Chapter 11 -- Marketable Securities, Derivatives, and Investments

FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition
Clyde P. Stickney and Roman L. Weil

Learning Objectives
1. Understand why firms acquire securities of other firms and how the purpose of the investment governs the method of accounting for that investment. 2. Develop skills to apply the market value method to minority, passive investments, including financial derivatives. 3. Develop skills to apply the equity method to minority, active investments, contrasting its financial statement effects with those of the market value method.

Learning Objectives
4. Understand the concepts underlying consolidated financial statements for majority, active investments, contrasting the financial statement effects of consolidation with those of the equity method. 5. Understand when a firm must consolidate a variable interest entity, for which it does not have conventional control, but does have parent-like characteristics.

Chapter Outline
1. Overview of the accounting and reporting of investment securities 2. Minority, passive investments 3. Derivative investments 4. Dealing with uncertainty by using measurement, not recognition

5. Minority, active investments

Chapter Outline
6. Majority, active investments

7. An International Perspective
Chapter Summary 8. Appendix 11:1: Effects on the statement of cash flows of investments in securities

Types of Investments

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

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.

Discuss Marketable Securities

Marketable

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

They

Marketable

Market Securities 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.

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.
is the same rule as the general rule for valuing assets at acquisition.

This

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

Debt Held to Maturity

Debt securities for which a firm has both the positive intent & 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.

What are trading securities?

Trading securities are assumed to be held for

short-term profit.
Characterized by frequent & active buying & selling with the object of generating profit. Typically only financial institutions hold trading securities.

Since trading securities are acquired for shortterm 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.

Recording Trading Securities

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
35,000

Dec 31 Marketable securities Year 3 Unrealized holding gain

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

Complete this trading securities problem.

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.

Jan 3 Year 4

cash marketable securities realized gain on sale

480,000 435,000 45,000

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

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.

Securities Available for Sale

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.

Solve Securities Available for Sale Problem

Reconsider the example, but assume that the securities are properly classified as securities available for sale. Record acquisition of trading securities at acquisition cost just as before to revalue the securities to market value and recognize an unrealized holding gain (also like before).

Dec 31 Year 3

Marketable securities Unrealized holding gain

35,000
35,000

This unrealized holding gain is not closed to income, but appears in the equity section of the balance sheet having bypassed the income statement.

Solve Securities Available for Sale Problem

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.

Trading Securities & 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.

Compare Trading Securities & Securities Available for Sale

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.

Disclosure Requirements for 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.

Disclosure Requirements for Securities

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.

Marketable Securities 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 wait until the firm sells or otherwise disposes of the instrument to record the gain or loss in income.

Derivative Instruments
Firms face risks in carrying out business operations: 1. That customers will stop buying its products and services 2. That raw material used in production will increase in cost after the firm has committed to a selling price 3. That currency exchange rates will change after the firm has made commitments fixed in terms of a foreign currency 4. That interest rates will change

5. That employees will quit or retire

Derivative Instruments

Many firms seek to avoid risk even if it is costly. Some financial firms specialize in helping firms avoid risk through financial instruments which are sold to the firm. In general, such a financial instrument substitutes a fixed known cost for an unknown cost.

Derivative Instruments
These

instruments are analogous to insurance. instruments act as hedging when money is involved and as derivative instruments when the payoff is based on economic outcomes. requires firms to show the market value of derivatives on their balance sheets.

These

GAAP

Minority, Passive Investments

Minority means > 50% ownership.

< 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. Owner of a passive minority investment must account for the investment using the
Initial investment recorded at acquisition cost Dividends recorded as revenue At the end of accounting periods, asset is adjusted to the market value Sale of asset results in a realized gain or loss

Minority, Active Investments

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. requires 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.

It

Whats the rationale for the 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 incomeby having the purchased firm declare or fail to declare a dividend. Recognizing a proportionate share of the purchased firms income removes this risk.

Majority, Active Investments

A

the voting stock of another firm, called the subsidiary firm. gives the parent complete control over the subsidiary. portion of the subsidiary not owned by the parent is called the minority

parent firm holds more than 50% of

This

The

interest.

Majority, Active Investments

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. 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,

Majority, Active Investments

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. 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).

Consolidated

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.

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.

Chapter Summary
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.

Appendix 11.1: 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.

Rapid Review - MC
1. If Pappa company owns between 20% and 50% of voting stock of Sunshine Company, this is a a. Minority passive investment b. Minority active investment c. Majority passive investment d. Majority active investment 2. Which one below is a risk to a firms business operations regarding derivative instruments? Interest rates will change People will stop buying their product Employees will quit or retire All of the above