Chapter 14 19th Edition Investments in Debt and Equity Securities Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 14-1 Why Companies Invest in Other Companies • • • • • Safety cushion Cyclical cash needs Investment for a return Investment for influence Purchase for control 14-2 Cyclist Cash Needs • Some companies operate in seasonal business environments that need cyclical inventory buildups requiring large amounts of cash, followed by lots of sales and cash collections Examples include: Toy stores Firework retailers Halloween retailers 14-3 Investment for Influence In general, companies can invest in other companies for many reasons other than to earn a return Some reasons are: • to ensure a supply of raw materials (e.g., Coca- Cola) • • to influence the board of directors to diversify product offerings 14-4 Purchase for Control • When a company purchases enough of another company to be able to control operating, investing, and financing decisions, different accounting treatment is required for that acquisition • For accounting purposes, a parent company is required to report the results of all of its subsidiaries of which it owns more than 50% as if the parent and subsidiaries are one company 14-5 Classification of Investment Securities • Debt securities are financial instruments issued by a company that typically have the following characteristics: a maturity value representing the amount to be repaid to the debt holder at maturity, an interest rate that specifies the periodic interest payments, and a maturity date indicating when the debt obligation will be redeemed (continued) 14-6 Classification of Investment Securities • Equity securities represent ownership in a company These shares of stock typically carry with them the right to collect dividends and to vote on corporate matters They are an attractive investment because of the potential for significant increases in the price of the security (continued) 14-7 Classification of Debt and Equity Securities • Held-to-maturity securities are debt securities purchased by a company with the intent and ability to hold those securities until they mature This category includes only debt securities because equity securities typically not mature The company must have the intention of holding the security until it matures (continued) 14-8 Classification of Debt and Equity Securities • • Available-for-sale securities are equity securities that are not considered trading securities and are not accounted for using the equity method Most of the typical company’s investment securities are classified as available for sale (continued) 14-9 Classification of Debt and Equity Securities • • Trading securities are debt and equity securities purchased with the intent of selling them in the near future Trading involves frequent buying and selling of securities, generally for the purpose of “generating profits on short-term differences in price.” (continued) 14-10 Cash Flows from Gains and Losses on Available-for-Sale Securities Caesh Company came into existence with a $1,000 investment by owners on January 1, 2013, and entered into the following transactions during 2013 Cash sales $ 1,700 Cash expenses (1,400) Purchase of investment securities (600) Sale of investment securities (costing $200) 170 (continued) 14-68 Cash Flows from Gains and Losses on Available-for-Sale Securities The investment securities are classified as available for sale The market value of the remaining securities was $500 on December 31, 2013 Caesh Company’s net income for 2013 can be computed as follows: Sales Expenses Operating income Realized loss on sale of investment securities ($200 – $170) Net income $1,700 (1,400) 300 (30) $270 (continued) 14-69 Cash Flows from Gains and Losses on Available-for-Sale Securities The statement of cash flows for Caesh Company for 2013 can be prepared as follows: 14-70 Cash Flows from Gains and Losses on Trading Securities If the investment securities purchased by Caesh Company are classified as trading securities and are deemed to have been acquired for operating purposes, the unrealized gain appears in the Operating Activities section Net income is $370 instead of $270 because the $100 unrealized increase in the fair value of the portfolio is reported as an unrealized gain on the income statement 14-71 Equity Method Securities and Operating Cash Flows • When a company owns equity method securities, an adjustment to operating cash flow must be made to reflect the fact that the cash received from the securities in the form of dividends is not equal to the income from the securities included in the computation of net income • Daltone Company owns 30% of the outstanding shares of Chase Company Chase Company’s net income for the year was $100,000, and cash dividends were $40,000 (continued) 14-72 Equity Method Securities and Operating Cash Flows • Daltone would include $30,000 ($100,000 x 0.30) in its income statement as income from the investment • Daltone received $12,000 ($40,000 x 0.30) in cash dividends from its investment in Chase Daltone would report a subtraction in the Operating Activities section for the $18,000 ($30,000 – $12,000) difference between the income reported and the cash dividends received 14-73 Required Additional Disclosures Trading securities The change in net unrealized holding gain or loss that is included in the income statement Available-for-sale securities Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type (continued) 14-74 Required Additional Disclosures The proceeds from sales of availablefor-sale securities and the gross realized gains and losses on those sales and the basis on which cost was determined in computing realized gains and losses The change in net unrealized holding gain or loss on available-for-sale securities that has been included in stockholder’s equity during the period (continued) 14-75 Required Additional Disclosures Held-to-maturity securities: Aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type Transfer of securities between categories: Gross gains and losses included in earnings from transfer of securities from available-for-sale into the trading category (continued) 14-76 Required Additional Disclosures For securities transferred from held-tomaturity, the company should disclose the amortized cost amount transferred, the related realized or unrealized gain or loss, and the reason for transferring the security 14-77 Measurement of Impairment • A creditor shall measure for impairment for • loans with no market value at the present value of expected future cash flows discounted at the loan’s effective interest rate The impairment is recorded by creating a valuation allowance account and charging the estimated loss to bad debt expense (continued) 14-78 Measurement of Impairment • If a loan agreement is restructured in a troubled debt restructuring, the interest rate to be used to discount the new modified contract terms is based on the original contract rate 14-79 Nature and Classifications of Paid-In Capital • A corporation is a legal artificial entity • • separate from its owners Individuals contribute capital for which the corporation issues stock certificates evidencing ownership interests Stockholders elect a board of directors whose members oversee the strategic and long-run planning of the corporation 14-80 Chapter 14 ₵ The The End End $ 14-81 14-82 ... of $3,000 would be added to the purchase price) (continued) 14- 14 Purchase of Debt Securities • The debt securities are classified by the purchaser as trading securities because management will... indicated in several ways, as listed in Slide 14- 44 (continued) 14- 26 Recognition of Revenue from Equity Securities Significant influence may be indicated by decisions affecting: • Representation... • For accounting purposes, a parent company is required to report the results of all of its subsidiaries of which it owns more than 50% as if the parent and subsidiaries are one company 14- 5 Classification