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Chapter 11 -- Marketable Securities and Investments

FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition

Clyde P. Stickney and Roman L. Weil

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Learning Objectives

1. Understand why firms acquire securities and other financial instruments. 2. Develop skills to apply the market value method to minority, passive investments. 3. Develop skills to apply the equity method to minority, active investments, contrasting its financial statement effects with those of the market value method. 4. Understand the concepts underlying consolidated financial statements for majority active investments, contrasting the financial statement effects with those of the equity method. 5. Develop the necessary skills to prepare consolidated financial statements. (Appendix 11.1) 6. Develop an understanding of the financial effects of using the purchase method to account for a corporate acquisition.

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Chapter Outline
5. Majority, active investments a. Legally separate corps. b. Purpose of consolidated statements c. Disclosure of consolidation policy d. Limitations of consolidated statements 6. An international perspective Chapter Summary Appendixes 11.1-11.3

1. Types of investments 2. Marketable securities: Current assets a. Classification b. Valuation at acquisition c. Valuation after acquisition d. Disclosures about securities e. Controversy 3. Minority, passive investments 4. Minority, active investments

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1. Types of Investments (Figure 11.1)

The accounting for investments depends on the purpose of the investment and the percentage of voting stock held.
Investor Corporation

Minority, Passive Investments (less than 20% ownership)

Minority, Active Investments (typically between 20% and 50% ownership)

Majority, Active Investments (greater than 50% ownership)

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1. Types of Investments (Cont.)

Minority, passive investments Less than 20% of voting stock. Assumed to be held for short term returns including dividends and growth. Minority, active investments Between 20% and 50% of voting stock. Assumed to be held to exert influence over the other company. Majority, active investments Greater than 50% of voting stock. Assumed to be held so for full control over the other company.

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2. Marketable Securities

Marketable securities are bonds or stocks for which there is an active market and hence a reliable market value. They are liquid assets in that they can easily and quickly be converted into cash. Marketable securities held as a temporary investment are classified as current assets.

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2.a. Classification

Securities are properly classified as marketable securities when 1. The firm can readily convert them into cash, and 2. Intends to do so when it needs cash. If either of the two tests for marketable securities do not apply, then the securities are properly classified as investment in securities. Investment in securities are securities held for long-term goals and are classified as long-term assets.

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2.b. Valuation at Acquisition

Marketable securities are initially recorded at acquisition cost. Which includes purchase price plus any commissions, taxes or other costs related to the acquisition. This is the same rule as the general rule for valuing assets at acquisition.

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2.c. Valuation after Acquisition

Because there exists a market value, marketable securities can be reliably written up or down to the market value giving a more current estimate of economic worth. This also results in a holding gain or loss which is not due to the normal operations of a firm. For the purposes of valuation after acquisition, there are three classes of marketable securities: 1. Debt held to maturity 2. Trading securities 3. Securities available for sale

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2.c.1. Debt Held to Maturity

Debt securities for which a firm has both the positive intent and ability to hold to maturity. Shown on the balance sheet at the amortized acquisition cost. Amortized acquisition cost means that the securities are amortized like a mortgage or bond. The acquisition cost is assumed to be the present value. The maturity value and maturity date are known from the bond certificate. An internal rate of return can be calculated using PV techniques.

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2.c.2. Trading Securities

Trading securities are assumed held for short-term profit. Characterized by frequent and active buying and selling with the object of generating profit. Typically only financial institutions hold trading securities. Since trading securities are acquired for short-term profit, unrealized gains or losses that result from adjustments to market value pass through the income statement and increase or reduce net income before there is a sale of the securities.

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2.c.2. Trading Securities

Example 6 from text, page 602

Record acquisition of trading securities

400,000 400,000

Dec 28 Marketable securities Year 3 Cash

To revalue the securities to market value and recognize an unrealized holding gain.
35,000

Dec 31 Marketable securities Year 3 Unrealized holding gain

35,000

The unrealized holding gain is closed to income, appears on the income statement and increases retained earnings.

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2.c.2. Trading Securities

Example 6 from Text (Cont.)

Record the sale for $480,000 in the next year after the unrealized gain has been closed to income. Recall at the new value of the securities is $435,000.
cash marketable securities realized gain on sale 480,000
435,000 45,000

Jan 3 Year 4

This realized gain (because it is supported by a sale) is closed to income also.

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2.c.3. Securities Available for Sale

Securities available for sale are neither trading securities or securities held to maturity. They are an intermediate class and are typically tied to a specific cash need. They are held by non-financial companies. For example, a manufacturing firm may build a large fund of securities to pay for a renovation to its plant or to retire bonds that will come due. Since they are acquired for longer-term return, unrealized gains or losses that result from adjustments to market value do not pass through the income statement but stay on the balance sheet as an equity account.

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2.c.3. Securities Available for Sale

Example 7 from text, page 603

Reconsider example 6, but assume that the securities are properly classified as securities available for sale. Record acquisition of trading securities at acquisition cost just as before
Marketable securities Unrealized holding gain 35,000 35,000

Dec 31 Year 3

To revalue the securities to market value and recognize an unrealized holding gain (also like before). This unrealized holding gain is not closed to income, but appears in the equity section of the balance sheet having bypassed the income statement.

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2.c.3. Securities Available for Sale

Example 7 from Text (Cont.)

Record the sale for $480,000 in the next year after the unrealized gain has been closed to income. Recall at the new value of the securities is $435,000.
Cash Unrealized holding gain Marketable securities Realized gain on sale 480,000 35,000
435,000 80,000

Jan 3 Year 4

This realized gain (because it is supported by a sale) is closed to income also.

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Comparing Trading Securities with Securities Available for Sale

Both are recorded at acquisition cost. Both are written up or down to market with adjusting entries. Both give rise to an unrealized holding gain or loss account upon adjustment. However, the unrealized holding gain or loss for trading securities is considered income; it is close to income and increases or decreases net income. While the unrealized holding gain or loss for available for sale securities is not closed but remains on the balance sheet. When these securities are sold, this account must then be closed and the realized gain or loss is the same as historical cost accounting.

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2.d. Disclosure about Securities

FASB 115 requires the following disclosures for each period for marketable securities: 1. The aggregate market value, gross unrealized holding gains, gross unrealized holding losses, and amortized costs for debt securities held to maturity and equity securities available for sale. 2. The proceeds from sales of securities available for sale and the gross realized gains and losses on those sales. 3. The change during the period in the net unrealized holding gains or loss on trading securities included in a separate shareholders equity account. 4. The change during the period in the net unrealized holding gain or loss on trading securities included in earnings.

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2.e. Controversy

The accounting for marketable securities has been controversial. The accounting issues are: Whether to report these instruments at historical cost (or some method based on historical cost) or at market value, and If at market value, whether to report the changes from period to period as part of that periods income or to await the period when the firm sells or otherwise disposes of the instrument to record the gain or loss in income.

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3. Minority, Passive

Minority

refers to less than 50% ownership. Greater than 50% of the voting stock means absolute control over the corporation. When the investing firm cannot or does not influence the decisions of the owned firm, the investment is passive. The owner of a passive minority investment must account for the investment using the Initial investment is recorded at acquisition cost Dividends are recorded as revenue At the end of accounting periods, the asset is adjusted to the market value A sale of the asset results in a realized gain or loss

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4. Minority, Active

Between

20% and 50% gives rise to the presumption of active because an investor can often exert influence over the decisions of the firm with less than 50% of the voting stock provided the remainder of the votes are split. Require the equity method of accounting Initial purchase is recorded as an asset at the acquisition cost. Each period, the investing firm recognized revenue equal to its proportionate share of the firm. Dividends reduce the asset and are not revenue but rather a return of capital.

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4. Rationale for Equity Method

Since the purchaser is assumed to be able to influence the decision of the purchased firm including its dividend policy, There is a risk that the purchaser might use this influence to manipulate its own income by having the purchased firm declare or fail to declare a dividend. Recognizing a proportionate share of the purchased firms income removes this risk.

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5. Majority, Active

parent firm holds more than 50% of the voting stock of another firm, called the subsidiary firm. This gives the parent complete control over the subsidiary. The portion of the subsidiary not owned by the parent is called the minority interest. A corporation is a legal entity and not necessarily an economic entity. Laws might require or allow separate legal entities that are controlled by one entity, thus being one economic entity. Certain legal risks can be reduced by having legally separate corporations.
Copyright 2000 by Harcourt Inc. All rights reserved.

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5. Majority, Active (Cont.)

Because

one economic entity can control several legal entities and because there is a risk that income might be manipulated by economic transactions between the legal entities, U.S. GAAP requires that the financial statements of legally separate entities be combined under one controlling economic entity and that one set of financial statements called the consolidated financial statements be produced. Consolidated financial statements combine the individual financial statements but reverse out all transactions that occur between the related firms (for example, sales from one to another).

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6. An International Perspective
Most countries account for minority, passive investments using the lower-of-cost-or-market rule. Accounting for minority and majority active investments is similar to U.S. GAAP. The IASC requires the equity method for investments where the holder exerts significant influence and has no plans to sell in the near future. The IASC expresses a preference for consolidations of controlled entities.

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Chapter Summary

Investments are held either for profit (resold at a higher price) or for control purposes. If held for profit, the current market value provides useful information on that profit potential. Because of this, GAAP provides for certain securities to be valued at market value. If held for control, then the profit of the subsidiary firm provides useful information. Both the equity method and consolidations require the parent firm to recognize accrued income of the subordinate.
Copyright 2000 by Harcourt Inc. All rights reserved.

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Appendix 11.1: Preparing Consolidated Financial Statements

Preparing consolidated statements requires: 1. Eliminating the parents investment account, 2. Eliminating intercompany receivables and payables, and 3. Eliminating intercompany sales and purchases. These accounts or transactions are identified and the journal entries made to eliminate the account or reverse the transaction. Balances are taken to equity accounts.

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Appendix. 11.2: Accounting for Corporate Acquisitions

In a corporate acquisition, one corporation acquires all, or substantially all of anothers common shares. Two methods of accounting for acquisitions: 1. Purchase method like the purchase of a single asset, records stock at the value of what was given. Assets and liabilities are recorded and any difference is goodwill. 2. Pooling-of-interest method not a purchase but the two firms continue to operate separately, records stock at book value and no excess of value over the purchase price is recorded.

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Appendix 11.3:Effects on the Statement of Cash Flows of Investments in Securities

Market Value Method: Calculating cash flow from operations normally requires no adjustments to net income. Unrealized gains or losses require an adjustment for trading securities but do not for available-for-sale securities. Equity Method: Does require an adjustment to net income.