FINANCIAL ACCOUNTING

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Chapter 11 -- Marketable Securities and
Investments

• FINANCIAL ACCOUNTING
• AN INTRODUCTION TO CONCEPTS,
• METHODS, AND USES
• 11th Edition

Clyde P. Stickney and Roman L. Weil
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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 and
  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.

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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 equity, for which it does not
  have conventional control, but does have
  parent-like characteristics.

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Chapter Outline

• 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
• f. Derivatives
• 3. Minority, passive investments
• 4. Minority, active investments

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Chapter Outline

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

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Types of Investments
The accounting for investments depends on the
purpose of the investment and the percentage of
voting stock held.
Investor Corporation
Minority, Active Investments (typically between
20 and 50 ownership)
Majority, Active Investments (greater than 50
ownership)
Minority, Passive Investments (less than 20
ownership)
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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 for full control over the
  other company.

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Discuss 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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Review 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.

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Comment on 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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How is valuation done 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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Explain 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.

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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
  short-term profit, unrealized gains or losses
  that result from adjustments to market value pass
  through the income statement increase or reduce
  net income before there is a sale of the
  securities.

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How are trading securities recorded?

• Record acquisition of trading securities

• To revalue the securities to market value and
  recognize an unrealized holding gain.

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

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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.

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

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Distinguish 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.

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Distinguish 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.

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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).
• 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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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 the new value of the securities is
  435,000.

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

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Compare 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.

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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.

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Discuss Disclosure Requirements 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.

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Discuss Disclosure Requirements about 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.

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What is the controversy about marketable
securities?

• 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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What are derivative instruments?

• Firms face risks in carrying out business
  operations
• 1. The risk that customers will stop buying its
  products and services,
• 2. The risk that raw material used in
  production will increase in cost after the firm
  has committed to a selling price,
• 3. The risk that currency exchange rates will
  change after the firm has made commitments fixed
  in terms of a foreign currency,
• 4. The risk that interest rates will change,
• 5. The risk that employees will quit or retire.

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What are derivative instruments? (Cont.)

• 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.

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What are derivative instruments? (Cont.)

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

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Minority, Passive Investments

• 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 recorded at acquisition cost
• Dividends are recorded as revenue
• At the end of accounting periods, the asset is
  adjusted to the market value
• Sale of asset results in a realized gain or loss

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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.
• 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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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 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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Majority, Active Investments

• A 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.

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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,

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Majority, Active Investments (Cont.)

• 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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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.

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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.

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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 11.3Effects 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.