
is a good indication of fair value).
H. 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. (T12-16)
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 as trading
securities, such that unrealized holding gains and losses are included in earnings. (T12-27)
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. (T12-28)
IV. Impairments (T12-17)
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
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
treatment of unrealized 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 (T12-18)
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
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: The Equity Method
I. Significant Influence
A. The equity method is used when an investor can’t control, but can “significantly influence”
the investee. (T12-19)
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. (T12-20)
II. 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). (T12-20)
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. (T12-22)
D. The investment account subsequently is: (T12-19, 22)
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.
12-6 Intermediate Accounting, 8/e
1. Both the investment account and investment revenue are adjusted for differences
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.
III. Reporting the Investment (T12-24)
A. The investment account is reported at its original cost:
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).
IV. A Change in Methods (T12-25)
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.
2. Both the investment and retained earnings would be increased by the investor’s share
of the undistributed earnings in years prior to a change to the equity method.
V. 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. (T12-26, 27)
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.
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
3. When analyzing a company’s profitability, lenders and investors should be alert to the
way accounting methods affect reported net income. (T12-29)
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.
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 gains and losses that are included in income. Footnote disclosures
about the reliability of the inputs to fair value estimates can be helpful.
Appendix 12-A: 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.
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.
(T12-30)
Appendix 12-B: Impairment of Investments
A. Overview provided by Illustration 12B-1. (T12-31)
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:
1. The impairment is temporary if the investing company can assert that it has the intent
2. If OTT, recognize the loss in earnings, reclassifying out of OCI if necessary.
D. For debt:
1. View the impairment as OTT if one of three conditions hold:
a. The investor intends to sell the investment.
investment less any credit losses arising in the current year.
c. The investor determines that a credit loss exists on the investment.
1) Credit losses reflect expected reductions in future cash flows from
anticipated defaults on interest or principal payments. We calculate credit
12-8 Intermediate Accounting, 8/e
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): (T12-32)
1. Companies recognize OTT impairments if there exists objective evidence of
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 losses are recognized
PowerPoint Slides
A PowerPoint presentation of the chapter is available in the Connect library.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or you can
first modify them to suit your particular needs or preferences. In addition, all
illustrations in the chapter are separately available in the Connect library.
12-10 Intermediate Accounting, 8/e
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:
Investments in debt securities for
which the investor has the
“positive intent and ability” to
hold to maturity
Held-to-maturity (“HTM”)—
investment reported at amortized cost*
Investments held in an active
trading account
Trading securities (“TS”)—investment
reported at fair value (with unrealized
holding gains and losses included in net
income)
directly in shareholders’ equity)*
The investor has significant influence
over the operating and financial
policies of the investee:
Typically the investor owns
between 20% and 50% of the
voting stock of the investee
Equity method—investment cost
adjusted for subsequent earnings and
dividends of the investee*
The investor controls the investee:
The investor owns more than 50%
of the investee
Consolidation—the financial statements
of the investor and investee are combined
as if they are a single company.
accounted for using the same approach that’s used for trading securities, with the
Illustration 12-1
T12-1
INVESTMENTS
IN MARKETABLE SECURITIES
Reporting Approach:
Treatment of
Unrealized Holding
Gains and Losses:
Investment
Reported in the
Balance Sheet at:
Held-to-maturity (HTM):
used for debt that is planned
to be held for its entire life
Not recognized
Amortized Cost
used for debt or equity that
does not qualify as held-to–
comprehensive
income, and therefore
Fair Value
Trading (TS): used for debt
or equity that is held in an
Recognized in net
income, and therefore
Fair Value
Illustration 12-2
T12-2
12-12 Intermediate Accounting, 8/e
HELD-TO-MATURITY (HTM) SECURITIES
◆ If an investor has the “positive intent and ability” to hold the securities to maturity,
investments in debt securities are classified as “held–to–maturity” and reported at
amortized cost in the balance sheet.
◆ Temporary unrealized holding gains or losses from market price changes are
ignored. Other-than-temporary unrealized holding losses are reported in net
income, as if they had been realized on sale, and the adjusted value of the
investment is treated as its new cost basis.
Example:
On July 1, 2016, Masterwear Industries issued $700,000 of 12% bonds, dated July
Calculation of the price of the bonds:
Present Values
Interest $42,000 x 4.76654 * = $200,195
Purchase:
July 1, 2016
Investment in bonds (face amount) …………… … 700,000
Illustration 12-4
Recording Interest (use effective interest method)
Full Amortization Table
Outstanding Cash Effective Increase in
Balance Interest Interest Balance
6% x 7% x Discount
Face Amount Outstanding Balance Reduction
666,633 42,000 .07(666,633) =46,664 4,664
December 31, 2016
June 30, 2017
Recording Sale of HTM Investments (shouldn’t happen often)
January 15, 2017
Cash…………………………………… 725,000
Illustration 12-5
T12-4
12-14 Intermediate Accounting, 8/e
Additional Data to Illustrate Accounting for
Trading Securities and
Available-for-Sale Securities
January 15, 2017
Valued the Bendac stock at $985,000.
Purchase
Investments
Purchased Masterwear Industries’ 12%, 3-year bonds for
$666,633 to yield an effective interest rate of 14%.
Illustration 12-6
T12-5
TRADING SECURITIES
❖ Investments in debt or equity securities acquired principally for
the purpose of selling them in the near term
❖ Can be classified on the balance sheet as current or non-current,
but typically are current assets.
❖ Trading securities are carried on the balance sheet at fair value.
❖ Unrealized holding gains or losses on trading securities are
reported on the income statement as if they actually had been
realized.
❖ Relatively few investments are classified this way – mostly
banks and other financial operations (but fair value option
could increase use of TS designation).
❖ When securities are actively managed, as trading securities are,
with the expressed intent of profiting from short-term market
price changes, the gains and losses that result from holding
securities during market price changes are appropriate
measures of performance.
T12-6
12-16 Intermediate Accounting, 8/e
Accounting for Trading Securities
Purchase Trading Security Investments
(Note: we use the same basic journal entries for HTM, TS, and AFS investments)
July 1, 2016
Investment in Masterwear bonds …………………………………………..700,000
Discount on bond investment ……………………………………… 33,367
Recognize Investment Revenue for Trading Securities
(Note: we use the same basic journal entries for HTM, TS, and AFS investments)
Adjust Trading Security Investments to Fair Value (2016)
December 31, 2016
Security
Amortized Cost
Fair Value
Fair Value
Adjustment
Masterwear
$ 671,297
$ 714,943
$ 43,646
Arjent
1,500,000
1,450,000
(50,000)
Bendac
1,000,000
(10,000)
$3,171,297
For Masterwear:
Face amount of the bond:
$700,000
Less: Discount on bond investment:
Amortized cost of the bonds:
Fair value of the bond at 12/31/09:
$714,943
December 31, 2016
T12-7 (continued)
12-18 Intermediate Accounting, 8/e
Sell Trading Security Investments
(Note: we use the same basic journal entries for HTM, TS, and AFS investments)
January 15, 2017
Cash (amount received) …………………………………………………….. 725,000
Adjust Trading Security Investments to Fair Value (2017)
December 31, 2017
Security
Amortized Cost
Fair Value
Fair Value
Adjustment
Masterwear
(sold)
-0-
-0-
Arjent
(sold)
-0-
Bendac
December 31, 2017
Fair value adjustment ……………………………………………………….. 1,354
T12-7 (continued)
Financial Statement Presentation of Trading Securities
2016
2017
Comprehensive Income Statement:
Revenues
$♦
$♦
Expenses
♦
♦
Other income (expense):
Interest and dividend income
-0-
Tax expense
♦
♦
Net income
Balance Sheet
Assets:
Trading securities
Statement of Cash Flows (direct method)
Operating Activities:
Cash from investment revenue
117,000
-0-
Illustration 12-7
T12-8
12-20 Intermediate Accounting, 8/e
AVAILABLE-FOR-SALE SECURITIES
❖ All investments in debt and equity securities that don’t fit the
definitions of the other reporting categories are classified as
“available–for–sale.”
❖ AFS securities can be classified as current or non-current assets
on the balance sheet.