Ch. 16: Investments

Debt securities

represent a creditor relationship with another entity

Held-to-Maturity

Debt securities that the company has the positive intent and ability to hold to maturity.

• Amortized Cost

Available-for-Sale

Debt securities not classified as held-to-maturity or trading securities

• Fair Value (Equity)

  • Unrealized Holding Gain/ Loss- Equity

Trading Securities

Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences

• Intention of selling them in a short period of time, generally holding these investments for less than three months

• Fair Value (Income)

Amortized Cost

Acquisition cost adjusted for the amortization of discount or premium

Fair Value

Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Effective Interest Method

Amortize a premium or discount

• Applies to bond investments

Fair Value Adjustment

Account enables the company to maintain a record of its amortized cost.

Gains Trading

Selling the winners and holding the losers

Holding Gain or Loss

The net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received

Equity Securities

Represent ownership interests such as common, preferred, or other capital stock

• Also include rights to acquire or dispose of ownership interests at an agreed-on or determinable price, such as in warrants, rights, and call or put options.

• Classification of such investments depends on the percentage of the investee voting stock that is held by the investor (LEVEL OF INFLUENCE)

Investor

Acquires an interest in the common stock of another corporation

Investee

Corporation that determines the accounting treatment for the investment subsequent to acquisition

Significant Influence

If ownership is between 20% and 50%

• Use equity method

Fair Value Method

Stock investment holdings of less than 20% are reported at fair value with gains or losses reported in net income

Equity Method

Thee investor and the investee acknowledge a substantive economic relationship.

• Accounting:

  1. The investment at the time of purchase is recorded at the cost of the shares acquired.

  2. The investor’s proportionate share of the income (losses) of the investee periodically increases or decreases the investment’s carrying amount.

  3. Cash dividends received by the investor from the investee decreases the investment’s carrying amount.

Controlling Interest

When one corporation acquires a voting interest of more than 50% in another corporation

Parent Company

Investor corporation

Subsidiary

Investee corporation

Consolidated Financial Statements

Treat the parent and subsidiary corporations as a single economic entity

Fair Value Option

Choice that companies have to report most financial assets and financial liabilities at fair value

1. All gains and losses related to changes in fair value are reported in net income

2. This option is applied on an instrument-by-instrument basis.

3. This option is generally available only at the time a company first purchases the financial asset or incurs a financial liability.

4. If the company chooses to use the fair value option, it measures the financial asset or liability at fair value until the company no longer has ownership

Reclassification Adjustment

Ensure that gains and losses are not counted twice when a sale occurs

Derivatives

Useful for managing risk

Spectualtor

Bets that the price of potatoes will rise, thereby increasing the value of the forward contract

Arbitrageurs

Market players who attempt to exploit inefficiencies in markets; they seek to lock in profits by simultaneously entering into transactions in two or more markets.

Call Option

Gives the holder the right, but not the obligation, to buy shares at a preset price

Strike Price (Exercise Price)

Contract price of Call Option

Notional Amount

Amount that’s locked into the contract

Option Premium

Payment for Call Option that is generally much less than the cost of purchasing the shares directly

• Consists of two amounts:

  1. Intrinsic value

  2. Time value

Intrinsic Value

The difference between the market price and the preset strike price at any point in time that represents the amount realized by the option holder, if exercising the option immediately.

Time Value

Refers to the option’s value over and above its intrinsic value, which reflects the possibility that the option has a fair value greater than zero

Underlying

Specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable

Hedging

Use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates (risks)

Fair Value Hedge

Company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment

Cash Flow Hedges

Derivative that hedges exposures to cash flow risk, which results from the variability in cash flows.

• Generally, companies measure and report derivatives at fair value on the balance sheet and report gains and losses directly in net income.

Spot Price

Price to be paid today for future delivery

Designation

Identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk

Highly Effective

Achieving offsetting changes in fair value or cash flows.

Swap

Transaction between two parties in which the first party promises to make a payment to the second party. Similarly, the second party promises to make a simultaneous payment to the first party.

Interest Rate Swap

One party makes payments based on a fixed or floating rate, and the second party does just the opposite

• Large money-center banks bring together the two parties and handle the flow of payments between the parties