FA2: Module 8 Investments and financial instruments

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FA2 Module 8Investments and financial
instruments

• Classification of investments
• Held-to-maturity (HTM) investments
• Accounting for investments
• The equity method
• Investments and the cash flow statement

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1. Classification of investments

• Accountants distinguish two broad categories of
  investments
• Passive investments are made in order to earn a
  return, either in the short or the long term,
  with no view to control or influence the investee
  (entity that issued the instrument). These can
  be voting or non-voting instruments.
• Strategic investments are made in order to
  influence or control the investee company.
  Typically, these investments are in voting
  instruments.

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Passive investments

• Held-to-maturity securities with fixed or
  determinable payments and payment dates, and a
  maturity date to which management has positive
  intent and capability to hold securities.
• Held-for-trading investments an investment that
  is held for the purpose of selling to earn
  short-term profits
• Available-for-sale investments that are not
  designated held-to-maturity or trading can be
  sold when needed
• Intention/designation of management is crucial!

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Strategic investments (type of control)

• Controlled investments give continuing power
  to determine strategic operating, investing and
  financing policies of investee without
  cooperation of others. (usually, more than 50
  of voting shares)
• Significant influence investments give
  influence over investee management but not
  control (usually gt 20, lt50 of voting shares)
• Joint ventures two or more venturers jointly
  control the entity (one venturer cannot decide
  without consent of other venturers)
• Example A11-3

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2. Held-to-maturity (HTM) investments

• Usually bonds and money market instruments
• Bonds typically offer interest payments annually
  or, more commonly, semi-annually, and repayment
  of the principal when the bond matures
• Bond valuation is a present value exercise, where
  the interest payments are an annuity and the
  principal repayment is a lump sum the discount
  rate is determined by the market as function of
  the risk-free rate and risk

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Key bond data

• Face value (or par value, principal value)
  amount payable when bond is due
• Maturity date end of bond term and due date for
  the face value
• Stated interest rate (or coupon rate, nominal
  rate) rate that determines periodic interest
  payments
• Interest payment dates dates at which periodic
  interest payments are due

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Bond characteristics determined by market

• Market rate of interest (or bond yield) return
  required by investors, function of prevailing
  interest rates and bond risk
• Market value present value of cash flows
  implied by coupon rate and principal repayment,
  discounted at market rate
• Bond discount/premium difference between bond
  face value and market value, at date of issue

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The market value of long term instruments

• The market value of a long term instrument is the
  present value of its associated future cash
  flows, discounted at the market (or effective)
  rate or yield.
• Cash flows associated with debt instruments are
  generally of two types
• Face value of instrument, payable at maturity
  date
• Stream of interest payments ( face value x
  stated interest rate) annuity

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Accounting for bond investment

• If the bonds are considered held-to-maturity
  investments, the cost method is appropriate.
  Year-to-year fluctuations in the market value of
  the investment are ignored. The investment is
  carried at amortized cost. Investment revenue is
  (generally) equal to cash interest received,
  plus/minus amortization of any discount/premium.
• The fair value method is used for
  available-for-sale or trading debt investments.

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Accounting for initial bond investment

• Dr. Investment in bonds Mkt
• Cr. Cash Mkt accrued int (if any)
• Dr. Interest receivable Accrued int (if any)
• Mkt market value of bond at date of issue
• Discount or premium (difference between face
  value and market value of bond) arises if market
  interest rate (yield) at date of investment
  differs from stated interest rate.

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Bond investment example Dougherty

• Dougherty Ltd. acquires 6 million of 10 bonds
  on June 1, 2005 to be held to maturity. The
  bonds pay interest on December 1 and June 1. The
  bonds mature on June 1, 2007.
• Record the investment in the bonds assuming that
  the bonds were priced to yield (1) 10 (2) 8
  and (3) 12.
• Prepare journal entries related to this
  investment through June 1, 2006, assuming the
  bonds yield 10.

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Amortization of discount/premium

• Effective interest method
• Interest received (cash) face value X (stated
  interest rate / of interest payments per year)
• Interest revenue market interest rate at date
  of bond issue X opening carrying value of bond
  (i. e., after last payment)
• Adjustment to bond carrying value difference
  between interest revenue and interest received
  (i. e., is a plug)

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Dougherty (part 2)

• Dougherty Ltd. acquires 6 million of 10 bonds
  on June 1, 2005 to be held to maturity. The
  bonds pay interest on December 1 and June 1. The
  bonds mature on June 1, 2007.
• Prepare an amortization table, assuming that the
  bonds are priced to yield (1) 8 and (2) 12.
• Prepare journal entries related to this
  investment through June 1, 2006, assuming the
  bonds yield (1) 8 and (2) 12.
• In all cases, use effective interest amortization.

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3. Accounting for investments

• Cost method
• investment is recorded at cost (transaction costs
  can be capitalized or expensed immediately)
• Interest or dividends recorded as income
• Any premium or discount on debt securities
  amortized over life of investment
• Sale before maturity gives rise to gain or loss
  if proceeds differ from book value
• Used for held-to-maturity, or available-for-sale
  when market value not available

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3. Accounting for investments

• Fair value method
• Investment is recorded at cost (transaction costs
  are expensed immediately if held-for-trading can
  be included in investment cost if
  available-for-sale)
• At the end of each reporting period, investments
  are revalued to fair value (market value),
  whether fair value is higher or lower than
  carrying value
• Interest or dividends are recorded as investment
  income

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Fair value method two approaches

• 1. Unrealized holding gains/losses in Other
  Comprehensive Income
• Unrealized gains and losses are in Accumulated
  OCI (AOCI) until instrument is sold, when they
  are transferred from AOCI into income.
• This method is used for available-for-sale.
• 2. Unrealized holding gains/losses in income
• This method is used for held-for-trading
  investments.

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Fair value method Other issues

• Transaction costs can be included in acquisition
  cost or expensed immediately (AFS) expensed
  immediately (HFT)
• AFS Changes in Accumulated OCI (AOCI) must be
  explained in financial statements
• AFS Realized gain/loss on sale net proceeds
  of sale less original acquisition cost
• HFT Realized gain/loss on sale net proceeds
  less carrying value at time of sale

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Available-for-sale Bookkeeping

• Acquisition
• Dr. Investment A
• Dr. Commissions expense B
• Cr. Cash AB
• (assumes transactions costs expensed immediately)

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Available-for-sale Bookkeeping

• Year-end (fair value has increased to F)
• Dr. Investment F-A
• Cr. Unrealized holding gain (OCI) F-A
• Sale of investment next year
• Dr. Cash (Net proceeds) P
• Cr. Investment F
• Dr. Unrealized holding gain (OCI) F-A
• Cr. Gain on sale P-A
• or Dr. Loss on sale A-P

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Available-for-sale Bookkeeping

• Year-end (fair value has decreased to D)
• Dr. Unrealized holding loss (OCI) A-D
• Cr. Investment A-D
• Sale of investment next year
• Dr. Cash (Net proceeds) P
• Cr. Investment D
• Cr. Unrealized holding loss (OCI) A-D
• Cr. Gain on sale P-A
• or Dr. Loss on sale A-P

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Trading investment Bookkeeping

• Acquisition
• Dr. Investment A
• Dr. Commissions expense B
• Cr. Cash AB
• (assumes transactions costs expensed immediately)

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Trading investment Bookkeeping

• Year-end (fair value has increased to F)
• Dr. Investment F-A
• Cr. Unrealized holding gain (I/S) F-A
• Sale of investment next year
• Dr. Cash (Net proceeds) P
• Cr. Investment F
• Cr. Gain on sale P-F
• or Dr. Loss on sale F-P

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Trading investment Bookkeeping

• Year-end (fair value has decreased to D)
• Dr. Unrealized holding loss (I/S) A-D
• Cr. Investment A-D
• Sale of investment next year
• Dr. Cash (Net proceeds) P
• Cr. Investment D
• Cr. Gain on sale P-D
• or Dr. Loss on sale D-P

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Investments example James Inc.

• James engages in these transactions in 20x7
• Jan. 1/x7 Purchased GM shares for 1,200
• Dec. 31/x7 Fair value, GM shares 1,275
• Jan. 9/x8 Sold GM shares for 1,310
• June 2/x8 Purchased Ford shares for 1,800
• Dec. 31/x8 Fair value, Ford shares 1,500
• Jan. 31/x9 Sold Ford shares for 1,550
• Prepare journal entries assuming (1) both are HFT
  investments and (2) both are AFS.

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AFS Statement of changes in AOCI

• Accumulated OCI, Jan. 1
• /- Unrealized holding gains/losses in
• AFS investments occurring this year
• /- Reclassifications (unrealized holding
  gains/losses recorded in prior years,
• realized this year through sale of AFS
  investments)
• Accumulated OCI, Dec. 31

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4. The equity method (significant influence)

• a. Equity method basics
• Basics Investor records its proportionate share
  of investee income as its own income (debit to
  investment account), and reduces the investment
  account by its share of investee dividends
  received.
• The equity method is one-line consolidation.
• e. g., Big buys 25 of voting shares of Small for
  100 on January 1. At year end, Small reports
  net income of 40 and declares and pays a cash
  dividend of 20.

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4.b. Acquisition cost greater than book value

• The purchase discrepancy is the difference
  between the cost of investment acquired and the
  book value of investor share of investee net
  assets on acquisition date. This difference
  arises from under- or overstated assets and/or
  liabilities on the investee balance sheet or
  unrecorded goodwill. The investor must attribute
  the purchase discrepancy to depreciable assets
  (and then amortize it), non-depreciable
  identifiable assets/liabilities, or goodwill.
• Example A11-22

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4.c. Investee income from nonoperating sources

• Investor company must record separately its share
  of investee income attributable to extraordinary
  items and/or discontinued operations. If these
  items are material from the investors point of
  view, they must be presented separately on
  investors income statement.

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4.d. Intercompany transactions

• Principle An economic entity cannot earn a
  profit by selling to itself. From an economic
  point of view, affiliated companies are (at least
  partly) a single entity.
• Investor company cannot earn a profit simply by
  transferring assets to or from investee. Profits
  are earned only by selling to an external party.
• Intercompany sales cause no problems as long as
  the asset in question is ultimately sold to an
  external party. Adjustments must be made if a
  profitable intercompany sale occurs and the
  asset remains inside the investor-investee
  entity.

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5. Investments and the cash flow statement

• Cash flows related to acquisition and sale of
  investments are investing cash flows (except HFT
  investments, which are operating)
• Interest and dividends received are generally
  operating cash flows
• Impairment losses, amortization of discount or
  premium (held-to-maturity), and investor share of
  investee income (significant influence
  investments) are non-cash items that must be
  removed from income (indirect method) or excluded
  from operating activities (direct)
• Example A11-30