CHAPTER SEVEN
INVESTMENTS
INVESTMENT ACCOUNTING APPROACHES
Companies have different motivations for investing in securities issued by other companies. One motivation is to earn a high rate of return. Companies can receive interest revenue from a debt investment or dividend revenue from an equity investment. In addition, they can realize capital gains on both types of securities. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company. It enables companies to exercise some control over another companies based on their significant equity investments.
To provide useful information, companies account for investments based on the type of security (debt or equity) and their intent with respect to the investment. As shown below we organize our study of investments by type of security. Within each section, we explain how the accounting for investments in debt and equity securities varies according to management intent.
SECTION 1 • INVESTMENTS IN DEBT SECURITIES
Debt securities represent a creditor relationship with another entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security.
Companies group investments in debt securities into three separate categories for accounting and reporting purposes:
- Held-to-maturity: Debt securities that the company has the positive intent and ability to hold to maturity.
- Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences.
- Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.
Illustration below identifies these categories, along with the accounting and reporting treatments required for each.
Amortized cost is the acquisition cost adjusted for the amortization of discount or premium, if appropriate. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
HELD-TO-MATURITY SECURITIES
Only debt securities can be classified as held-to-maturity. By definition, equity securities have no maturity date. A company should classify a debt security as held-to-maturity only if it has both (1) the positive intent and (2) The ability to hold those securities to maturity. It should not classify a debt security as held-to-maturity if it intends to hold the security for an indefinite period of time. Likewise, if the company anticipates that a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reasons, it should not classify the security as held to- maturity.
Companies account for held-to-maturity securities at amortized cost, not fair value.
If management intends to hold certain investment securities to maturity and has no plans to sell them, fair values (selling prices) are not relevant for measuring and evaluating the cash flows associated with these securities. Finally, because companies do not adjust held-to-maturity securities to fair value, these securities do not increase the volatility of either reported earnings or reported capital as do trading securities and available-for-sale securities.
To illustrate the accounting for held-to-maturity debt securities, assume that Robinson Company purchased $100,000 of 8 percent bonds of Ever Master Corporation on January 1, 2009, at a discount, paying $92,278. The bonds mature January 1, 2014 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows:
January 1, 2009
Held-to-Maturity Securities 92,278
Cash 92,278
Robinson uses a Held-to-Maturity Securities account to indicate the type of debt security purchased.
As indicated in Chapter 6, companies must amortize premium or discount using the effective-interest method unless some other method—such as the straight-line method—yields a similar result. They apply the effective-interest method to bond investments in a way similar to that for bonds payable. To compute interest revenue, companies compute the effective-interest rate or yield at the time of investment and apply that rate to the beginning carrying amount (book value) for each interest period. The investment carrying amount is increased by the amortized discount or decreased by the amortized premium in each period.
Illustration below shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in ever master bonds.
Robinson records the receipt of the first semiannual interest payment on July 1,
2009 using the data in above, as follows:
July 1, 2009
Cash 4,000
Held-to-Maturity Securities 614
Interest Revenue 4,614
Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2009, as follows.
December 31, 2009
Interest Receivable 4,000
Held-to-Maturity Securities 645
Interest Revenue 4,645
Robinson reports its investment in ever master bonds in its December 31, 2009, financial statements, as follows.
Sometimes a company sells a held-to-maturity debt security so close to its maturity date that a change in the market interest rate would not significantly affect the security’s fair value. Such a sale may be considered a sale at maturity and would not call into question the company’s original intent to hold the investment to maturity. Let’s assume, as an example, that Robinson Company sells its investment in Ever master bonds on November 1, 2013, at 99 3⁄4 plus accrued interest. The discount amortization from July 1, 2013, to November 1, 2013, is $635 (4⁄6 x $952). Robinson records this discount amortization as follows.
November 1, 2013
Held-to-Maturity Securities 635
Interest Revenue 635
The following shows the computation of the realized gain on the sale
Robinson records the sale of the bonds as:
November 1, 2013
Cash 102,417
Interest Revenue (4/6 x $4,000) 2,667
Held-to-Maturity Securities 99,683
Gain on Sale of Securities 67
The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest ($99,750 + $2,667). The credit to Held-to-Maturity Securities represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Securities represents the excess of the selling price over the book value of the bonds.
AVAILABLE-FOR-SALE SECURITIES
Companies report available-for-sale securities at fair value. They record the unrealized gains and losses related to changes in the fair value of available-for-sale debt securities in an unrealized holding gain or loss account. They add (subtract) this amount to other comprehensive income for the period. Other comprehensive income is then added to (subtract from) accumulated other comprehensive income, which is shown as a separate component of stockholders’ equity until realized. Thus, companies report available-for-sale securities At fair value on the balance sheet, but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income.
Example: Single Security
To illustrate the accounting for available-for-sale securities, assume that Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2009, with interest payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective interest rate of 8 percent.
Graff records the purchase of the bonds as follows.
January 1, 2009
Available-for-Sale Securities 108,111
Cash 108,111
The table below discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method.
The entry to record interest revenue on July 1, 2009, is as follows.
July 1, 2009
Cash 5,000
Available-for-Sale Securities 676
Interest Revenue 4,324
At December 31, 2009, Graff makes the following entry to recognize interest revenue.
December 31, 2009
Interest Receivable 5,000
Available-for-Sale Securities 703
Interest Revenue 4,297
As a result, Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297).
To apply the fair value method to these debt securities, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732. Comparing this fair value with the carrying amount (amortized cost) of the bonds at December 31, 2009, Graff recognizes an unrealized holding loss of $1,732 ($106,732 _ $105,000). It reports this loss as other comprehensive income. Graff makes the following entry.
December 31, 2009
Unrealized Holding Gain or Loss—Equity 1,732
Securities Fair Value Adjustment (Available-for-Sale) 1,732
Graff uses a valuation account instead of crediting the Available-for-Sale Securities account. The use of the Securities Fair Value Adjustment (Available-for-Sale) account enables the company to maintain a record of its amortized cost. Because the adjustment account has a credit balance in this case, Graff subtracts it from the balance of the
Available-for-Sale Securities account to determine fair value. Graff reports this fair value amount on the balance sheet. At each reporting date, Graff reports the bonds at fair value with an adjustment to the Unrealized Holding Gain or Loss—Equity account.
Example: Portfolio of Securities
To illustrate the accounting for a portfolio of securities, assume that Webb Corporation has two debt securities classified as available-for-sale. Table below identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.
The fair value of Webb’s available-for-sale portfolio totals $284,000. The gross unrealized gains are $10,063, and the gross unrealized losses are $19,600, resulting in a net unrealized loss of $9,537. That is, the fair value of available-for-sale securities is $9,537 lower than its amortized cost. Webb makes an adjusting entry to a valuation allowance to record the decrease in value and to record the loss as follows.
December 31, 2010
Unrealized Holding Gain or Loss—Equity 9,537
Securities Fair Value Adjustment (Available-for-Sale) 9,537
Webb reports the unrealized holding loss of $9,537 as other comprehensive income and a reduction of stockholders’ equity. Recall that companies exclude from net income any unrealized holding gains and losses related to available-for-sale securities.
Sale of Available-for-Sale Securities
If a company sells bonds carried as investments in available-for-sale securities before the maturity date, it must make entries to remove from the Available-for-Sale Securities account the amortized cost of bonds sold. To illustrate, assume that Webb Corporation sold the Watson bonds (from illustrated above) on July 1, 2011, for $90,000, at which time it had an amortized cost of $94,214. Below is the computation of the realized loss.
Webb records the sale of the Watson bonds as follows.
July 1, 2011
Cash 90,000
Loss on Sale of Securities 4,214
Available-for-Sale Securities 94,214
Webb reports this realized loss in the “Other expenses and losses” section of the income statement. Assuming no other purchases and sales of bonds in 2011, Webb on December 31, 2011, prepares the information depicted below.
Webb has an unrealized holding loss of $5,000. However, the Securities Fair Value
Adjustment account already has a credit balance of $9,537. To reduce the adjustment account balance to $5,000, Webb debits it for $4,537, as follows.
December 31, 2011
Securities Fair Value Adjustment (Available-for-Sale) 4,537
Unrealized Holding Gain or Loss—Equity 4,537
Financial Statement Presentation
Webb’s December 31, 2011, balance sheet and the 2011 income statement include the following items and amounts (the Anacomp bonds are long-term investments but are not intended to be held to maturity).
Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income. However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company.
This argument convinced the FASB. As a result, companies do not include in net income these unrealized gains and losses. However, even this approach solves only some of the problems, because volatility of capital still results. This is of concern to financial institutions because regulators restrict financial institutions’ operations based on their level of capital. In addition, companies can still manage their net income by engaging in gains trading (i.e., selling the winners and holding the losers).
TRADING SECURITIES
Companies hold trading securities with the intention of selling them in a short period of time. “Trading” in this context means frequent buying and selling. Companies thus use trading securities to generate profits from short-term differences in price. Companies generally hold these securities for less than three months, some for merely days or hours.
Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-for sale investments, they are required to amortize any discount or premium. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income
To illustrate, assume that on December 31, 2010, Western Publishing Corporation determined its trading securities portfolio to be as shown below. (Assume that 2010 is the first year that Western Publishing held trading securities.) At the date of acquisition, Western Publishing recorded these trading securities at cost, including brokerage commissions and taxes, in the account entitled Trading Securities. This is the first valuation of this recently purchased portfolio.
The total cost of Western Publishing’s trading portfolio is $314,450. The gross unrealized gains are $12,780 ($7,640 + $5,140), and the gross unrealized losses are $9,030, resulting in a net unrealized gain of $3,750. The fair value of trading securities is $3,750 greater than its cost.
At December 31, Western Publishing makes an adjusting entry to a valuation allowance, referred to as Securities Fair Value Adjustment (Trading), to record the increase in value and to record the unrealized holding gain.
December 31, 2010
Securities Fair Value Adjustment (Trading) 3,750
Unrealized Holding Gain or Loss—Income 3,750
Because the Securities Fair Value Adjustment account balance is a debit, Western
Publishing adds it to the cost of the Trading Securities account to arrive at a fair value for the trading securities. Western Publishing reports this fair value amount on the balance sheet. When securities are actively traded, the FASB believes that the investments should be reported at fair value on the balance sheet. In addition, changes in fair value (unrealized gains and losses) should be reported in income. Such reporting on trading securities provides more relevant information to existing and prospective stockholders.
SECTION 2 • INVESTMENTS IN EQUITY SECURITIES
Equity securities represent ownership interests such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants, rights, and call or put options.
Companies do not treat convertible debt securities as equity securities. Nor do they treat as equity securities redeemable preferred stock (which must be redeemed for common stock). The cost of equity securities includes the purchase price of the security plus broker’s commissions and other fees incidental to the purchase.
The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. The classification of such investments depends on the percentage of the investee voting stock that is held by the investor:
- Holdings of less than 20 percent (fair value method)—investor has passive interest.
- Holdings between 20 percent and 50 percent (equity method)—investor has significant influence.
- Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.
The following illustration lists these levels of interest or influence and the corresponding valuation and reporting method those companies must apply to the investment.
The accounting and reporting for equity securities therefore depend on the level of influence and the type of security involved, as shown below.
HOLDINGS OF LESS THAN 20%
When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. In such cases, if market prices are available subsequent to acquisition, the company values and reports the investment using the fair value method. The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities.
Because equity securities have no maturity date, companies cannot classify them as held-to-maturity.
Available-for-Sale Securities
Upon acquisition, companies record available-for-sale securities at cost.To illustrate, assume that on November 3, 2010 Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest
Republic records these investments on November 3, 2010 as follows.
Available-for-Sale Securities 718,550
Cash 718,550
On December 6, 2010, Republic receives a cash dividend of $4,200 on its investment in the common stock of Campbell Soup Co. It records the cash dividend as follows.
Cash 4,200
Dividend Revenue 4,200
All three of the investee companies reported net income for the year, but only Campbell Soup declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the common stock of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income earned by the investee is not a proper basis for recognizing income from the investment by the investor. Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investee’s business. Therefore, the investor earns net income only when the investee declares cash dividends. At December 31, 2010, Republic’s available-for-sale equity security portfolio has the cost and fair value shown below.
For Republic’s available-for-sale equity securities portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 + $37,350), resulting in a net unrealized loss of $35,550. The fair value of the available-for-sale securities portfolio is below cost by $35,550.
As with available-for-sale debt securities, Republic records the net unrealized gains and losses related to changes in the fair value of available-for-sale equity securities in an Unrealized Holding Gain or Loss—Equity account. Republic reports this amount as a part of other comprehensive income and as a component of other accumulated comprehensive income (reported in stockholders’ equity) until realized. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss— Equity account and crediting the Securities Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows.
December 31, 2010
Unrealized Holding Gain or Loss—Equity 35,550
Securities Fair Value Adjustment (Available-for-Sale) 35,550
On January 23, 2011, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. Illustration below shows the computation of the realized gain on the sale.
Republic records the sale as follows.
January 23, 2011
Cash 287,220
Available-for-Sale Securities 259,700
Gain on Sale of Stock 27,520
In addition, assume that on February 10, 2011, Republic purchased 20,000 shares of Continental Trucking at a market price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850).
The lists Republic’s portfolio of available-for-sale securities, as of December 31, 2011 appears below.
At December 31, 2011, the fair value of Republic’s available-for-sale equity securities portfolio exceeds cost by $64,250 (unrealized gain). The Securities Fair Value Adjustment account had a credit balance of $35,550 at December 31, 2011. To adjust its December 31, 2011, available-for-sale portfolio to fair value, the company debits the Securities Fair Value Adjustment account for $99,800 ($35,550 + $64,250). Republic records this adjustment as follows.
December 31, 2011
Securities Fair Value Adjustment (Available-for-Sale) 99,800
Unrealized Holding Gain or Loss—Equity 99,800
Trading Securities
The accounting entries to record trading equity securities are the same as for available for- sale equity securities, except for recording the unrealized holding gain or loss. For trading equity securities, companies report the unrealized holding gain or loss as part of net income. Thus, the account titled Unrealized Holding Gain or Loss—Income is used.
HOLDINGS BETWEEN 20% AND 50%
An investor corporation may hold an interest of less than 50 percent in an investee corporation and thus not possess legal control. However, an investment in voting stock of less than 50 percent can still give the investor the ability to exercise significant influence over the operating and financial policies of its bottlers. Significant influence may be indicated in several ways. Examples include representation on the board of directors, participation in policymaking processes, material intercompany transactions, interchange of managerial personnel, or technological dependency.
Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. To achieve a reasonable degree of uniformity in application of the “significant influence” criterion, the profession concluded that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.
In instances of “significant influence” (generally an investment of 20 percent or more), the investor must account for the investment using the equity method.
Equity Method
Under the equity method, the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at the cost of the shares acquired but subsequently adjusts the amount each period for changes in the investee’s net assets. That is, the investor’s proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment’s carrying amount. All dividends received by the investor from the investee also decrease the investment’s carrying amount. The equity method recognizes that investee’s earnings increase investee’s net assets, and that investee’s losses and dividends decrease these net assets.
To illustrate the equity method and compare it with the fair value method, assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this example, assume that Maxi does not have the ability to exercise significant influence, and classifies the securities as available-for-sale. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to exercise significant influence. The following illustration shows the entries.
Note that under the fair value method, Maxi reports as revenue only the cash dividends received from Mini. The earning of net income by Mini (the investee) is not considered a proper basis for recognition of income from the investment by Maxi (the investor). Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only earns revenue when it receives dividends from Mini.
Under the equity method, Maxi reports as revenue its share of the net income reported by Mini. Maxi records the cash dividends received from Mini as a decrease in the investment carrying value. As a result, Maxi records its share of the net income of Mini in the year when it is earned. With significant influence, Maxi can ensure that Mini will pay dividends, if desired, on any net asset increases resulting from net income. To wait until receiving a dividend ignores the fact that Maxi is better off if the investee has earned income. Using dividends as a basis for recognizing income poses an additional problem.
For example, assume that the investee reports a net loss. However, the investor exerts influence to force a dividend payment from the investee. In this case, the investor reports income, even though the investee is experiencing a loss. In other words, using dividends as a basis for recognizing income fails to report properly the economics of the situation.
If an investor’s share of the investee’s losses exceeds the carrying amount of the investment, should the investor recognize additional losses? Ordinarily, the investor should discontinue applying the equity method and not recognize additional losses.
If the investor’s potential loss is not limited to the amount of its original investment (by guarantee of the investee’s obligations or other commitment to provide further financial support), or if imminent return to profitable operations by the investee appears to be assured, the investor should recognize additional losses.
HOLDINGS OF MORE THAN 50%
When one corporation acquires a voting interest of more than 50 percent in another corporation, it is said to have a controlling interest. In such a relationship, the investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a long term investment on the separate financial statements of the parent.
When the parent treats the subsidiary as an investment, the parent generally prepares consolidated financial statements. Consolidated financial statements treat the parent and subsidiary corporations as a single economic entity.
(Advanced accounting courses extensively discuss the subject of when and how to prepare consolidated financial statements.) Whether or not consolidated financial statements are prepared, the parent company generally accounts for the investment in the subsidiary using the equity method as explained in the previous section of this chapter.
FAIR VALUE OPTION
As indicated in earlier chapters, companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument by- instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.
For example, assume that Abbott Laboratories purchased debt securities in 2010 that it classified as held-to-maturity. Abbott does not choose to report this security using the fair value option. In 2011, Abbott buys another held-to-maturity debt security.
Abbott decides to report this security using the fair value option. Once it chooses the fair value option for the security bought in 2011, the decision is irrevocable (may not be changed). In addition, Abbott does not have the option to value the held-to maturity security purchased in 2010 at fair value in 2011 or in subsequent periods.
Many support the use of the fair value option as a step closer to total fair value reporting for financial instruments. They believe this treatment leads to an improvement in financial reporting. Others argue that the fair value option is confusing. A company can choose from period to period whether to use the fair value option for any new investment in a financial instrument. By permitting an instrument-by-instrument approach, companies are able to report some financial instruments at fair value but not others.
To illustrate the accounting issues related to the fair value option, we discuss three different situations.
Available-for-Sale Securities
Available-for-sale securities are presently reported at fair value, and any unrealized gains and losses are recorded as part of other comprehensive income.
Assume that Hardy Company purchases stock in Fielder Company during 2010 that it classifies as available-for-sale. At December 31, 2010, the cost of this security is $100,000; its fair value at December 31, 2010, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2010.
Investment in Fielder Stock 25,000
Unrealized Holding Gain or Loss—Income 25,000
In this situation, Hardy uses an account titled Investment in Fielder Stock to record the change in fair value at December 31. It does not use a Securities Fair Value Adjustment account because the accounting for a fair value option is on an investment-by investment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security.
Equity Method of Accounting
Companies may also use the fair value option for investments that otherwise follow the equity method of accounting. To illustrate, assume that Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2010 for $930,000. At December 31, 2010, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows.
Unrealized Holding Gain or Loss—Income 30,000
Investment in Suppan Stock 30,000
In contrast to equity method accounting, if the fair value option is chosen, Durham does not have to report its pro rata share of the income or loss from Suppan. In addition, any dividend payments are credited to Dividend Revenue and therefore do not reduce the Investment in Suppan Stock account.
One major advantage of using the fair value option for this type of investment is that it addresses confusion about the equity method of accounting. In other words, what exactly does the one-line consolidation related to the equity method of accounting on the balance sheet tell investors? Many believe it does not provide information about liquidity or solvency, nor does it provide an indication of the worth of the company.
Financial Liabilities
One of the more controversial aspects of the fair value option relates to valuation of a company’s own liabilities. Companies may apply the fair value option to their own debt instruments. As a result, changes in the fair value of the debt instrument are included as part of earnings in any given period.
To illustrate, Edmonds Company has issued $500,000 of 6% bonds at face value on May 1, 2010. Edmonds chooses the fair value option for these bonds. At December 31, 2010, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent. The value of the debt securities falls because the bond is paying less than market rate for similar securities. Under the fair value option, Edmonds makes the following entry.
Bonds Payable 20,000
Unrealized Holding Gain or Loss—Income 20,000
As the journal entry indicates, the value of the bonds declined. This decline leads to a reduction in the bond liability and a resulting unrealized holding gain, which is reported as part of net income. The value of Edmonds’ debt declined because interest rates increased. In addition, if the creditworthiness of Edmonds Company declines, the value of its debt also declines. That is, Edmonds issued debt at rates reflecting higher creditworthiness. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. If Edmonds is using the fair value option in this case, it records an unrealized holding gain due to its worsening credit position.
Some question how Edmonds can record a gain when its creditworthiness is becoming worse. As one writer noted, “It seems counter-intuitive.” However, the FASB notes that the debt holders’ loss is the stockholders’ gain. That is, the stockholders’ claims on the assets of the company increase when the value of the debt holders declines.
In addition, the worsening credit position may indicate that the assets of the company are declining in value as well. Thus, the company may be reporting losses on the asset side which will be offsetting gains on the liability side.
SECTION 3 • OTHER REPORTING ISSUES
We have identified the basic issues involved in accounting for investments in debt and equity securities. In addition, the following issues relate to both of these types of securities.
- Impairment of value.
- Reclassification adjustments.
3. Transfers between categories.
- Fair value controversy.
IMPAIRMENT OF VALUE
A company should evaluate every investment, at each reporting date, to determine if it has suffered impairment—a loss in value that is other than temporary. For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the decline is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss. Therefore, it includes the amount in net income.
For debt securities, a company uses the impairment test to determine whether “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.”
For equity securities, the guideline is less precise. Any time realizable value is lower than the carrying amount of the investment, a company must consider an impairment. Factors involved include the length of time and the extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; and the intent and ability of the investor company to retain its investment to allow for any anticipated recovery in fair value.
To illustrate an impairment, assume that Strickler Company holds available-for sale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these securities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due.
In this case, it reports the unrealized loss of $200,000 as a loss on impairment of $200,000. Strickler includes this amount in income, with the bonds stated at their new cost basis. It records this impairment as follows.
Loss on Impairment 200,000
Available-for-Sale Securities 200,000
The new cost basis of the investment in debt securities is $800,000. Strickler includes subsequent increases and decreases in the fair value of impaired available-for sale securities as other comprehensive income.
Companies base impairment for debt and equity securities on a fair value test. This test differs slightly from the impairment test for loans.
RECLASSIFICATION ADJUSTMENTS
As we indicated earlier, companies report changes in unrealized holding gains and losses related to available-for-sale securities as part of other comprehensive income. Companies may display the components of other comprehensive income in one of three ways: (1) in a combined statement of income and comprehensive income, (2) in a separate statement of comprehensive income that begins with net income, or (3) in a statement of stockholders’ equity.
The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless a company sells securities during the year. In that case, double counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods.
To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary. To illustrate, assume that Open Company has the following two available-for-sale securities in its portfolio at the end of 2009 (its first year of operations).
If Open Company reports net income in 2009 of $350,000, it presents a statement of comprehensive income as follows.
During 2010, Open Company sold the Lehman Inc. common stock for $105,000 and realized a gain on the sale of $25,000 ($105,000 – $80,000). At the end of 2010, the fair value of the Woods Co. common stock increased an additional $20,000, to $155,000.
Illustration below shows the computation of the change in the securities fair value adjustment account
The above computation indicates that Open should report an unrealized holding loss of $5,000 in comprehensive income in 2010. In addition, Open realized a gain of $25,000 on the sale of the Lehman common stock. Comprehensive income includes both realized and unrealized components. Therefore, Open recognizes a total holding gain (loss) in 2010 of $20,000, computed as follows.
Open reports net income of $720,000 in 2010, which includes the realized gain on sale of the Lehman securities. Below is shown a statement of comprehensive income for 2010, indicating how Open reported the components of holding gains (losses).
In 2009, Open included the unrealized gain on the Lehman Co. common stock in comprehensive income. In 2010, Open sold the stock. It reported the realized gain in net income, which increased comprehensive income again. To avoid double counting this gain, Open makes a reclassification adjustment to eliminate the realized gain from the computation of comprehensive income in 2010.
A company may display reclassification adjustments on the face of the financial statement in which it reports comprehensive income. Or it may disclose these reclassification adjustments in the notes to the financial statements.
Comprehensive Example
To illustrate the reporting of investment securities and related gain or loss on available for- sale securities, assume that on January 1, 2010, Hinges Co. had cash and common stock of $50,000. At that date the company had no other asset, liability, or equity balance.
On January 2, Hinges purchased for cash $50,000 of equity securities classified as available-for-sale. On June 30, Hinges sold part of the available-for-sale security portfolio, realizing a gain as shown below.
Hinges did not purchase or sell any other securities during 2010. It received $3,000 in dividends during the year. At December 31, 2010, the remaining portfolio is as shown here below.
Illustration below shows the company’s income statement for 2010
The company reports its change in the unrealized holding gain in a statement of comprehensive income as follows
Its statement of stockholders’ equity appears in as follows.
The comparative balance sheet is shown on the here next.
This example indicates how an unrealized gain or loss on available-for-sale securities affects all the financial statements. Note that a company must disclose the components that comprise accumulated other comprehensive income.
TRANSFERS BETWEEN CATEGORIES
Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale securities to held-to-maturity investments, it records the new investment (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available- for-sale investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held-to-maturity category. Illustration below summarizes the accounting treatment for transfers.
FAIR VALUE CONTROVERSY
The reporting of investment securities is controversial. Some believe that all securities should be reported at fair value; others believe they all should be stated at amortized cost. Others favor the present approach. In this section we look at some of the major unresolved issues.
Measurement Based on Intent
Companies classify debt securities as held-to-maturity, available-for-sale, or trading. As a result, companies can report three identical debt securities in three different ways in the financial statements. Some argue such treatment is confusing. Furthermore, the held-to-maturity category relies solely on intent, a subjective evaluation. What is not subjective is the fair value of the debt instrument. In other words, the three classifications are subjective, resulting in arbitrary classifications.
Gains Trading
Companies can classify certain debt securities as held-to-maturity and therefore report them at amortized cost. Companies can classify other debt and equity securities as available-for-sale and report them at fair value with the unrealized gain or loss reported as other comprehensive income. In either case, a company can become involved in “gains trading” (also referred to as “cherry picking,” “snacking,” or “sell the best and keep the rest”). In gains trading, companies sell their “winners,” reporting the gains in income, and hold on to the losers.
Liabilities Not Fairly Valued
Many argue that if companies report investment securities at fair value, they also should report liabilities at fair value. Why? By recognizing changes in value on only one side of the balance sheet (the asset side), a high degree of volatility can occur in the income and stockholders’ equity amounts. Further, financial institutions are involved in asset and liability management (not just asset management). Viewing only one side may lead managers to make uneconomic decisions as a result of the accounting.
Fair Values—Final Comment
Both the IASB and the FASB believe that fair value information for financial assets and financial liabilities provides more useful and relevant information than a cost based system. The Boards take this position because fair value reflects the current cash equivalent of the financial instrument rather that the cost of a past transaction.
As a consequence, only fair value provides an understanding of the current worth of the investment.
Companies must report fair values for some types of financial instruments. In addition, they have the option to record fair values for any of their financial instruments.
How many companies will choose this fair value option? We are hopeful that many companies will select this option; we believe that the information provided by fair value reporting for financial instruments is useful and more understandable to financial statement users.
SUMMARY OF REPORTING TREATMENT OF SECURITIES
Illustration below summarizes the major debt and equity securities and their reporting treatment.
*Companies have the option to report financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. If a company chooses to use the fair option for some of its financial instruments, these assets or liabilities should be reported separately from other financial instruments that used a different valuation basis. To accomplish separate reporting, a company may either (a) report separate line items for the fair value and non–fair value amounts or (b) report the total fair value and non–fair value amounts in one line and parenthetically report the fair value amount in that line also.
