Chapter 16: Investments PDF

CHAPTER 16 INVESTMENTS I. Investments in Debt Securities A. Three Categories 1. Held-to-Maturity Securities (HTM): Intent and ability to hold to maturity 2. Trading Securities (TS): Actively managed in a trading...

CHAPTER 16 INVESTMENTS I. Investments in Debt Securities A. Three Categories 1. Held-to-Maturity Securities (HTM): Intent and ability to hold to maturity 2. Trading Securities (TS): Actively managed in a trading account to profit from short-term price changes 3. Available-for-Sale Securities (AFS): Investments not classified as Held-to-Maturity or Trading Securities B. Investment initially recorded at purchase price C. Interest is recorded using effectivevate method 1. Interest Revenue Carrying : Value x Market Rate Face Value Stated Rate 2. Coupon Payment : x 3. Difference adjusts investment's value carrying 1 D. Fair Value Adjustment 1. Fair Value irrelevant HTM : changes are and fair Value changes are reported in earnings 2. TS : FVA is required and fair value changes are reported in OC 3. AfS : FUA is required I Income Comprehensive Other E. Balance Sheet Classification 1. HTM Reported : at Carrying Value (faceH-Premium/Discount) and usually classified as nor current asset current Fair value and usually classified as 2. TS : Reported at noncurrent asset 3. AfS Reported : at fair Value and may be classified as current or (based on managements intent) F. Sale of Debt Securities 1. Realized gain or loss in earnings 2. TS and AFS: Update Fair Value Adjustment Account 2  INVESTMENT IN DEBT SECURITIES Rate Payment -Face Value-Stated coup On July 1, 2022, 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. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. I The fair value of the bond is $670,000 at December 31, 2022. Market Rate Present value (price) of the bonds: Present Values Interest $42,000 x 4.76654 * = $200,195 Principal $700,000 x 0.66634 ** = 466,438 Price Present value (price) of the bonds $666,633 * present value of an ordinary annuity of $1: n=6, i=7% (5A-4) ** present value of $1: n=6, i=7% (Table 5A-2) Because interest is paid semiannually, the PV calculations use: (a) semiannual market rate (7%), and (b) 6 (3 x 2) semi-annual periods. At Purchase (July 1, 2022) Investment in Masterwear bonds (carrying value) 666,633 Cash 666,633 3  DETERMINING INTEREST – THE EFFECTIVE INTEREST METHOD Cash Effective Amortization Carrying Payment Interest of Discount Value 6% x Face 7% x CV 7/01/22 upon Interest Revenue 666,633 12/31/22 42,000.07(666,633) = 46,664 4,664 671,297 6/30/23 42,000.07(671,297) = 46,991 4,991 676,288 12/31/23 42,000.07(676,288) = 47,340 5,340 681,628 6/30/24 42,000.07(681,628) = 47,714 5,714 687,342 12/31/24 42,000.07(687,342) = 48,114 6,114 693,456 6/30/25 42,000.07(693,456) = 48,544* 6,544 700,000 252,000 285,367 33,367 *Rounded At the First Interest Date (December 31, 2022) Cash (stated rate * face amount) 42,000 Investment in Masterwear bonds (difference) 4,664 Interest revenue (market rate * outstanding balance) 46,664 4  FAIR VALUE ADJUSTMENT TRADING SECURITIES (TS) AVAILABLE-FOR-SALE SECURITIES (AFS) If Classified as a Trading Security Fair Value Adjustment (December 31, 2022) Unrealized Holding Loss – IS 1,297 Fair Value Adjustment – TS ($671,297 - $670,000) 1,297 If Classified as an Available-for-Sale Security Fair Value Adjustment (December 31, 2022) Unrealized Holding Loss – OCI 1,297 Fair Value Adjustment – AFS ($671,297 - $670,000) 1,297 Ending E fair Value Diff Carrying value 671 , 297 670 , 000 1 , 297 12/31/22 It * 1 , 297 5 II. Investments in Equity Securities (based on ownership and not intent A. Fair Value Method: Less than 20% Ownership 1. Initially recorded at cost recorded 2. Dividends are in earnings 3. fair Value changes are recorded in earnings noncurrent asset 4. Reported at fair Value and may be classified as current or 5. Sale of Equity Securities a. Realized loss in earnings (based original cost) gain or on b. Update FUA account accordingly 6  FAIR VALUE METHOD: < 20% OWNERSHIP fair Value Method On January 1, 2022, Romeo purchased 200 shares of Juliet Company for $40 each. The investment was less than 20% ownership of the Juliet ~ Shares. On December 15, 2022, Romeo received a $2 dividend per share. At December 31, 2022, the price per share of Juliet stock was $35. On February 1, 2023, Romeo sold 100 shares for $45 each. At December 31, 2023, the price per share of Juliet stock was $42. At Purchase (January 1, 2022) Investment in Juliet shares 8,000 Cash (200 shares * $40) 8,000 Investment Revenue (December 15, 2022) Cash ($2 * 200 shares) 400 Investment (dividend) revenue 400 Adjust Securities to Fair Value (December 31, 2022) f at 12/31/2022 : $35 x 200 shares = $7000 Unrealized holding loss—I/S 1,000 Fair value adjustment [($40 - $35) * 200 shares] 1,000 Record Sale of Investment (February 1, 2023) Cash (100 shares * $45) 4,500 Investment in Juliet shares (100 shares * $40) 4,000 Gain on sale of investments (to balance) cost original 500 Adjust Securities to Fair Value (December 31, 2023) fV at 12/31/23 $42 : x100 = $4200 Fair value adjustment 1,200 Unrealized holding gain—I/S 1,200 7  Ending Cost Fu - DIJE FUA $1000 12/31/22$80004 1000 $4000$4200 $200 12/31/23 #account otemetment is an asset FUA 12/31/22 12/31/23 = 200 B. Equity Method: 20% and 50% ownership of investee’s voting shares 1. Investor can exercise significant influence over investee’s financial and operating policies. 2. Investment is initially recorded at cost 3. Investment is subsequently adjusted for - a. Increased/decreased by % share of Investee’s net income/loss Investment in ABC XX Investment Revenue XX b. Decreased by dividends declared Cash XX Investment in ABC XX 8  APPLYING THE EQUITY METHOD On January 1, 2022, Scarlett Inc. purchased 30% of Rhett’s common stock for $1,500,000 cash and this investment qualifies for the equity method. Rhett’s net income and dividends for 2022 were $500,000 and $250,000, respectively. Purchase Securities (January 1, 2022) Investment in Rhett stock 1,500,000 Cash 1,500,000 Record Ownership % of Investee Income (Dec. 31, 2022) Investment in Rhett stock 150,000 Investment revenue (30% × $500,000) 150,000 Receive Dividends: Liquidation of investment Cash 75,000 Investment in Rhett stock (30% × $250,000) 75,000 REPORTING AN EQUITY-METHOD INVESTMENT ON THE BALANCE SHEET Investment in Equity Securities _____________________________________________ ($ in millions) Cost 1500 Share of income 150 75 Dividends _________________ Balance 1575 9 III. Other Considerations A. Fair Value Option 1. At initial recognition, US GAAP allows companies to value financial assets and liabilities at fair value instead of carrying value. 2. Fair Value Option is made for each individual security and is irrevocable. 3. Fair Value adjustments are made each reporting period directly to the Investment Account because “fair value option” is on individual investment basis instead of a portfolio basis. 4. May be applied to: a. HTM Securities unrealized gais/losses b. Available-for-Sale Debt Securities will be recorded in earnings instead OCI of c. Equity Method Investments 5. Reporting Implications: a. Investment reported at fair Market Value b. Unrealized gains/losses recorded in earnings 10 B. Impairment 1. Debt Securities Classified as Held-to-Maturity a. Record an impairment loss in earnings if fair value declines below carrying value and it is considered other-than- temporary (OTT) b. Factors to consider to determine OTT Length of time market value < cost Financial condition of issuer and possibility of recovery Intent and ability to retain the investment to allow for anticipated recovery of the decline. c. The allowance for credit loss adjusts the carrying value of the investment to the net amount expected to be collected. 2. Debt Securities Classified as Available-for-Sale a. If fair value > carrying value – no credit loss recognized b. If fair value < carrying value The amount attributed to credit loss is recognized in earnings The amount not attributed to credit loss is recognized in OCI 3. Debt Securities Classified as Trading and Fair Value Equity Securities Already recorded at fair value with gains/losses in earnings INVESTMENTS IN DEBT SECURITIES 11  Investment Reported in Balance Classification Income Effects Sheet Held-to-Maturity (HTM): Carrying Value Investor has intent and Interest Revenue ability to hold to maturity Noncurrent Asset Trading (TS): Interest Revenue Fair Value Held in an active trading account for immediate Unrealized holding resale gains/losses in income Current Asset Interest Revenue Fair Value Available-for-Sale (AFS): Investments not Unrealized holding Current or Noncurrent classified as HTM or TS gains/losses in OCI Asset INVESTMENT IN EQUITY SECURITIES Investment Reported in Balance Investment Category Income Effects Sheet Fair Value Method: Dividend Revenue Investor has passive Fair Value interest in investee Unrealized holding gains/losses in income Current or Noncurrent Owns less than 20% of Asset investee voting stock Equity Method: Investment recorded Investor has significant at cost and adjusted influence over investee Investment Revenue to for subsequent policies extent of investee’s earnings and income or loss dividends of the Owns 20% - 50% of investee* investee voting stock Consolidation: Financial statements Investor controls investee Parent and subsidiary of the investor and income/loss combined investee combined Owns > 50% of the into single entity investee voting stock *If the investor elects the fair value option, the investment is reported at fair value and unrealized holding gains/losses are included in earnings. 12  stated Value EXAMPLE 1 Market Rate Face Tanner Corporation acquired as a long-term investment $240 million of 6% bonds, dated July 1, on July 1, 2022. Management classified the investment as an available-for-sale debt security. The market interest rate was 8% for bonds of similar risk and maturity. Tanner paid $200 million for the bonds. The company will receive interest semiannually on June 30 and December 31, As a result of changing market conditions, the fair value of the bonds at December 31, 2022 was $210 million. Coupon Payment $240mx = $7.2M Fair Value Required: 1. Prepare the journal entry to record Tanner’s investment in the bonds on July 1, 2022. ($ in millions) Investment in Bonds 200 Cash 200 2. Prepare the journal entry used by Tanner to record interest on December 31, 2022, at the effective (market) rate. ($ in millions) 7-2 Cash 0 8 Investment Bonds. in.O 8 Interest Revenue 3. At what amount will Tanner report its investment in the December 31, 2022 balance sheet? Why? Prepare any necessary journal entries. m I # $ 200 8 m. remem 92M FUA. 13 9 2 m Unrealized Gain 02:. · % o : -  EXAMPLE 2 Bella Company entered into the following transactions related to an investment in Bailey Company. Bella Company’s fiscal year ends on December 31. 2022 Dec. 17 Purchased 100,000 of Bailey Company’s preferred shares for $350,000 (less than 20% ownership in Bailey). Dec. 28 Received cash dividends of $2,000 from Bailey’s preferred shares. Dec. 31 The market price of Bailey’s preferred shares was $4 per share. fair Value & 12/31/22 $4 100 000 = $400 , 000 = x , 2023 Dec. 31 The market price of Bailey’s preferred shares was $3 per share. fair 100 000 = $300 Value D12/31/23 , 000 = $3 x , 2024 Jan. 5 Sold Bailey’s preferred shares for $395,000. Required: 1. Prepare the appropriate journal entry for each 2022 transaction. Del Investment in Bailey 350 , 000 350 , 000 Cash - is Cash 2000 Dividend Revenue 2000 Des 50 , 000 fUA 50 , 000 Unrealized Gain 1/s : 14  EXAMPLE 2 (continued) 2. Indicate any amounts that Bella Company would report in its 2022 balance sheet and income statement as a result of this investment. Balance Sheet - Investment in Bailey $400 000 , Statement Income - Dividend Revenue 2000 Income 50 , 000 Unrealized 3. Prepare the appropriate journal entry for the 2023 transaction. 1/3 100 , 000 Unrealized Loss : 100 , 000 FUA 4. Prepare the appropriate journal entry for the 2024 transaction. Cast 395 , 000 Realized Gain 45 ,000 Investment in Bailey 350,000 15  Lost EU Hitt 12/31/ 22 350 , 000 400 ,000 50, 000 300 , 000 50 , 000 12/31/23 350 , 000 12/31/ -F  Method Equity EXAMPLE 3 Mickey paid $68 million on January 2, 2022, for 4 million shares of Minnie common stock. The investment represents a 25% interest in the net assets of Minnie and gave Mickey the ability to exercise significant influence over Minnie’s operations. Mickey received dividends of $1 per share on December 21, 2022, and Minnie reported net income of $40 million for the year ended December 31, 2022. The fair value of Minnie’s common stock at December 31, 2022 was $18.50 per share. Required: 1. Prepare all journal entries related to the investment during 2022. ($ in millions) 2 Jam - Investment in Minnie GS Cash 68 i te m e n 2 Cash ($1 x 4 million shares) 4 Dec - Investment in Minnie 4 - Investment Minnie (25 % y $40 million) 10 ⑭ in Investment Revenue 10 2. Calculate the December 31, 2022 balance in the Investment account. Investment in Minnie > i 10 12131/22 -16 Balance sheet  EXAMPLE 4 Will acquired 20% of the outstanding common stock of Grace on December 31, 2022. The purchase price was $1,200,000 for 50,000 shares. On June 30, 2023, Grace declared and paid an $0.85 per share cash dividend. Grace also reported net income of $730,000 for 2023. The fair value of Grace’s stock was $27 per share at December 31, 2023. Required: Method fair value - 1. Prepare Will’s journal entries for 2022 and 2023, assuming that Will cannot exercise significant influence over Grace. 1322Investment in Grace 1 200 , 000 , cash 1 200 , 000 , -mean- 6130/23 - Cash /$0. 85 x 50 , 000 shares) 42500 Dividend Revenue 42500 i n te re s 1 12/31/23 -FUA 150K FUA Unrealized Gain : 11S 150K - I 150 , 000 mem - Lost # Lif 1231123- 150 , 000 150 , 000 1 35 M 12131/23 1 2m.. 17  EXAMPLE 4 (continued) Method Equity 2. Prepare Will’s journal entries for 2022 and 2023, assuming that Will can exercise significant influence over Grace. Investment in Grace 4322 1 2 m. Cash 1 2 m. Cash 6130123 42, 500 - Investment in Grace 42508 123 Investment in Grace (20% of 730K) 146 ,000 146 ,000 Investment Revenue Trement Balancesheet 3. At what amount is the investment in securities reported on the balance inGrea sheet under each of these methods at December 31, 2023? What is the total income reported in 2023 under each of these methods? Fair Value Equity Method - Method Investment in Grace 1 , 303, 1 , 350 , 000 500 - 42 , 500 - Dividend Revenue - 150 , 000 Gain Unrealized 18 146 , 000 Investment Revenue - Tasoo 14 , 000