Accounting Clinic III

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

With contributions by

Stephen H. Penman – Columbia University

Clinic III-2

Why do Firms Hold Debt and Equity Securities?

To invest idle funds (usually in debt securities)

As part of their operational plan (usually equity securities)

In an investment portfolio where investments are bought or sold

As a permanent investment in affiliates and subsidiaries

Clinic III-3

Classifying Debt and Equity Securities by their Accounting Treatment

Debt

Held to Maturity

Available for Sale

Trading

Equity

Less than 20%

ownership

Greater than 20%

ownership

Available for Sale

Trading

Go to clinic V

Clinic III-4

What are Marketable Securities?

Debt securities

Equity securities representing less then 20% interest in another corporation

For the accounting for equity securities with greater than 20% ownership go to Accounting Clinic V

Clinic III-5

Classifications of Marketable Securities

Debt securities are classified into one of three categories:held-to-maturityavailable-for-saletrading.

Equity securities (representing less then 20% ownership) are classified into one of two categories:

available-for-saletrading.

The appropriateness of the classification should be reassessed at each reporting date.

Clinic III-6

Held-to-Maturity Debt Securities

Investments in debt securities should be classified as held-to-maturity only if the reporting enterprise has the positive intent and ability to hold those securities to maturity.

An enterprise should not classify a debt security as held-to-maturity if it intends to hold the security for only an indefinite period.

Clinic III-7

Held-to-Maturity Debt Securities – The Accounting Rule

Held to maturity are measured at their historical cost.

If debt were purchased at a discount or premium over par value, the discount of premium is amortized to the income statement.

Clinic III-8

The Effective Interest Method

The effective interest rate is the internal rate of return or yield to maturity at the time of issue.

Under the effective interest rate method, the interest expense for a period is calculated as the effective interest rate times the bonds’ book value at the beginning of the period. Thus, under this method, the implied interest rate is constant.

Clinic III-9

Trading Securities and Available-for-Sale Securities (both Debt and Equity)

Investments in debt securities (not classified as held-to-maturity) and equity securities that have readily determinable fair values should be classified as either:

Trading

available-for-sale

Clinic III-10

Trading Securities

Securities that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time) should be classified as trading securities.

Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.

Clinic III-11

Available-for-Sale Securities

Investments not classified as trading securities (nor as held-to-maturity securities) should be classified as available-for-sale securities.

Clinic III-12

Reporting Changes in Fair Value - Unrealized

Unrealized holding gains and losses for trading securities should be included in net income

Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) should be excluded from net income and reported as a net amount in other comprehensive income within shareholders' equity until realized.

Clinic III-13

Reporting Changes in Fair Value - Realized

Dividend and interest income, including amortization of the premium and discount arising at acquisition, should be included in net income (for all securities).

Realized gains and losses should be included in net income (for all securities).

Clinic III-14

Balance Sheet Presentation

An enterprise should report all trading securities as current assets in the balance sheet and should report individual held-to-maturity securities and individual available-for-sale securities as either current or noncurrent, as appropriate.

Clinic III-15

Statement of Cash Flows

Cash flows from purchases, sales, and maturities of available-for-sale securities and held-to-maturity securities should be classified as cash flows from investing activities and reported gross for each security classification in the statement of cash flows.

Cash flows from purchases, sales, and maturities of trading securities should be classified as cash flows from operating activities.

Clinic III-16

Example: Marketable Equity Securities – Journal Entries

Alexis Co. purchased 100 common shares of Ball Co. on February 1, 2004, for $500,000. The market value of the shares on December 31, 2004, was $560,000. Alexis Co. sold these shares on June 30, 2005, for $600,000.

Give the journal entries to record this transaction assuming:

the shares are classified as trading securities

the shares are classified as available for sale securities

Clinic III-17

If the shares were classified as trading securities

February 1, 2004

Marketable Securities 500,000

Cash 500,000

December 31, 2004

Marketable Securities 60,000

Unrealized Holding Gain 60,000

on Trading Securities

The unrealized gain is reported in the income statement

Clinic III-18

June 30, 2005

Cash 600,000

Marketable Securities 560,000

Realized Gain on Sale 40,000

of Trading Securities

The realized gain is reported in the income statement

Clinic III-19

If the shares were classified as available for sale securities

February 1, 2004Marketable Securities 500,000

Cash 500,000December 31, 2004 Marketable Securities 60,000

Unrealized Holding Gain 60,000on Available for sale Securities

The unrealized holding gain is reported in “other comprehensive income”

Clinic III-20

June 30, 2005

Cash 600,000

Marketable Securities 500,000

Realized Gain on Sale100,000

of Trading Securities

The realized gain is reported in the income statement

Clinic III-21

At December 31, 2005 the security adjustment account had a debit balance of $60,000 ($560,000-$500,000). The adjustment entry is as follows:

Unrealized Holding Gain 60,000on Available for sale SecuritiesMarketable Securities 60,000

To remove the unrealized gain from shareholder’s equity.

Clinic III-22

Example: Different Accounting Treatments for Marketable Equity Securities

Wonder Corporation has the following portfolio of marketable equity securities:

Cost in

Dividends received

Market

Value on

Dec. 31,

Dividends received

Market

Value on

Dec. 31,

Selling

Price on

June 30,

Security 2003 2003 2003 2004 2004 2004

A $16,000 $1,000 $19,000 $1,200 $17,500 -

B 20,000 1,600 25,000 800 - $28,500

C 15,000 800 12,000 400 - 10,500

$51,000 $3,400 $56,000 $2,400 $17,500 $39,000

Clinic III-23

A. Assume that these securities represent trading securities. How much income would be recognized during 2003

and 2004? How would these securities be presented on the

balance sheet on December 31, 2003 and 2004?

B. Assume that these securities represent available for sale securities by Wonder Corporation. How would your answer to part A change?

Clinic III-24

Solution2003 2004

Income Statement:

Dividend Revenue

(the total in the dividend column)

Unrealized Holding Gain (Loss):

2003: ($56,000 - $51,000)

2004: ($17,500 - $19,000)

Realized Holding Gain $39,000 -

($12,000 + $25,000)

$3,400

5,000

--

$8,400

$2,400

(1,500)

2,000

$2,900

Balance Sheet:

Current Assets:

Marketable Securities $56,000 $17,500

A. Trading Securities

Clinic III-25

2003 2004

Income Statement:

Dividend Revenue

Realized Holding Gain:

[$39,000 – ($15,000 + $20,000)]

$3,400

--

$3,400

$2,400

4,000

$6,400

B. Securities Available for Sale

Clinic III-26

2003 2004

Balance Sheet:

Current Assets:

Marketable Securities $56,000 $17,500

Shareholder’s Equity:

Net Unrealized Holding Gain (Loss) on

Securities Available for Sale:

($56,000 - $51,000)

($17,500 - $16,000)

5,000

--

--

(1,500)

B. Securities Available for Sale

Clinic III-27

Disclosures About Securities

FASB Statement No. 115 requires the following disclosures each period:

The aggregate market value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost for debt securities held to maturity and debt and equity securities available for sale

The proceeds from sales of securities available for sale and the gross realized gains and gross realized losses on those sales

Clinic III-28

Disclosures About Securities

The change during the period in the net unrealized holding gain or loss on securities available for sale included in a separate shareholders’ equity account

The change during the period in the net unrealized holding gain or loss on trading securities included in earnings

Clinic III-29

Controversy Surrounding the Accounting for Marketable Securities

The accounting for marketable securities has been controversial. The accounting issues are as follows:

Whether to report the investments at historical cost or at market value on the balance sheet date

If reported at market value, when to record the gain/loss from the change in market value in the income statement

• Each period?

• Only when the firm disposes of the investments?

Clinic III-30

Keep in mind…

We have seen that there are two measurement basis for recording securities:

Amortized cost

Market value

Which method gives us the a better estimate of the value of the securities?

Clinic III-31

Amortized cost is based on the historical cost measurement rule and avoids manipulation in the financial statements. But historical cost does not capture any change in value since acquisition.

Market prices give the change in value since acquisition. But (fair) market values can be biased if market values are estimated. Actual market prices can be bubble prices which are not “fair” value.

Clinic III-32

Fair Value

Fair Value is exit value, that is, what a firm could sell the item for (or pay someone else to relieve them of a liability).

Fair value is measured in three ways:

Level 1. If there is an active, liquid market for the item: at market price

Level 2. If there is no available market price: at the price of a comparable if that is available

Level 3. If there is no comparable price, then the fair value must be estimated using a valuation model

Clinic III-33