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CHAPTER 14 QUESTIONS Companies make investments in the securities of another company to provide a safety cushion of available funds and to store a temporary excess of cash Companies also invest in other companies to earn a return, to secure influence, or to gain control stock or having a majority voting interest in determining who is on the company’s board of directors When these other factors exist, then control may be assumed and consolidation would be appropriate (a) Factors that may indicate the ability of a minority-interest investor to exercise significant influence over an investee’s operating and financial policies are as follows: Statement No 115 applies to many debt and equity securities All debt securities with a readily determinable fair value fall under its scope Debt securities that not have a readily determinable fair value are accounted for under the rules outlined in FASB Statement No 114 Equity securities with a readily determinable fair value that are not accounted for (1) using the equity method (i.e., greater than 20% ownership) or (2) as investments in consolidated subsidiaries are accounted for using the rules outlined in No 115 (a) The stated rate of interest is used to determine the amount of the annuity to be received Representation on the board of directors of the investee Participation in the policy-making process Material intercompany transactions between investee and investor Interchange of managerial personnel between investee and investor Technological dependency of investee on investor Substantial minority interest of the investor in an investee whose shares of stock are widely distributed and not concentrated for control purposes (b) Factors that may indicate the inability of an investor with more than 20% of a company’s stock to exercise significant influence over an investee’s operating and financial policies are as follows: (b) The market or effective rate of interest is used in the present-value computations to determine the present value of both the principal sum and the annuity The effective-interest method computes interest revenue by multiplying the effective interest rate by the carrying value of the investment When a company does not own more than 50% of a company, other factors may be considered to determine if control exists Such factors include owning a large minority voting interest with no other shareholder owning a significant block of Opposition by the investee, such as litigation or complaints to governmental regulatory authorities An agreement between the investor and the investee under which the investor surrenders significant rights as a shareholder Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor The investor needs or wants more financial information to apply the equity method than is available to A security is classified as held to maturity if the business has the intent and the ability to hold the security to maturity To be classified as a trading security, the security must have a readily determinable fair value and must be purchased and held for the purpose of selling it to generate profits on short-term differences in price 181 181 182 Chapter 14 the investee’s other shareholders, tries to obtain the information, and fails The investor tries and fails to obtain representation on the investee’s board of directors A joint venture is accounted for using the equity method for those partners that own 20% or more and not more than 50% of the joint venture For these joint venture partners, the liabilities of the joint venture not show up on the balance sheet Instead, only the net investment in the joint venture shows up on the balance sheet Thus, the liabilities of the joint venture are “off” the balance sheet of the partners that account for the joint venture using the equity method 10 FASB Statement No 115 developed new rules for reporting changes in value; the disclosure varies depending on the classification of the security For trading securities and available-for-sale securities, a market adjustment account is used on the balance sheet to report the securities at their market values Held-to-maturity securities are reported on the balance sheet at their amortized cost For trading securities, the change in fair value for the current period is reported on the income statement The change in value for available-for-sale securities is reported in the equity section on the balance sheet 11 Market Adjustment is a real account used in valuing investments on the balance sheet If the fair value of a security that falls under the scope of Statement No 115 increases, the market adjustment account will be debited If the value of the security decreases, the market adjustment account will be credited The market adjustment account is disclosed on the balance sheet either netted against the related securities account or disclosed separately in addition to the securities account 12 For “other than temporary” declines, the cost basis of the security should be reduced by crediting the investment account rather than a market adjustment account In addition, the write-down should be recognized as a loss and charged against current income The new cost basis for the security may not be adjusted upward to its original cost for any subsequent increases in market value 182 However, the market adjustment account may be used to record any subsequent increases 13 The sale of trading securities during the year results in the computed unrealized gain or loss on trading securities being a combination of unrealized gains and losses for the year and reversals of cumulative unrealized gains and losses from prior years for trading securities sold during the year The same is true with respect to the computation of unrealized increases and decreases in value for available-for-sale securities 14 When FASB No 115 securities are transferred between categories, the transfer is accounted for at the security’s current fair value The historical cost of the security is removed from the books along with any associated market adjustment The difference between the security’s current fair value and its fair value on the most recent balance sheet date is accounted for differently, depending on the classifications involved in the transfer 15 Realized gains on trading securities are subtracted in computing cash from operating activities (when the indirect method is used) Realized losses are added The same is true for unrealized items; unrealized gains on trading securities are subtracted and unrealized losses on trading securities are added 16 Because trading securities, by their very definition, are held to take advantage of short-term differences in price, these securities are always classified as current Held-to-maturity securities are always classified as long-term unless the security is maturing in the current period The major classification problem arises with available-for-sale securities These securities can be classified as either current or long-term, depending on the intention and assessments of management 17 For all securities not classified as trading, the cash flow effects of purchases and sales are disclosed in the Investing section of the statement of cash flows For securities classified as trading, the purchase and sale of securities are disclosed in the Operating section 18 FASB Statement No 115 requires the following additional disclosures for the different classifications of securities: 19 The only significant difference between the provisions of IFRS 39 and those of SFAS No 115 is in the reporting of unrealized gains and losses Under IFRS 39, a company can elect to recognize all unrealized gains and losses—both for trading and available-for-sale securities— in net income for the period Trading securities—the change in the net unrealized holding gain or loss that is included in the income statement Available-for-sale securities—the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type In addition, for debt securities the company should disclose information about contractual maturities Companies need to also disclose the proceeds from sales of available-for-sale securities, the gross unrealized gains and losses on those sales, and the basis on which cost was determined in computing unrealized gains and losses Finally, companies should disclose the change in net unrealized holding gain or loss on available-for-sale securities that has been included in stockholders’ equity during the period Held-to-maturity securities—the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type In addition, the company should disclose information about contractual maturities 20.‡ FASB Statement No 115 applies to all debt securities for which there is a readily determinable fair value Thus, most debt securities would fall under the scope of this pronouncement Loans often not have a readily determinable fair value because they are not traded on an exchange as are most debt securities Thus, the provisions of Statement No 115 are not applicable to impaired loans FASB Statement No 114 addresses the accounting for the impairment of a loan ‡ 183 Relates to Expanded Material 183 184 Chapter 14 PRACTICE EXERCISES PRACTICE 141 Feb PURCHASING DEBT SECURITIES Asset approach Investment in Trading Securities Interest Receivable Cash 50,000 333 50,333 Interest Receivable: $50,000 0.08 (1/12) = $333 June 30 Cash 2,000 Interest Receivable Interest Revenue 333 1,667 Cash: $50,000 0.08 (6/12) = $2,000 Feb Revenue approach Investment in Trading Securities Interest Revenue Cash 50,000 333 50,333 Interest Revenue: $50,000 0.08 (1/12) = $333 June 30 Cash 2,000 Interest Revenue 2,000 Cash: $50,000 0.08 (6/12) = $2,000 PRACTICE 142 PURCHASING EQUITY SECURITIES Investment in Available-for-Sale Securities Cash 32,020 32,020 Investment: (1,000 shares $32) + $20 = $32,020 PRACTICE 143 COMPUTING THE VALUE OF DEBT SECURITIES N = years = 14 I = 12/2 = PMT = $100,000 0.08 (6/12) = $4,000 FV = $100,000 (the face value is paid at the end of years) PV = $81,410 PRACTICE 144 184 INTEREST REVENUE FOR HELD-TO-MATURITY SECURITIES Investment in Held-to-Maturity Securities Cash 25,518 25,518 Cash [$20,000 0.10 (6/12)] Investment in Held-to-Maturity Securities Interest Revenue 1,000 107 893 Interest Revenue: $25,518 0.07 (6/12) = $893 Cash 1,000 Investment in Held-to-Maturity Securities Interest Revenue 111 889 Interest Revenue: ($25,518 $107) 0.07 (6/12) = $889 PRACTICE 145 COST METHOD, EQUITY METHOD, AND CONSOLIDATION Number of Shares Owned by Investor Company Total Shares of Investee Company Outstanding 1,200 10,000 12% 6,000 20,000 8,000 55,000 75 36 PRACTICE 146 Percentage Ownership Accounting Classification Trading or available for sale Consolidation Equity method REVENUE FOR TRADING AND AVAILABLE-FOR-SALE SECURITIES Dividends received on trading and available-for-sale securities are both classified as dividend revenue Cash 7,600 Dividend Revenue 7,600 Cash: (2,000 shares $2.50) + (4,000 shares $0.65) = $7,600 185 185 186 Chapter 14 PRACTICE 147 REVENUE FOR EQUITY METHOD SECURITIES Because Burton owns more than 20% of Company A stock (2,000/8,000 = 25%), the investment is accounted for using the equity method Because the purchase price was equal to Burton’s share of the book value of Company A’s equity, there is no excess of purchase price over cost basis Year Investment in Company A Stock Cash Investment in Company A Stock Income from Company A Stock 27,000 27,000 5,000 5,000 Income from Company A Stock: $20,000 (2,000 shares/8,000 shares) = $5,000 Cash Investment in Company A Stock 1,600 1,600 Cash: $0.80 2,000 shares = $1,600 Year Investment in Company A Stock Income from Company A Stock 6,250 6,250 Income from Company A Stock: $25,000 (2,000 shares/8,000 shares) = $6,250 Cash Investment in Company A Stock 2,000 2,000 Cash: $1.00 2,000 shares = $2,000 PRACTICE 148 EQUITY METHOD: EXCESS DEPRECIATION Underlying market value of net assets ($65,000/0.40) Book value of net assets Implied amount of excess value of building $ 162,500 120,000 $ 42,500 Investor’s interest in net assets Amount of excess building value to be depreciated Depreciation period Annual extra depreciation 0.40 $ 17,000 ÷ 20 years $ 850 Year Investment in Company B Stock Cash 65,000 Investment in Company B Stock Income from Company B Stock 16,000 65,000 16,000 Income from Company B Stock: $40,000 (4,000 shares/10,000 shares) = $16,000 Cash Investment in Company B Stock Cash: 4,000 shares $1.10 = $4,400 186 4,400 4,400 PRACTICE 148 (Concluded) Income from Company B Stock Investment in Company B Stock 850 850 Investment in Company B Purchase 65,000 Income 16,000 Ending 4,400 Dividends 850 Extra Depreciation 75,750 PRACTICE 149 EQUITY METHOD: COST GREATER THAN BOOK VALUE Underlying market value of net assets ($100,000/0.25) Book value of net assets Implied amount of excess of market over book value $400,000 300,000 $100,000 Excess market value identified with: Inventory Building Goodwill Total $ 10,000 50,000 40,000 $100,000 Investor’s interest in net assets 0.25 Amount of excess inventory cost this year $ Amount of excess building value to be depreciated Depreciation period Annual extra depreciation 2,500 $ 12,500 ÷ 10 years $ 1,250 No extra expense is associated with the goodwill, assuming that it is not impaired during the year Year Investment in Company C Stock Cash 100,000 100,000 Investment in Company C Stock Income from Company C Stock 17,500 17,500 Income from Company C Stock: $70,000 (2,500 shares/10,000 shares) = $17,500 187 187 188 Chapter 14 PRACTICE 149 (Concluded) Cash 5,000 Investment in Company C Stock 5,000 Cash: 2,500 shares $2.00 = $5,000 Income from Company C Stock Investment in Company C Stock 3,750 3,750 Extra inventory cost $2,500 + Extra depreciation $1,250 = $3,750 Investment in Company C Purchase Income Ending 100,000 17,500 5,000 Dividends 3,750 Extra Expense 108,750 PRACTICE 1410 CHANGES IN VALUE: TRADING SECURITIES (a) (b) Market AdjustmentTrading Securities Unrealized Gain on Trading Securities 200 Unrealized Loss on Trading Securities Market AdjustmentTrading Securities 150 (c) $1,500 + $200 = $1,700 (d) $1,500 $150 = $1,350 200 150 PRACTICE 1411 CHANGES IN VALUE: AVAILABLE-FOR-SALE SECURITIES (a) Market AdjustmentAvailable-for-Sale Securities 200 Unrealized Increase in Available-for-Sale Securities 200 (b) Unrealized Decrease in Available-for-Sale Securities 150 Market AdjustmentAvailable-for-Sale Securities (c) $1,500 + No income impact = $1,500 (d) $1,500 – No income impact = $1,500 150 PRACTICE 1412 CHANGES IN VALUE: HELD-TO-MATURITY SECURITIES 188 (a) No adjusting entry (b) No adjusting entry (c) $1,500 + No income impact = $1,500 (d) $1,500 – No income impact = $1,500 PRACTICE 1413 CHANGES IN VALUE: EQUITY METHOD (a) No adjusting entry (b) No adjusting entry (c) $1,500 + No income impact = $1,500 (d) $1,500 – No income impact = $1,500 PRACTICE 1414 SALE OF SECURITIES Cash (400 $27) 10,800 Realized Gain on Trading Securities 1,600 Investment SecuritiesTrading (400 $23) 9,200 Cash (400 $20) 8,000 Realized Loss on Trading Securities 1,200 Investment SecuritiesTrading (400 $23) 9,200 PRACTICE 1415 SALE OF SECURITIES AND THE MARKET ADJUSTMENT ACCOUNT Cash proceeds Cost Realized loss $ 9,500 10,000 $ (500) Cumulative unrealized loss, end of year ($5,800 $9,000) Cumulative unrealized gain, beginning of year ($26,000 $19,000) Unrealized loss for the year 189 $ (3,200) 7,000 $(10,200) 189 190 Chapter 14 PRACTICE 1416 TRANSFER BETWEEN CATEGORIES: TO AND FROM TRADING Security A Investment SecuritiesAvailable for Sale Market AdjustmentTrading Unrealized Gain on Transfer of Securities Investment SecuritiesTrading 5,500 1,000 1,500 5,000 Security B Investment SecuritiesTrading Unrealized Loss on Transfer of Securities Market AdjustmentAvailable for Sale Investment SecuritiesAvailable for Sale 4,100 3,900 2,000 6,000 PRACTICE 1417 TRANSFER BETWEEN CATEGORIES: AVAILABLE FOR SALE Security A Investment SecuritiesHeld to Maturity Market AdjustmentAvailable for Sale Unrealized Increase in Available-for-Sale Securities Investment SecuritiesAvailable for Sale 8,000 1,500 2,000 7,500 Security B Investment SecuritiesAvailable for Sale Unrealized Decrease in Available-for-Sale Securities Investment SecuritiesHeld to Maturity 7,100 1,900 9,000 PRACTICE 1418 CASH FLOW AND AVAILABLE-FOR-SALE SECURITIES Realized gain: $470 sales proceeds $350 cost = $120 realized gain Unrealized increase: $65 market value $50 cost ($400 $350) = $15 unrealized increase 190 Operating activities: Net income Less: Realized gain on sale of securities $1,000 (120) $880 Investing activities: Purchase of available-for-sale securities Sale of available-for-sale securities $ (400) 470 70 Statement of cash flows Operating activities: Net income Plus: Depreciation Purchase of trading securities Sale of trading securities Less: Increase in accounts receivable Less: Realized gain on sale of trading securities Plus: Realized loss on sale of available-for-sale securities Plus: Unrealized loss on trading securities $ 440 70 (500) 220 (250) (120) 70 140 Investing activities: Purchase of building Purchase of available-for-sale securities Sale of available-for-sale securities $ (600) (400) 30 $ 70 (970) Financing activities: Initial investment by owners 1,000 Net increase in cash $ 100 Balance sheet Assets: Cash Accounts receivable Trading securities (cost, $400) Available-for-sale securities (cost, $300) Building (less accumulated depreciation of $70) $ 100 250 260 380 530 Liabilities Equity: Paid-in capital Retained earnings (beginning balance = $0) Accumulated other comprehensive income 225 $1,520 $1,000 440 80 $ 1,520 225 226 Chapter 14 14–57.‡ December 31, 2005, cash flow projection: Date Payment Time Table ValuePresent Value @ 11% Dec 31, 2006 $ 50,000 year 0.9009 $ 45,045 Dec 31, 2007 100,000 years 0.8116 81,160 Dec 31, 2008 200,000 years 0.7312 146,240 Dec 31, 2009 300,000 years 0.6587 197,610 Dec 31, 2010 100,000 years 0.5935 59,350 $750,000 $529,405 Book value of loan receivable at December 31, 2005: Principal $ 750,000 2004 interest receivable 82,500 Total loan receivable $ 832,500 Loan impairment: $832,500 – $529,405 = $303,095 Allowance required: $303,095 – $82,500 = $220,595 2005 Dec 31 Bad Debt Expense Interest Receivable Allowance for Loan Impairment To record loan impairment 2006 Dec 31 Cash Loan Receivable 303,095 82,500 220,595 50,000 50,000 31 Allowance for Loan Impairment 58,235 Interest Revenue 58,235 $529,405 0.11 = $58,235 Although a work sheet is not required, it facilitates understanding of the annual interest computation, assuming the 2005 cash flow projection was not changed Interest Revenue from Loan Impairment: (1) (2) Loan Receivable Allowance before for Current Loan Payment Date Payment Impairment Dec 31, 2006 $750,000 $220,595 Dec 31, 2007 700,000 162,360 Dec 31, 2008 600,000 103,220 Dec 31, 2009 400,000 48,574 Dec 31, 2010 100,000 9,917 *Rounded to close allowance account 14–57.‡ (Continued) 226 (3) (4) (5) Net Interest Receivable (1) – (2) $529,405 537,640 496,780 351,426 90,083 11% (3) $ 58,235 59,140 54,646 38,657 9,917* $220,595 Received $ 50,000 100,000 200,000 300,000 100,000 $750,000 December 31, 2006, cash flow projection: Date Dec 31, 2007 Dec 31, 2008 Dec 31, 2009 Payment $150,000 300,000 250,000 $700,000 Time year years years Table ValuePresent Value @ 11% 0.9009 $135,135 0.8116 243,480 0.7312 182,800 $561,415 Balance in loan receivable and allowance accounts before valuation adjustment: Loan Receivable Bal 750,000 Bal 700,000 2006 Pmt Allowance for Loan Impairment 50,000 58,235 220,595 Bal 162,360 Net balance before adjustment: $700,000 – $162,360 = $537,640 Decrease in Allowance for Loan Impairment: $561,415 – $537,640 = $23,775 2006 Dec 31 Allowance for Loan Impairment Bad Debt Expense To adjust net loan receivable to present value of new cash flow projections 23,775 23,775 Alternative computation: Current balance in allowance $162,360 Required balance ($700,000 – $561,415) 138,585 Adjustment $ 23,775 2007 Dec 31 Cash Loan Receivable 31 Allowance for Loan Impairment Interest Revenue 150,000 150,000 61,756 61,756 $561,415 0.11 = $61,756 Although a work sheet is not required, it facilitates understanding of the annual interest computation, assuming the 2006 cash flow projection was not changed 227 227 228 Chapter 14 14–57.‡ (Concluded) Interest Revenue from Loan Impairment: Date Dec 31, 2007 Dec 31, 2008 Dec 31, 2009 (1) Loan Receivable before Current Payment $700,000 550,000 250,000 (2) (3) (4) (5) Allowance for Loan Impairment $138,585 76,829 24,780 Net Receivable (1) – (2) $561,415 473,171 225,220 Interest Revenue 11% (3) $ 61,756 52,049 24,780* $138,585 Payment Received $150,000 300,000 250,000 $700,000 *Rounded to close allowance account 228 DISCUSSION CASES Discussion Case 14–58 The issue of current value accounting has been a difficult one for all standard-setting bodies throughout the world In the United States, the issue of supplementing the historical cost statements with current value information was a topic of discussion by the original Committee on Accounting Principles, the Accounting Principles Board, and the Financial Accounting Standards Board For several years, FASB Statement No 33 required certain companies to report limited current value information in supplemental notes to the financial statements In many cases, a lower-of-cost-or-market valuation method was used Inventories and marketable equity securities were primary examples of this type of valuation Because of the savings and loan losses in the 1980s, many critics complained that historical cost balance sheets were of little value when evaluating the soundness of an institution The SEC has periodically pushed the FASB to move toward “market” accounting FASB Statement No 115 was a compromise: It moved the profession toward market on the balance sheet but left many unrealized gains and losses off the income statement The majority of members of the FASB argued that only trading securities should reflect increases in market values on the income statement If the security is not considered to be a trading security, valuation changes are to be deferred as an adjustment of equity and recognized on the income statement only when the investment is sold or reclassified If international accounting standards move toward the use of more current values or if inflation returns in our economy, further extensions of market values in accounting will certainly appear Perhaps future years will reveal that this move to market accounting as evidenced by FASB Statement No 115 was very significant in long-term transition to relevance Discussion Case 14–59 This case demonstrates how FASB statements may lead to manipulation of the financial statements to reflect the desires of management If Diamond classifies the securities as trading securities, all market gains and losses would be recognized in net income If the securities are classified as available for sale, none of the changes in market value would be reflected on the income statement A strategy available to Diamond would be to classify securities that are increasing in market value as trading securities and securities that are declining in value as available-for-sale securities When a profitable security reverses and starts going down, Diamond could either sell the security or reclassify the security to available for sale and vice versa The classification selected depends on management’s intent, and, thus, auditors must judge the veracity of the explanation in deciding whether to accept management’s decision One way Diamond could justify this policy would be to indicate that profitable securities are subject to immediate sale and thus are trading securities, whereas securities with declining market values will be held until such time as management no longer feels they will increase in value or they increase The auditor would have a difficult time refuting whatever management indicated regarding classification In order to prevent this type of manipulation, SFAS No 115 requires securities to be classified as trading, available for sale, or held to maturity at the time the securities are initially acquired (see paragraph 6) Discussion Case 14–60 Students should discuss the question of applying this standard to nonfinancial institutions and why it may be difficult to apply The concept of a trading security is less clear for a nonfinancial institution than it is for a bank The possibility of manipulation as discussed in Case 14–59 is real If a company classifies its investments as available for sale, all market value changes, both increases and decreases, bypass the income statement Pre–FASB Statement No 115 standards required the lowerof-cost-or-market method; thus, losses would have been recognized on the income statement for marketable securities, but now, under Statement No 115, the same losses would be charged directly to equity 229 229 230 Chapter 14 Students might explore some definitions for trading securities that can help users and auditors to consistently classify investments 230 Discussion Case 14–61 As stated in APB Opinion No 18, if a firm owns 50% or more of the outstanding stock of a company, consolidation is required unless the parent company’s investment is temporary or the parent company does not have control of the subsidiary Owning more than 50% of a firm ensures, in most cases, the parent’s control of the management decisions of the subsidiary By owning less than 50%, The Coca-Cola Company is not required to prepare consolidated financial statements Rather, by a proper application of the equity method, the investment in the subsidiary account will reflect the parent company’s 49% interest in the net assets of the subsidiary By not being required to consolidate, the $2.4 billion debt that is on the financial statements of Coca-Cola Enterprises is not required to be recognized by the parent company Thus, The CocaCola Company was able to finance a substantial purchase without reporting the debt on its balance sheet Discussion Case 14–62 This case illustrates the complexities associated with assessing the differences among control, significant influence, and simple ownership While the FASB has provided guidance in the form of ownership percentages, the student must recognize that certain factors can override the application of those percentages Subsidiary Although International owns 75% of Subsidiary 1, it is not clear if control of the company rests with the management of International If it is likely that the oil company will be nationalized, consolidation of the subsidiary would not be the most appropriate accounting method Use of the cost or equity methods along with a note discussing the potential loss would be appropriate Subsidiary While International owns less than 20% of the stock of Ecological Inc., with two officers on Ecological’s board of directors, it would appear that International is able to significantly influence decisions made by Ecological The fact that Ecological’s stock is widely held also allows International, which holds a large voting block, to influence company policy Thus, the equity method seems appropriate in this situation Subsidiary Even though a financial institution’s accounting information may be drastically different from the information relating to a manufacturing facility, FASB Statement No 94 states that majority-owned, nonhomogeneous operations must be consolidated unless there is a question as to control Subsidiary If the percentages provided in APB Opinion No 18 are strictly applied in this situation, International would use the equity method However, with another company owning 50% of Campton’s common stock, International cannot significantly influence Campton’s policy without approval of Beatrix Thus, use of the cost method may be most appropriate in this instance Discussion Case 14–63 This case requires students to understand the fundamental differences between the cost and equity methods The varying methods reflect the parent company’s different levels of influence on the operating decisions of the subsidiary Logical’s notes could state the following: Investments in companies in which ownership interests are more than 20% and in which the Company exercises significant influence over operating and financial policies are accounted for using the equity method Other investments are accounted for using the cost method It is important to note that Logical applies two criteria for using the equity method It must own more than 20% of the subsidiary’s stock and be able to exercise significant influence 231 231 232 Chapter 14 Using the cost method, the receipt of dividends is recorded as revenue by the parent company The initial purchase is recorded in the same way under both the cost and equity methods The equity method requires journal entries when income is reported by the subsidiary as well as when dividends are paid A major difference is that under the equity method, the declaration of dividends by the subsidiary serves to reduce the investment account on the books of the parent Revenue is recognized by the parent when income is reported by the subsidiary In addition, when the equity method is employed, any difference between the price paid for the stock and the underlying book value of the subsidiary must be analyzed and amortized, if appropriate, over time Under the cost method, the investment account typically remains at the initial cost of the investment Only under unusual circumstances (e.g., when there is a liquidating dividend or a permanent decline in value) does the investment account change However, the companion account to the investment account, called the market adjustment account, changes each period to reflect changes in the market value of the investment When the equity method is used, the investment account changes when net income (or loss) is reported by the subsidiary, a dividend is declared, or when an additional amount involved in the purchase is amortized The investment account changes when the net assets of the subsidiary change Discussion Case 14–64 In many areas, particularly in the area of accounting for investment securities, international financial reporting standards (IFRS) are very similar to U.S GAAP In fact, as discussed in the text, IFRS 39, which was approved by the IASB in December 1998, draws heavily on Statement No 115, which was adopted by the FASB in 1993 The only significant difference is that under IFRS 39, a company can elect to recognize all unrealized gains and losses as part of net income, even those unrealized items related to available-for-sale securities The general point to remember is that someone who understands U.S GAAP should be able to grasp the differences between U.S GAAP and IFRS As international accounting harmonization increases, those differences should decrease in the future 232 SOLUTIONS TO STOP & THINK Stop & Think (p 854): Can you think of other reasons for corporations to invest in the debt and equity securities of other companies? Other reasons to invest in the debt and equity securities of another company include expansion of production capacity without building that capacity yourself, achieving strategic horizontal and vertical integration, and acquiring access to important technology owned by another company Stop & Think (p 860): Theoretically, we should amortize the discount or premium associated with trading and available-for-sale debt securities just as we with held-to-maturity securities Why don’t we? In most cases, it would not be cost-effective to amortize the discount or premium associated with an investment that is being held for the short term The benefit received from the more accurate information would not compensate for the cost of producing that information In addition, as illustrated later in the chapter, trading and available-for-sale securities are revalued and reported at current market value at the end of each period, eliminating the need to systematically adjust the carrying value of the investment to its maturity value Stop & Think (p 872): What is the difference between realized and recognized? Recognized is an accounting term that indicates that a transaction has been recorded using a journal entry Realized means that an amount has been earned (in the case of revenues) Stop & Think (p 877): Based on having just read about how to transfer securities to and from each category, can you specify a set of rules that will apply to every transfer? For example, rule could be that every security being transferred is recorded at its current market value What else? As stated, rule could be that every security being transferred is recorded at its market value Rule could be that historical cost and any market adjustment associated with the security are removed from the books Rule would depend on the original and new classification of the security involved If the reclassification involves a trading security (either to or from that classification), the difference between the amount recorded in rule and rule would be recognized in income If the reclassification involves available-for-sale or held-to-maturity securities, then the difference between cost and market value does not appear on the income statement Instead, it is recorded in an equity account (if going from held to maturity [HTM] to available for sale [AFS]), or the amount in the market adjustment account is amortized (if going from AFS to HTM) 233 233 234 Chapter 14 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 861): The FASB continues to examine the issue of control and consolidation Search the FASB’s Web site (at http://www.fasb.org) and determine the status of the FASB’s deliberations As of June 2002, the FASB was focusing on the issue of special purpose entities (SPEs) and whether they should be consolidated This focus was driven by widespread dissatisfaction over SPE accounting in the wake of the Enron scandal In terms of the percentage of ownership and control, the FASB determined in January 2001 that there were not sufficient votes on the FASB to pass a new standard loosening the 50% ownership rule The FASB continues to consider the issue Stop & Research (p 874): Access a copy of Microsoft’s most recent annual report and determine the total economic return on the company’s available-for-sale securities portfolio for the most recent year In its June 30, 2001, annual report, Microsoft reports that it classifies all of its cash and short-term investment portfolio as available for sale In addition, the company has other investment securities that are classified as available for sale Information for the fiscal year ended June 30, 2001, is as follows: (in millions) Equity and other investments Net Unrealized Increase Beginning $2,981 Net unrealized decrease, equity and other investments Net unrealized decrease, cash and short-term investments Net realized gain, equity and other investments Net realized gain, cash and short-term investments Total economic return Net Unrealized Increase Ending $ 916 Unrealized Decrease for the Year $(2,065) $(2,065) 3,007 172 $ 1,114 The following additional items can also be included in the calculation of net economic return: Decline other than temporary $(4,800) Dividends 377 Interest 1,808 234 SOLUTIONS TO BOXED ITEM The FASB Embraces Market-Value Accounting (pp 868–869) Lobbying is not necessarily bad Some would argue that lobbying is simply making sure that decision makers have available to them relevant information Lobbyists for the banking and insurance industries were to ensure that the FASB understood all financial statement implications associated with FASB Statement No 115 For example, the lobbyists raised a valid issue in pointing out that it seems contradictory to use fair values on the asset side of the balance sheet but not on the liability side Congress created the Securities and Exchange Commission in the early 1930s One of the SEC’s charges was to develop rules for financial reporting The SEC has delegated responsibility to private standard setters (currently the FASB) but could, if it deemed it necessary, assume the responsibility for developing rules for accounting Thus, the SEC has every right to influence the standard-setting process as it is ultimately responsible for ensuring that appropriate accounting and disclosure rules are established There is nothing wrong with a firm selling securities and realizing a profit However, if the firm is selling the security only to satisfy an accounting concept (i.e., arm’s-length transactions), then perhaps a poor resource allocation decision has been made Accounting rules are designed to capture and report the effects of transactions—not to cause transactions to happen Cherry-picking involves firms selectively identifying securities to be sold with the primary purpose of being to be able to disclose favorable effects on the financial statements The FASB’s objective with FASB Statement No 115 is to eliminate the incentive for firms to “cherry-pick” by requiring most securities to be reported at the fair value regardless of whether they have increased or decreased in value 235 235 236 Chapter 14 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 14–1 (The Walt Disney Company) According to Note 12, as of September 30, 2001, Disney held $92 million of securities classified as available-for-sale The total investment balance for Disney was $2.061 billion Available-forsale securities constituted approximately 4.5% of the total The remainder of the investment portfolio consisted of securities classified as held-to-maturity or as equity method securities In addition, Disney reports in Note 12 that it held $756 million in non-public securities that are reported at cost These securities must be reported at cost because market values are not available Note discusses the various types of investment securities that Disney holds: “Debt securities that the Company has the positive intent and ability to hold to maturity are classified as ‘held-tomaturity’ and reported at amortized cost Debt securities not classified as held-to-maturity and marketable equity securities are classified as either ‘trading’ or ‘available-for-sale,’ and are recorded at fair value with unrealized gains and losses included in earnings or stockholders' equity, respectively All other equity securities are accounted for using either the cost method or the equity method.” Also in Note 1, we find that Disney classifies marketable securities with an original maturity of months or less as cash equivalents Thus, certain of Disney’s investments are not reported under Investments in the balance sheet Per Note 12, on September 30, 2001, the fair value of investments was $621 million and the carrying value was $405 million, suggesting an increase in the overall value of the investments While Disney reported an investment account balance of $2.061 billion, not all of that was subject to fair value accounting For example, recall that Disney has a substantial number of investments in non-public companies for which no reliable market values are available Deciphering 14–2 (Archer Daniels Midland Company) You might think that because ADM buys and sells billions of dollars worth of securities each year, much of its portfolio would be classified as trading However, ADM classifies all of its investment securities as being available-for-sale The reason for this classification is that ADM is buying and selling securities as they mature, and in order to rebalance its portfolio ADM claims that it is not using this trading activity to try to make money on short-term price fluctuations This is the common practice for most large U.S companies Given the large turnover in its securities portfolio, one might question ADM’s policy of classifying all of its investment securities as available-for-sale However, FASB Statement No 115 allows management discretion in classifying securities In addition, the bulk of this buying and selling is associated with routine management of ADM’s portfolio as short-term debt securities mature and are sold and replaced with other securities Remember, trading securities are restricted to those purchased with the intent of making money on short-term price fluctuations The company’s investment portfolio experienced an unrealized net loss for the year of $16,738,000 Had these securities been classified as trading, this amount would have been reported as an unrealized loss on the income statement Deciphering 14–3 (Ford Motor Company) The net realized gains of $58 million were included in the 2001 income statement Unrealized gains and losses from available-for-sale securities are not reported in the income statement The net unrealized holding gain for available-for-sale securities as of the end of 2001 was $48 million The change in the cumulative unrealized gain during 2001 was $0, computed as follows: Cumulative net unrealized gain as of December 31, 2001 ($60 – $12) $48 m Cumulative net unrealized gain as of December 31, 2000 ($54 – $6) 48 Increase in cumulative net unrealized gain during 2001 $ m 236 The net realized gain for the year was $53 million ($58 – $5) Accordingly, the sum of the realized and unrealized net gains for the year is $53; this is the economic return on the available-for-sale portfolio for the year (ignoring interest and dividends) Sample CPA Exam Questions The correct answer is d Marketable equity securities are reported at fair value When they are classified as trading securities, all holding gains and losses are reported in earnings The correct answer is b When a company holds securities that it does not intend to sell in the near term, they are classified as securities available-for-sale As such, they are reported at fair market value and any difference between the original cost and the fair value is reported as part of accumulated other comprehensive income in stockholders' equity The correct answer is b An investment in bonds that is to be held to maturity is initially recorded at cost Any difference between the cost and the face value is amortized as a discount or premium using the effective-interest method As a result, at any balance sheet date, the amount reported will be the cost, net of amortization, or the amortized cost Writing Assignment: Going around the income statement The objective of this assignment is to have students put themselves in the position of the FASB and figure out why the FASB made the decision it did regarding the recognition of changes in value of available-for-sale securities In completing this assignment, students should examine the pros and cons associated with recognizing changes in value of available-for-sale securities on the income statement There is no “right” answer for this assignment Points that might be made are as follows: Reasons given by the FASB for not including unrealized gains and losses on available-for-sale securities in the computation of net income Including unrealized holding gains and losses in the computation of net income increases income volatility It isn’t fair to include unrealized holding gains and losses on assets in the computation of net income when unrealized gains and losses on liabilities are not also included in income If a company, particularly a financial institution, carefully manages its assets and liabilities, these unrealized gains and losses will offset one another Response to FASB position Basically, it sounds like the FASB is saying that including unrealized gains and losses on available-for-sale securities will increase the volatility of reported net income of companies, particularly financial institutions, and the harm to these companies should be mitigated This sounds like the FASB is bowing to pressure from one particular industry (banks and other financial institutions) The second point sounds like a “two wrongs make a right” argument If the problem is that unrealized gains and losses on assets and liabilities should be allowed to offset one another, then the better approach is to include both of them in net income It seems that the FASB should have gone further with SFAS No 115 and included a mark-to-market provision for financial liabilities Research Project: Classification of securities The objectives of this assignment are: To realize that many firms not have investment securities 237 237 238 Chapter 14 For those firms that have investment securities, to notice how many of those firms classify all (or a large part of) their securities as available-for-sale To review disclosure regarding realized and unrealized gains and losses By reviewing actual annual reports, students will realize that the concepts and terms we discuss in the textbook and in class are actually incorporated in a firm’s disclosure practices They will also realize that they can read and understand note disclosure—a primary objective of intermediate accounting The following sample solution is based on the 2001 financial statements of Coca-Cola: In its 2001 balance sheet, Coca-Cola reported $1,866 million in cash and cash equivalents, $68 million in marketable securities, and $5,422 million in long-term investments The bulk of Coca-Cola’s long-term investments are accounted for using the equity method CocaCola also has available-for-sale and held-to-maturity securities The company reported that it had no trading securities as of December 31, 2001 Surprisingly, about half of the cash and cash equivalents amount is attributable to held-to-maturity securities Coca-Cola does not give any explicit explanation for its classification of the securities As of December 31, 2001, Coca-Cola included a net unrealized loss on available-for-sale securities of $55 million in its computation of accumulated other comprehensive income Of this amount, $29 million arose in 2001 One conclusion that can be drawn from this sample is that for a normal, nonfinancial company, trading securities are relatively rare The Debate: Control: What is it? This debate should have students considering the issue of control and whether or not it can be defined with an objective percentage While the 50% criterion certainly makes the decision of consolidation easy, firms may exercise control with far less than 50% ownership Students should consider other criteria that may provide a better measure of control Students should be sure to familiarize themselves with any new pronouncements relating to this issue Points that might be made in the debate are outlined below Status Quo of 50% Modern corporations form a web of interconnections with a variety of companies A typical corporation is influenced by, and influences, scores of other companies In this setting, the notion of “control” is a slippery one Accordingly, the best approach for accountants to take is to retain the bright-line, 50% plus rule With this rule, there will be certainty and consistency with respect to the determination of whether one company controls another Effective Control at Less than 50% If one corporation owns 49% of another, and the remaining 51% is in the hands of a diffuse set of unrelated shareholders, then the corporation that owns 49% effectively controls the other corporation even though it technically owns only a minority of the shares In clear cases such as this, it should be easy for accountants to exercise professional judgment in identifying a controlling interest even when it is less than 50% For example, this is the type of ownership arrangement Coca-Cola has with many of its large bottlers Ethical Dilemma: Reclassifying securities for gain With this ethical dilemma, students will come to understand the difference between applying the “letter of the law”—the rule—and the “spirit of the law”—the rule’s intent While this reclassification may be within the rules, if management’s intent is to manipulate income, then this reclassification could be considered a violation of the rules Specific answers to the questions in the case are as follows: Reclassifying available-for-sale securities as trading would result in all increases in value being recognized as gains in the income statement in the period of reclassification 238 A strict reading of FASB Statement No 115 would indicate that this reclassification is within the rules Auditors, however, may question the reclassification policy Reclassifying securities in an attempt to inflate income would be inconsistent with the objectives of FASB Statement No 115 If this reclassification policy were consistently applied year after year, it would be difficult for auditors to question the policy But the inconsistent application of this policy would surely get the attention of the external auditor Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM provided with this manual Internet Search As of July 31, 2002, the staff of the FASB had posted the following update on the status of the “Consolidations Policy” project: “In early 2001, after completing extensive redeliberations of the guidance proposed in the proposed Statement, the Board determined there was insufficient Board member support to proceed to a final Statement In reaching that decision, the Board expressed concern about the appropriateness of determining that nonshared decision-making ability can exist based on the anticipated nonaction by other holders of voting rights The Board also expressed concern about the effectiveness of the proposed treatment of convertible and option instruments that offer the ability to obtain voting rights as well as the operationality of certain other provisions Thus, the Board decided to temporarily suspend its work on consolidation policy issues and focus its efforts on developing effective guidance for special-purpose entities.” From “Owner’s Manual,” Warren Buffett, 1996: “You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education Think of the education's cost as its "book value." If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day The dollar result equals the intrinsic economic value of the education Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.” 239 239 ... Number of Shares Owned by Investor Company Total Shares of Investee Company Outstanding 1,200 10,000 12% 6,000 20,000 8,000 55,000 75 36 PRACTICE 146 Percentage Ownership Accounting Classification... historical cost of the trading securities exceeds the fair value by $4,000 ($38,000 – $34,000) Thus, income for 2004 would be reduced by $4,000 Unrealized Loss on Trading Securities Market Adjustment—Trading... value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type In addition, for debt securities the company should disclose information
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