Chapter 8 Investments PDF

Chapter 8 Investments Professor Ghosh  Investments Financial instruments: Equity securities Debt securities Common stock Bonds Preferred stock Notes Purchased by individual investors, mutual funds, and corporations Objective: – To earn a return from...

Chapter 8 Investments Professor Ghosh  Investments Financial instruments: Equity securities Debt securities Common stock Bonds Preferred stock Notes Purchased by individual investors, mutual funds, and corporations Objective: – To earn a return from the dividends or interest the securities pay or from increases in the market prices of the securities – To develop ongoing affiliations with the companies whose securities are acquired 12-02  Accounting for Debt Investments Debt Security – Specified date when it matures – Face amount paid to investors on maturity – In the meantime, interest paid to investors 12-03  Debt Investment: Bonds Discount On July 1, 2024, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, 2027. United Intergroup, Inc., purchased the entire bond issue on a date when the market interest rate for bonds of similar risk Calculation of the Price of and maturity was 14%. Present Values the Bonds Interest × 4.7665 $200,19 = $ Principal (face amount) 42,000 $700,00 ×4 0.6663 = 5 466,438 Present value (price) of the 0 4 $666,6 bonds 33 Present value of an ordinary Present value of $1 annuity of $1 table: n = 6, i = table: n = 6, i = 7% 7% 12-04 Bond Investments: Premiums and Discounts Fair value of a bond changes when market interest rates change Market value of a fixed-rate investment moves in the opposite direction of market rates of interest Interest rate Market Premiu > sold at (stated rate m rate) Interest rate > Market Discoun sold at (stated rate t rate) 12-05  Purchase of a Debt Investment When debt investments are purchased, they are recorded at cost—that is, the total amount paid for the investment, including any brokerage fees. United paid $666,633 to purchase Masterwear’s $700,000 bonds. United debits Investment in bonds for the face amount and credits Cash for the price paid for the bonds. Because United purchased the bonds for an amount that’s less than their face amount, it credits Discount on bond investment for the difference. Journal Entry – July 1, Debit Credit 2024 Investment in bonds 700,000 Discount on bond 33,367 investment Cash 666,63 3 12-06  Recording Interest Revenue $700,0 × [12% ÷ = $42,00 Face amount 00 2] rate Stated Interest0 received $666,6 × [14% ÷ = $46,66 33 Outstanding 2] Market Interest4 balance rate revenue Journal Entry – Dec 31, Debit Credi Cash 2024 42,000 t Discount on bond 4,664 Interest revenue investment 46,664 12-07  Amortization Schedule—Discount $700,000 × $46,664 − $666,633 + 6% $42,000 $4,664 Amortizatio Cash Effective Discount Amortized Date n of Interest Interest Balance Cost Discount 7/1/2024 33,367 $666,633 12/31/2024$ 42,000.07 (666,633) = $ $ 4,664 28,703 671,297 46,664 6/30/2025 42,000.07 (671,297) = 4,991 23,712 676,288 46,991 12/31/2025 42,000.07 (676,288) = 5,340 18,372 681,628 47,340 12,658 6/30/2026 42,000.07 (681,628) = 5,714 687,342 47,714 6,544 12/31/2026 42,000.07 (687,342) = 6,114 693,456 48,114 6/30/2027 42,000.07 (693,456) = 6,544 0 700,000 48,544 $33,367 $252,000 $285,367 12-08  Three Classifications of Debt Investments Reporting Approach Carried in Treatment of Unrealized Balance Holding Gains and Losses Sheet at Held-to-maturity Not recognized* Amortized (HTM): used for debt Cost for which the investor has the “positive intent and ability” to hold to maturity. Trading (TS): used for Recognized in net income, Fair Value debt that is held in an and therefore in retained active trading account earnings as part of for immediate resale. shareholders’ equity. Available-for-sale Recognized in other Fair Value (AFS): used for debt comprehensive income, that does not qualify as and therefore in Key difference held-to-maturity or among the reporting accumulated other approaches is trading. how we account comprehensive for unrealized income in holding gains and shareholders’ equity. losses 12-9  Disclosure about Investments— General Motors Note 2 (in part): Significant Accounting Policies Marketable Debt Securities: We classify marketable debt securities as either available-for-sale or trading. Various factors, including turnover of holdings and investment guidelines, are considered in determining the classification of securities. Available-for-sale debt securities are recorded at fair value with unrealized gains and losses recorded net of related income taxes in Accumulated other comprehensive loss until realized. Trading debt securities are recorded at fair value with changes in fair value recorded in Interest income and other non-operating income, net. 12-10  Debt Investment: Held-to-Maturity Investor has the “positive intent and ability” to hold the securities to maturity Securities Maturity date mature Also called the face Principal amount Paid to investors Interest paid to Interest dates investors 12-11  HTM Investments: No Unrealized Holding Gains and Losses Example: The Wall Street Journal indicates that the fair value of the Masterwear bonds on 12/31/2024 is $714,943. How will United account for this increase in fair value? If viewed as an HTM investment: – The change in fair value will be ignored so long as it is viewed as temporary – The investment simply will be recorded at amortized cost – United will disclose the fair value of its HTM investments in a note to the financial statements – It will not recognize any fair value changes in the income statement or balance sheet 12-12  Sale of HTM Investments On July 1, 2024, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, 2027. The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Due to unforeseen circumstances the company decided to sell its debt investment for $725,000 on January 5, 2025. Journal Entry – Jan 5, Debit Credi Cash 2025 725,000 t Discount on bond 28,703 Investment in bonds investment 700,000 Gain on sale of 53,703 investments ($33,367 − $4,664) 12-13  Impairment of HTM Investments There is one important exception to the general rule that companies don’t recognize unrealized gains and losses for HTM investments. If viewed as an HTM investment: – Companies likewise are required to use the Current Expected Credit Loss (CECL) model to account for credit losses on HTM investments This requires companies to make an estimate of the amount of interest and principal payments they won’t receive in the future Companies account for that estimate by recognizing a credit loss in net income and reducing the carrying value of the HTM investment with an allowance for credit losses 12-14  Financial Statement Presentation—HTM Income Statement and Statement of Comprehensive Income: – Realized gains and losses are shown in net income in the period in which securities are sold – Unrealized holding gains and losses are disclosed in notes to financial statements – Do not affect other comprehensive income (OCI) Balance Sheet: – Investments in HTM securities are reported at amortized cost, less any allowance for credit losses – Fair values of those investments are disclosed in the notes to financial statements Cash Flow Statement: – Cash flows from buying and selling HTM securities are classified as investing activities 12-15 Reporting Held-to-Maturity Investments (Ignoring income taxes) 2024 2025 Statement of Comprehensive Income Revenues $ $ Expenses Other income (expense): Interest revenue 46,664 0 Gain on investments 0 53,703 Net income 46,664 53,703 Other comprehensive income (OCI) 0 0 Comprehensive income (Net income + OCI) 46,664 53,703 Balance Sheet Assets: Investments in bonds (HTM) 671,297 0 Shareholders’ equity: Retained earnings 46,664 100,367 Statement of Cash Flows (direct method) Operating activities: Cash from interest received 42,000 0 Investing activities Purchase of HTM securities (666,633) 0 Sale of HTM securities 0 725,000 12-16  Trading Securities (TS) Investments in debt or equity securities acquired principally for the purpose of selling them in the near term – Active buying and selling of securities – Holding period generally is measured in hours and days rather than months or years – Typically reported among the investor’s current assets Fair value information is more relevant, so – Carried at fair value on the balance sheet, and – Unrealized holding gains and losses are included in net income in the income statement 12-17  Trading Security to Fair Value (2024) Assuming the Masterwear bonds have a fair value of $714,943 as of December 31, 2024, the table shows the calculation of the balance in the fair value adjustment account that is required on that date. December 31,2024 Security Amortized Fair Value FV Adj Bal Cost Masterwea $671,297 $714,943 $43,646 r Journal Entry – Dec 31, Debit Credi Fair value2024 adjustment 43,646 t Gain on investments—(unrealized, 43,646 NI) 12-18  Sale of Trading Security Investments Assuming United sells the bond for $725,000 on January 5, 2025. 1. Adjust trading securities to fair value (2025) January 5, 2025 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $725,000 Fair Value$53,703 Adjustment Beginning balance on 43,646 12/31/24 Adjustment needed to update ? fair valueneeded on date Balance 53,703 of sale Journal Entry – Jan 5, Debit Credi Fair value2025 adjustment 10,057 t Gain on investments—(unrealized, 10,057 NI)  Sale of Trading Security Investments Assuming United sells the bond for $725,000 on January 5, 2025. 2. Record the sale transaction January 5, 2025 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $725,000 $53,703 Journal Entry – Jan 5, Debit Credi Cash 2025 725,000 t Discount on bond investment 28,703 Investment in bonds 700,000 Fair value adjustment 53,703 12-20  What If the Company Doesn’t Update FV Adjustment as of 1/5/25? As noted in FASB ASC 320-10-40, for expediency companies may not update the fair value adjustment to the fair value as of the date of sale before recording the sale. In our example, the fair value adjustment balance was $43,646 on December 31, 2024, and United would record the following Entry Journal sale entry on 5, – Jan January 5, 2025: Debit Credi 2025 t Cash 725,000 Discount on bond investment 28,703 Investment in bonds 700,000 Fair value adjustment 43,646 Gain on trading securities—NI 10,057 12-21  Financial Statement Presentation: Trading Securities Income statement and statement of comprehensive income: – Gains and losses are included in the income statement in the periods in which fair value changes, regardless of whether they are realized or unrealized – Do not affect other comprehensive income (OCI) Balance sheet: – Investments in trading securities are reported at fair value, typically as current assets Cash flow statement: – Cash flows from buying and selling trading securities are classified as operating activities 12-22  Reporting Trading Securities (Ignoring income taxes) Statement of Comprehensive Income 2024 2025 Revenues $ $ Expenses Other income (expense): Interest revenue 46,664 0 Gain on investments 43,646 10,057 Net income 90,310 10,057 Other comprehensive income (OCI) 0 0 Comprehensive income (Net income + OCI) $90,310 $10,057 Balance Sheet Assets: Investment in bonds (TS) 714,943 0 Shareholders’ equity: Retained earnings 90,310 100,367 Statement of Cash Flows (direct method) Operating activities: Cash from interest received 42,000 0 Purchase of trading securities (666,633) 0 Sale of trading securities 0 725,000 12-23  Debt Investments: Available-for-Sale Securities Available-for-sale (AFS) securities aren’t held for trading or designated as held to maturity – The investment is available for sale – Reported in balance sheet at fair value – Unrealized holding gains and losses are not included in net income but reported in statement of comprehensive income as other comprehensive income (OCI) 12-24  Adjust AFS Investments to Fair Value Let’s assume the Masterwear bond investment is classified as AFS. As of December 31, 2024, Masterwear has recorded the purchase of the bonds on July 1, 2024, as well as receipt of the first semiannual interest payment, so the bonds have an amortized cost of $671,297. The fair value of the bonds on December 31, 2024, is $714,943. December 31, 2024 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $714,943 $43,646 Journal Entry – Dec 31, Debit Credi 2024 Fair value adjustment 43,646 t Gain on investments (unrealized, OCI) 43,646 12-25  Sale of AFS Investments Assuming that United sells the Masterwear bond for $725,000 on January 5, 2025. 1. Adjust AFS investment to fair value (2025) January 5, 2025 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $725,000 $53,703 Fair Value Adjustment Beginning balance on 43,646 12/31/24 Adjustment needed to update fair value Balance needed as of date ? 53,703 of sale Journal Entry – Jan 5, Debit Credit 2025 Fair value adjustment 10,057 Gain on investments (unrealized, OCI) 10,057  Sale of AFS Investments Assuming that United sells the bond for $725,000 on January 5, 2025. 2. Reverse previous fair value adjustments January 5, 2025 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $725,000 $53,703 Journal Entry – Jan 5, Debit Credi 2025 adjustment Reclassification 53,703 t (OCI) Fair value adjustment (account 53,703 balance) 12-27  Sale of AFS Investments Assuming that Masterwear sells the bond for $725,000 on January 5, 2025. 3. Record the sale transaction January 5, 2025 Security Amortized Fair Value FV Adj Bal Cost Masterwear $671,297 $725,000 $53,703 Journal Entry – Jan 5, Debit Credi Cash 2025 725,000 t Discount on bond investment 28,703 Investment in bonds 700,000 Gain on investment (NI) 53,703 12-28  Impairment of AFS Investments Companies are required to account for impairments of AFS investments, but the accounting is somewhat complex: – If fair value is less than amortized cost, impairment exists. accounting for the impairment depends on management’s belief about whether it will sell the investment If management either intends to sell the investment or believes it is more likely than not that it will have to sell it before fair value recovers, the AFS investment is written down to fair value and the impairment loss recognized in net income If management does not intend to sell the investment and does not believe it is more likely than not it will have to sell the investment before fair value recovers, management is required to estimate and recognize credit losses and reduce the carrying value of the AFS investment with an allowance for credit losses 12-29  Financial Statement Presentation: AFS Income statement and statement of comprehensive income: – Gains and losses are shown in OCI in the periods in which changes in fair value occur – Those amounts are reclassified out of OCI and recognized in net income in the periods in which securities are sold Balance sheet: – Investments in AFS securities are reported at fair value – Unrealized holding gains and losses become part of AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold Cash flow statement: – Cash flows from buying and selling AFS securities are classified as investing activities 12-30 Statement of Comprehensive Income (ignoring income taxes) 2024 2025 Revenues $ $ Expenses Other income (expense): Interest revenue 46,664 0 Gain on AFS investments 0 53,703 Net income 46,664 53,703 Other comprehensive income (loss) items (OCI): Gain on investments (unrealized) 43,646 10,057 Reclassification adj. for net gains and losses inc’d in NI 0 (53,703) Reporting Total OCI 43,646 (43,646) Available- Comprehensive income (Net income + OCI) $90,310 $10,057 for-Sale Balance Sheet Assets: Securities Investment in bonds (AFS) $714,943 $ 0 Shareholders’ equity: Accumulated other comprehensive income 43,646 0 (AOCI) Retained earnings 46,664 100,367 Statement of Cash Flows (direct method) Operating activities: Cash from interest received 42,000 0 Investing activities 12-31 Purchase of available-for-sale securities (666,633) 0 Investments in Securities Available-for-Sale—Cisco Systems Note 10: Available-for-Sale Debt and Equity Investments (in part) The following tables summarize our available-for-sale debt investments (in millions) Gross Gross Unrealiz Amortize Unrealiz ed Fair July 25, 2020 d Cost ed Gains Losses Value U.S. government securities $ 2,614 $ 71 $ ― $ 2,685 U.S. government agency 110 ― ― 110 securities Corporate debt securities 11,549 334 (6) 11,877 U.S. agency mortgage-backed 1,987 49 (1) 2,035 securities Commercial paper 727 ― ― 727 Certificates of deposit 176 ― ― 176 Total $17,163 $454 $(7) $17,61 0 12-32  Comparison of HTM, TS, and AFS Approaches Held-to-Maturity(HTM Trading (TS) Available-for-Sale (AFS) Purchas Investment 700,000 e bonds s 33,367 Same as HTM Same as HTM at a Discount 666,633 discount Cash Record Cash 42,000 interest Discount 4,664 Same as HTM Same as HTM revenue Interest 46,664 rev. Adjust FV adjustment 43,646 FV adjustment 43,646 to fair Gain Gain No entry value, (unrealized 43,646 (unrealized, 43,646 2024 , NI) OCI) Sell bonds in FV adjustment 10,057 FV adjustment 10,057 2025 Gain 10,057 Gain 10,057 1. Adjust No entry (unrealized (unrealized, to fair ,NI) OCI) value, 2025 2. Reclassificatio 53,703 Reclassif n (OCI) 53,703 y FV adjustment unrealiz No entry No entry ed holding gains/los ses 3. Cash 725,000 Cash 725,000 Cash 725,000 Record Discount 28,703 Discount 28,703 Discount 12-33 28,703 sale of Investmen 700,000 Investments 700,000 Investments 12-33 700,000  Transfers between Reporting Categories Transfer Unrealized Gain or Loss from Transfer at from: To: Fair Value Either HTM Trading Include in current net income the total or AFS unrealized gain or loss, as if it all occurred in the current period. Trading Either HTM or Include in current net income any unrealized AFS gain or loss that occurred in the current period prior to the transfer. (Unrealized gains and losses that occurred in prior periods already were included in net income in those periods.) Held-to- Available-for- No current income effect. Report total maturity sale unrealized gain or loss as a separate component of shareholders’ equity (in AOCI). Available-for- Held-to- No current income effect. Don’t write off any sale maturity existing unrealized holding gain or loss in AOCI, but amortize it to net income over the remaining life of the security (fair value amount becomes the security’s amortized cost basis). 12-34  Fair Value Option (FVO—HTM & AFS) The election is optional but irrevocable on the date of investment purchase. Under FVO: HTM and AFS investments are shown in the balance sheets at fair value Unrealized gains and losses are recognized in net income in the period in which they occur Purchases and sales of investments are likely to be classified as investing activities 12-35 Financial Statement Presentation and Disclosure Trading securities, held-to-maturity securities, and available-for-sale securities are either current or noncurrent depending on when they are expected to mature or to be sold. Investors should disclose the following in the disclosure notes for each year presented: – Aggregate fair value – Gross realized and unrealized holding gains – Gross realized and unrealized holding losses – Change in net unrealized holding gains and losses – Amortized cost basis by major security type 12-36 Fair Value Disclosures of Investment Securities HP Incorporated As of October 31, 2020 Fair Value Measured Using Level Level Level 1 2 3 Total Assets: Cash Equivalents Corporate debt $ ― $1,700 $― $1,700 Financial institution instruments ― 59 ― 59 Government debt 1,992 181 ― 2,173 Available-for-Sale Investments Corporate debt ― 169 ― 169 Financial institution instruments ― 32 ― 32 Government debt ― 73 ― 73 Marketable equity securities and 5 53 ― 58 Mutual funds Derivative instruments Interest rate contracts ― 4 ― 4 Foreign currency contracts ― 191 ― 191 Other derivatives ― ― ― ― 12-37  Accounting for Equity Investments Purchasing the investment Recognizing investment revenue Critical events For debt: Interest that an For equity: Dividends investor experiences in the life of an Holding the investment during periods in investment which the investment’s fair value changes Unrealized holding gains and losses Selling the Investment Realized gains and losses 12-38 Reporting Categories for Equity Investments Characteristics of the Equity Reporting Method Used by the Investment Investor The investor does not have Fair value through net income— significant influence over the similar to the trading-securities operating and financial policies of the approach used for debt; investment investee (typically owns less than 20% reported at fair value (with of voting stock). unrealized holding gains and losses included in net income), unless fair value is not readily determinable. The investor has significant Equity method—investment influence over the operating and reported at cost adjusted for financial policies of the investee investor’s share of subsequent (typically owns between 20% and 50% earnings and dividends of the of the voting stock). investee. The investor controls the investee Consolidation—the financial (typically owns more than 50% of statements of the investor and voting stock). investee are combined as if they are a single company. 12-39  Investor Lacks Significant Influence Less than 20% of Lacks significant influence over the The following voting events during shares 2024 and 2025 pertain to investee United Intergroup’s investment in the common stock of Arjent, Inc.: July 1, 2024 Purchase Arjent, Inc., common stock for $1,500,000 December 31, 2024 Recognize investment revenue for a $75,000 cash dividend received from Arjent December 31, 2024 Record a fair value adjustment to recognize a decline in the value of the Arjent stock investment to $1,450,000 January 5, 2025 Sell the Arjent stock for $1,446,000 12-40  Investor Lacks Significant Influence Purchase Investments Journal Entry – July 1, Debit Credi 2024 Investment in equity 1,500,0 t securities Cash 00 1,500,0 00 Recognize Investment Revenue Journal Entry – Dec 31, Debit Credi Cash 2024 75,000 t Dividend revenue 75,000 12-41  Adjust Equity Investments to Fair Value (2024) Adjust Valued the Arjent stock at $1,450,000 investments to fair value December 31, 2024 Fair FV Adj Security Cost Value Bal Arjent $1,500,00 $1,450,00 $(50,000) 0 0 Fair Value Adjustment Beginning balance 0 ? Adjustment needed to update fair value 50,000 Balance needed December 50,000 31, 2024 Journal Entry – Dec 31, 2024 Debit Credi Loss on investments (unrealized, NI) 50,000 t Fair value adjustment 50,000  Sell the Equity Investment Step 1. Adjust securities to fair value (2025) January 5, 2025 Security Cost Fair Value FV Adj Bal Arjent $1,500,000 $1,446,000 $(54,000) Fair Value Adjustment Beginning balance 0 50,000 1/1/2025 Adjustment needed to update fair value ?4,000 Balance needed as of the date of 54,000 sale Journal Entry – Jan 5, 2025 Debit Credit Loss on investments 4,000 (unrealized, Fair value NI) adjustment 4,000 Step 2. Record the sale Journal Entry – Jan 5, 2025 Debit Credit Cash 1,446,00 Fair value adjustment 54,0000 Investment equity securities 1,500,00 0  Adjust Equity Investments to Fair Value (2025) December 31, 2025 Security Cost Fair Value FV Adj Bal Arjent $1,500,000 $1,300,000 $(200,000) Fair Value Adjustment 12/31/2024 balance 50,000 Adjustment needed to update fair value 150,000 12/31/2025 200,000 balance Journal Entry – Dec 31, Debi Cred 2025 t it Loss on investments (unrealized, NI) 150,00 Fair value adjustment 0 150,0 00 12-44  Financial Statement Presentation Equity Securities Balance sheet: – Short term: Current assets – Long term: Noncurrent assets Cash flow statement: – Short term: Operating activities – Long term: Investing activities Notes to financial statement: – Disclose the portion of unrealized gains and losses for the period – How carrying value was calculated when fair value is not readily determinable 12-45  Investor Has Significant Influence Equity Method Significant influence usually is assumed to exist if the investor owns between 20% and 50% of the investee’s voting shares – If more than 50%, the investor has control What does significant influence mean? – Decisions can be swayed in the direction the investor desires Investment is accounted for by the equity method 12-46  Equity Method—Purchase of Investment On 1/2/24 United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash $5,000,000 Book × 30% Fair Value at Time of Value on purchased Arjent’s = Financial United’s Investment $1,500,000 Statementspurchase Total fair value of Arjent price 10 year remaining (1/2/24) 5,000,000 useful life, no Buildings $1,000,000 salvage value $2,000,000 Land 500,000 1,000,000 Other identifiable net assets Other net assets = 600,000 600,000 other assets – total Identifiable net assets $2,100,000 liabilities 3,600,000 Goodwill $1,400,00 0 Other information (12/31/24) Arjent’s 2024 net income: $ 500,000 Arjent’s 2024 dividends 12-47  Equity Method—Purchase of Investment Book Value on Fair Value at Time of Arjent’s Financial United’s Investment Statements Total fair value of Arjent (1/2/24) 5,000,000 Buildings $1,000,000 $2,000,000 Land 500,000 1,000,000 Other identifiable net assets 600,000 600,000 $5,000,000 × Identifiable net assets $2,100,000 30% = 3,600,000 $1,500,000 Goodwill $1,400,00 0 Other information (12/31/24) Arjent’s 2024 net income: $ 500,000 Credi Journal Entry Arjent’s 2024 dividends Debit declared and paid t Investment in equity affiliate $ 250,000 1,500,0 Cash 00 1,500,00 0 12-48  Equity Method—Purchase of Investment Book Value on Fair Value at Time of Arjent’s Financial United’s Investment Statements Total fair value of Arjent (1/2/24) 5,000,000 Buildings $1,000,000 $2,000,000 Land 500,000 1,000,000 Other identifiable net assets 600,000 600,000 Identifiable net assets $2,100,000 3,600,000 $500,000 × Goodwill 30%$1,400,00 = $150,000 0 Other information (12/31/24) Arjent’s 2024 net income: $ 500,000 Credi Journal Entry Arjent’s 2024 dividends Debit declared and paid t Investment in equity affiliate $ 250,000 150,000 Investment revenue 150,000 12-49  Equity Method—Purchase of Investment Book Value on Fair Value at Time of Arjent’s Financial United’s Investment Statements Total fair value of Arjent (1/2/24) 5,000,000 Buildings $1,000,000 $2,000,000 Land 500,000 1,000,000 Other identifiable net assets 600,000 600,000 Identifiable net assets $2,100,000 3,600,000 Goodwill $250,000 × $1,400,00 30% = 0 Other information (12/31/24) $75,000 Arjent’s 2024 net income: $ 500,000 Credi Journal Entry Arjent’s 2024 dividends Debit declared and paid t Cash $ 250,000 75,000 Investment in equity 75,000 affiliate 12-50 Further Adjustments under the Equity Method Occur when investor’s expenditure to acquire an equity-method investment exceeds the book value of the underlying net assets acquired Purpose: – To approximate the effects of consolidation, without actually consolidating financial statements Amortizing the differential between purchase price and book value: – Adjust investment account and investment revenue to act as if consolidation procedures had been followed If assets would have been written up to fair value, act as if that happened Impute higher expenses in subsequent periods when those assets are expensed, such that Earnings are lower by the investor’s share in that additional expense 12-51 Differences between the Investment and the Book Value of Net Assets Acquired Proporti on Net Net Purchas Assets Assets ed by Purchas Difference of Investo ed by of Investee r Investor $420,000 Fair value of $5,000,0 × 30% = $1,500,0 attributed to investee 00 00 goodwill Difference of $450,000 Fair value of $3,600,0 × 30% = $1,080,0 investee’s 00 00 attributed to identifiable net buildings assets ($300,000) and land Book value of $2,100,0 × 30% = $ ($150,000) investee’s 00 630,000 identifiable net  Equity Method—Purchase of Investment Book Value on Fair Value at Time of Arjent’s Financial United’s Investment Statements Total fair value of Arjent (1/2/24) 5,000,000 Buildings $1,000,000 $2,000,000 Land 500,000 1,000,000 Other identifiable net assets 600,000 600,000 Identifiable net assets $2,100,000 3,600,000 30% × Goodwill $1,400,00 [$2,000,000 − 1,000,000] ÷ 10 0 Other information (12/31/24) yrs. Arjent’s 2024 net income: $ 500,000 Credi Journal Entry Arjent’s 2024 dividends Debit declared and paid t Investment revenue $ 250,000 30,000 Investment in equity 30,000 affiliate 12-53  No Adjustments for Land or Goodwill Land: – Land is not depreciated – Difference between the fair value and book value of the land would not cause higher expenses Goodwill: – Unlike most of the other intangible assets, goodwill is not amortized – Acquiring goodwill will not cause higher expenses 12-54  Adjustments for Other Assets and Liabilities If the fair value of purchased inventory exceeds its book value, the period in which that inventory is sold should be identified – Inventory is usually sold in the next year Investment revenue and the investment in the stock is reduced in the next year by the amount of the differential attributable to inventory Key Point 12-55  Reporting the Investment The fair value of the investment shares at the end of the reporting period is not reported when using the equity method. Instead, the investment account is reported at: The investor’s equity in Initial the undistributed cost earnings of the investee The balance of United’s 30% investment in Arjent at December 31, 2024, is calculated as: Investment in Equity Affiliate 1,500,0 Purchase price 00 Share of income 150,000 75,000Dividends Depreciation 30,000 1,545,0 adjustment 00 Reporting the Investment: Losses & Mid-Year When the investment is acquired in mid-year: – Only recognize the investor’s share of the year’s activity – Example: If United purchased 30% of Arjent on October 1: Investment in Equity Affiliate 1,500,0 Cost 00 Share of income Depreciation (3/12 × 37,500 adjustment $150,000) 7,500 (3/12 × $30,000) Dividends 18,75 (3/12 × $75,000) 0 1,511,2 50 When the investee reports a net loss: – The investment account would be decreased by the investor’s share of the investee’s net loss 12-57  Equity Method Investments: AT&T Dec 31, Dec 31, 2018 2019 Total current assets $ 54,761 $ 51,427 Noncurrent inventories and theatrical film and television production costs 12,434 7,713 Property, plant, and equipment- Net 130,128 131,473 Goodwill 146,241 146,370 Licenses-Net 97,907 96,144 Trademarks and trade names-Net 23,567 24,345 Distribution networks-Net 15,345 17,069 Other intangible assets-Net 20,798 26,269 Investments in and advances to equity affiliates 3,695 6,245 Operating lease right-of-use assets 24,039 -- 12-58 Other assets 22,754 24,809  Impairment of Equity Method Investments A series of losses or other factors could indicate that an equity-method investment’s fair value has declined to an amount below its current carrying value – If that decline is viewed as other than temporary, the investor should: Recognize an impairment loss in net income and reduce the carrying value of the investment to fair value in the balance sheet Continues with accounting under the equity method 12-59  What If Conditions Change? A change to or from the equity method to another method – No adjustment is made to the remaining carrying amount of the investment (except to account for any purchase or sale of shares) – Previous method is discontinued and the new method applied from then on – The balance in the investment account serves as the starting point for the new method 12-60  If an Equity Method Investment is Sold When an investment reported by the equity method is sold: Selling > Book (carrying) Gain is price >value recognized Selling Book (carrying) Loss is price Example: value recognized The balance of United’s 30% investment in Arjent at December 31, 2024, is $1,545,000. United sells its investment in Arjent on January 1, 2025, for $1,446,000. Journal Entry – Jan 1, 2025 Debi Cred Cash t 1,446,0 it Loss on investments (NI) 00 99,000 Investment in equity 1,545,0  Comparison of Fair Value and Equity Methods Fair Value Through Net Income Equity Method Purchase equity Investment in Investment in 1,500,0 investment equity securities 1,500,0 equity affiliate 00 Cash 00 1,500,0 Cash 1,500,0 00 00 Recognize Investment in proportionate share equity affiliate 150,000 of investee’s net Investment 150,00 income and any revenue 30,000 0 No entry related adjustments Investment revenue 30,000 Investment in equity affiliate Adjust to fair value, Loss (unrealized, 50,000 2024 NI) 50,000 No entry FV adjustment Receive dividend Cash 75,000 Cash 75,000 Dividend 75,000 Investment in revenue equity affiliate 75,000 Sell equity investment Loss (unrealized, 4,000 No entry 1. Adjust to fair NI) 4,000 value, 2025 FV adjustment 2. Record Sale Cash 1,446,0 Cash 1,446,0 FV adjustment 00 Loss (NI)(to 00 Investment in 54,000 balance) 99,000 equity securities 1,500,0 Investment in 1,545,0  Fair Value Option: Equity Method Irrevocable decision about whether to elect the fair value option or not is made by the company Company carries the investment at fair value in the balance sheet and unrealized gains and losses are included in earnings Investments are shown on their own line in the balance sheet or are combined with equity method investments with the amount at fair value shown parenthetically (1) Investment is accounted for using the entries that would be used if the investor lacked significant influence and accounted for Alternatives it at fair value through net income for bookkeepin g (2) Record all the accounting entries during the period under the equity method, and then record a fair value adjustment at the end of the period 12-63  Credit Losses for Held-to-Maturity Investments Companies recognize credit losses for HTM investments by using a contra asset account, an allowance for credit losses, to reduce the carrying value of HTM investments to the net amount expected to be collected. – Each period they record whatever credit loss expense or recovery of credit loss is necessary to adjust that allowance to its appropriate balance – The CECL model allows for various methods to estimate credit losses for HTM debt investments A very common approach is for the investor to estimate the future cash flows it expects to receive and then discount those cash flows at the effective interest rate that existed when the debt investment was purchased The investor then compares that discounted cash flow estimate to the balance (amortized cost) of the debt and adjusts the allowance for credit losses to reduce the carrying value of the debt to that estimate. 12-64  Credit Losses for Held-to-Maturity Investments On July 1, 2024, United Industries purchased bonds with a face value of $700,000 from Masterwear Industries. The stated rate of interest for the bonds is 12%, so $42,000 of interest is receivable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, 2027. The market interest rate for bonds of similar risk and maturity is 14%. United purchased the bonds for $666,633, reflecting a discount of $33,367. United received its $42,000 interest payment on December 31, 2024, so it amortized $4,664 of discount, leaving the amortized cost of the bond investment at $671,297.* When preparing its 2024 financial statements, United considered whether credit losses had occurred with respect to the Masterwear investment. United concluded that it was likely to receive interest payments of only $30,000 each period and a return of principal at maturity of only $600,000. To calculate its credit loss, United discounted those cash flows at the 7% effective interest rate that existed when the Amortized bonds cost of were purchased, the bonds and compared that at 12/31/2024: $ discounted amount to the amortized cost of the Interest bonds atx 12/31/2024: $ 30,000 671,297 4.10020 = $123,006 Principal $600,000 x 0.71299 = 427,794 Total discounted cash (550,800) flow Necessary balance in the allowance for $ 120,497 credit losses Discounted cash flow of the bond (using effective interest rate on date of bond 12-65 purchase) at Present Values  Credit Losses for Held-to-Maturity Investments On July 1, 2024, United Industries purchased bonds with a face value of $700,000 from Masterwear Industries. The stated rate of interest for the bonds is 12%, so $42,000 of interest is receivable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, 2027. The market interest rate for bonds of similar risk and maturity is 14%. United purchased the bonds for $666,633, reflecting a discount of $33,367. United received its $42,000 interest payment on December 31, 2024, so it amortized $4,664 of discount, leaving the amortized cost of the bond investment at $671,297.* When preparing its 2024 financial statements, United considered whether credit losses had occurred with respect to the Masterwear investment. United concluded that it was likely to receive interest payments of only $30,000 each period and a return of principal at maturity of only $600,000. To record theJournal $120,497Entry credit loss, United makes the following journal Debitentry: Credit Credit loss expense 120,49 Allowance for credit losses 7120,49 7 12-66  Credit Losses for Available-for-Sale Investments Assume the same facts as in the previous illustration. Also assume that United believes that, given the troubles Masterwear Industries has been facing, a discount rate of 20% (10% every six months) is appropriate for valuing those bonds in the current market. Using a discounted cash flow approach to value the Masterwear bonds, the fair value of those bonds and the related unrealized loss would be calculated as follows at 12/31/2024: Amortized cost of the bonds at 12/31/2024: $ Interest 671,297 $ 30,000 x 3.79079 = $113,724 Principal $600,000 x 0.62092 = 372,552 Total discounted cash (486,276) flow Unrealized loss $ 185,021 Credit loss (from HTM illustration) $ 120,497 Non-credit loss $ 64,524 Discounted cash flow of the bond (using effective interest rate on date of bond purchase) at Present Values 12-67 Account for Impairment of AFS Investments No impairment; Is fair value < amortized N recognize any cost? O unrealized gains in OCI YES Recognize entire Does the investor intend YES unrealized loss in to sell the investment? - earnings and reduce or- Is it more likely than amortized cost to fair not that the investor will value have to sell the Recognize credit loss investment before fair in earnings and use value recovers? allowance for credit N losses to reduce O carrying value of Is some of the YES investment unrealized loss a credit loss? Recognize noncredit portion of unrealized N loss in OCI and use O fair value adjustment Recognize entire to reduce carrying unrealized loss in OCI value of investment 12-68  Impairment of AFS Investments Case 1: If United intends to sell the bonds, or thinks it will have to sell the bonds before the fair value of the bonds can recover to amortized cost, United would make the following journal entry to write down the investment and recognize a loss in net income: Journal Entry – Dec 31, Debi Cred 2024 (NI) Loss on impairment t 185,0 it Discount on bond investment 21 185,02 1 12-69  Impairment of AFS Investments Case 2: If United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, it will make the following journal entries: Journal Entry – Dec 31, Debi Cred Credit loss 2024 expense t 120,4 it Allowance for credit losses 97 120,49 7 Journal Entry – Dec 31, Debi Cred Loss on AFS2024 investment (unrealized, t 64,52 it OCI) Fair value adjustment 4 64,524 12-70