Financial Investments PDF

Chapter 12 – Financial Investments Chapter Objectives – Be able to: 1. explain why companies purchase the debt and equity securities of other companies 2. explain the concepts of Fair Value and the Fair Value Hierarchy (three levels) 3. explain the accounting treatment for investments in debt...

Chapter 12 – Financial Investments Chapter Objectives – Be able to: 1. explain why companies purchase the debt and equity securities of other companies 2. explain the concepts of Fair Value and the Fair Value Hierarchy (three levels) 3. explain the accounting treatment for investments in debt securities as either Trading or Available-for-Sale Securities 4. account for passive investments in equity securities (Fair Value through Net Income) 5. account for investments with significant influence in equity securities under the Equity Method 1  Purchasing Securities of Other Organizations  Called financial investments  Aimed at activities such as… Short-term investment of excess cash Alliances for strategic purposes Market penetration or expansion 2  Financial Investments  The accounting for financial investments depends on both the type and the amount of securities purchased  Accounting for investments depends on the degree of influence or control that the investor company can exert over the investee company 3 Financial Investment Diagram Three levels of influence/control 4  Passive Influence  Investor cannot exert influence over the investee company  Generally less than 20% of the outstanding voting stock of the investee is owned by investor  Can be investments in stock, bonds, or notes of other companies 5  Significant Influence  Investor can exert influence over, but not control, the investee company  Level of influence can result from  Percentage of voting stock owned  Legal agreements  Result of being a sole supplier or customer  Influence generally assumed if ownership is between 20% to 50% of the outstanding voting stock 6  Controlling Influence  Investor has control over investee  Ability to elect a majority of the board of directors  Ability to affect the strategic corporate direction  Can affect hiring of executive management  Control presumed when ownership is 50% or more of the outstanding voting stock  However, can occur at less than 50% through  Legal agreements  Technology licensing 7  Investment Treatment and Effects The level of influence/control determines the proper accounting procedures Investment Type, Accounting Treatment, and Financial Statement Effects 8 Investment Treatment and Effects (cont.) The level of influence/control determines the proper accounting procedures Exhibit continued from previous slide Investment Type, Accounting Treatment, and Financial Statement Effects 9  Fair Value U.S. GAAP defines fair value as the amount that an independent buyer would be willing to pay for an asset  For an asset that is actively traded on financial markets:  Fair value is the amount that we would receive by selling that asset  This is referred to as “mark-to-market”  Fair value is also used when there is no active market for the asset:  This is referred to as “mark-to-model” and is regarded as more subjective than mark-to-market values U.S. GAAP requires that firms use the fair value hierarchy to disclose the methods used to determine fair value 10  Fair Value Hierarchy Level 1 Values based on quoted prices in active markets for identical assets/liabilities Example: A common share of a company traded on an active exchange Level 2 Values based observable inputs other than Level 1 (e.g., quoted prices for similar assets/liabilities, or interest rates, or yield curves) Example: A bond that is infrequently traded, but similar to actively traded bonds Level 3 Values based inputs observable only to the reporting entity (e.g., management estimates or assumptions) Example: An operating asset that is judged to be impaired 11  Acquisition and Sale of Passive Investments Investor does not possess sufficient ownership to enable it to influence or control the investee company When Acquired Recorded at cost of acquisition on the purchase date When Sold Gain or loss Proceeds Book value of on sale = from sale ̶ investment sold Reported as a component of other income on the income statement 12  Purchase of Passive Debt Investment Suppose that, on January 1, Technix, Inc. is issuing 5-year $1,000 bonds with annual interest of 10% payable semi-annually on June 30 and December 31. On January 1, WebPros, Inc. purchases 500 of these bonds for $500,000. Investment in Technix 500,000 Cash 500,000 Investment in Technix Cash 500,000 500,000 13  Recording Interest Income On June 30, WebPros received $25,000 in cash for the semi-annual interest on the Technix bonds. Cash 25,000 Interest Income 25,000 Cash Interest Income 25,000 25,000 14  Accounting for Changes in Value Over this six-month period, assume that market interest rates rose and reduced the fair value of WebPros’ Technix bonds from $500,000 to $487,000. How should that event be reflected in WebPros’ June 30 financial statements? There are three possible answers to that question. Let’s take the simplest one first. If WebPros has the ability and the intent to hold the Technix bonds until their 5-year maturity, then they use the held-to-maturity method.  On the balance sheet, the investment remains at its cost  No gain or loss reported in the income statement Temporary fluctuations in value are not deemed relevant if the investor intends to hold the bonds to maturity. 15  Investments Marked to Fair Value If the investor does not have the ability and intent to hold the debt security to maturity, then the securities must be reported on the balance sheet at current fair value using one of two methods  Trading securities Management intends to actively buy and sell for trading profits as market prices fluctuate  Available-for-sale (AFS) securities Management intends to hold for capital gains and interest or dividend revenue; may sell if the price is right or if cash is needed 16  Accounting for Trading and Available-for Sale Investments 17  Fair Value Adjustment of Trading Investment WebPros now has 500 bonds of Technix recorded at $500,000 and classified as Trading. The fair value at year-end is $487,000 Fair value decrease = $487,000 - $500,000 = $13,000 Unrealized Loss 13,000 Investment in Technix 13,000 Unrealized Loss Investment in Technix 13,000 13,000 18  Fair Value Adjustment of Available for Sale Investment The $13,000 drop in value is reflected in the investment asset, but not in income. The loss is “parked” in Accumulated Other Comprehensive Income (AOCI) in the equity section of the balance sheet. Unrealized Loss 13,000 Investment in Technix 13,000 Unrealized Loss (AOCI) Investment in Technix 13,000 13,000 19  Passive Equity Investments Investments in equity investments in another company are accounting for as “Fair Value through Net Income” which is the same treatment as a Trading debt security. Unrealized gains and losses are recognized in income in the period that they occur. 20  Investments with Significant Influence  Significant influence exists when the investor is able to affect the financing or operating policies of the investee  Reasons for making this type of investment  Prelude to acquisition  Strategic alliance  For purposes of expanding to a new location  Such as a company that provides inputs for the investor’s production process  Pursuit of research and development - Joint efforts can reduce risk or amount of capital invested 21  Equity Method  Used when significant influence by the investor over the investee exists  NOT reported at fair value (so no gains or losses recorded for changes in value) Investment Account Investment purchase cost % share of Recognized as investee’s dividends income by the investor % share of Treated as recovery of investment. investee's income Not part of investor’s income 22  Acquisition of Investment Using the Equity Method WebPros purchased a 40% interest (common stock) in Technix for $60,000. At the acquisition date, Technix has fair value of net assets and stockholders’ equity of $150,000. Investment in Technix 60,000 Cash 60,000 Investment in Technix Cash 60,000 60,000 23  Investee Income Using the Equity Method Technix reported $8,000 of net income WebPros’ income share = $8,000 x 40% = $3,200 Investment in Technix 3,200 Investment income 3,200 Investment in Technix Investment Income 60,000 3,200 3,200 24  Investee Dividend Using the Equity Method Technix paid $6,000 of dividends for the year WebPros’ dividend share = $6,000 x 40% = $2,400 Cash 2,400 Investment in Technix 2,400 Cash Investment in Technix 2,400 60,000 3,200 2,400 Year end balance 60,800 of investment 25 Accounting for Investments with Control  Applicable when an investor owns more than 50% of the voting common stock of the investee  GAAP requires consolidation of the two balance sheets (parent/subsidiary)  Requires summing individual lines for each balance sheet line, and  eliminating intercompany transactions  Investments and loans  Sales and purchases within the consolidated group 26  Consolidation Accounting Example Purchase at Book Value WebPros acquires all of the common stock of Technix by exchanging its newly issued shares for all of Technix’s stock. The purchase price is $100,000. Technix’s contributed capital is $40,000 and retained earnings is $60,000. WebPros Technix Current assets $ 29,000 $ 36,000 Investment in Technix 100,000 — PPE, net 116,000 70,000 Balance sheets Total assets $245,000 $106,000 just after purchase Liabilities $ 32,000 $ 6,000 Contributed capital 88,000 40,000 Retained earnings 125,000 60,000 Total liabilities and equity $245,000 $106,000 27  Consolidation Accounting Example Purchase at Book Value WebPros Technix Adjustments Consolidated Current assets $29,000 $36,000 $65,000 Investment in Technix 100,000 — (100,000) — PPE, net 116,000 70,000 186,000 Total assets $245,000 $106,000 $251,000 Liabilities $32,000 $6,000 $38,000 Contributed capital 88,000 40,000 (40,000) 88,000 Retained earnings 125,000 60,000 (60,000) 125,000 Total liabilities and equity $245,000 $106,000 $251,000  Eliminating adjustments:  Eliminate WebPros’ investment in Technix  Eliminate Technix’s equity  The remaining assets and liabilities are combined 28