Chapter 14 Investments in Debt and Equity Securities

14-1 Account for debt securities measured at amortized cost

• debt security

  • security (such as a bond) representing a creditor relationship with an entity

• held-to-maturity securities

  • positive intent to hold maturity

  • ability to hold maturity

    • investor doesn’t anticipate a NEED to sell the security before maturity

  *sale before maturity is rare

• Sale of an HTM security before maturity calls into question the investor’s intent to hold to maturity

• may require investor to reclassify other HTM securities

• Guidance provides circumstances that may not question intent

Bond Investment Terminology

• amortized cost: amount at which an investment is acquired, adjusted for amortization of any premium or a discount.

• Discount: Amount equal to the excess of a bond investment’s face value over its present value. A discount reduces the investment account to its amortized cost. A discount represents deferred interest revenue that will be recognized over the term of the bond investment.

• Premium: Amount equal to the excess of the present value of a bond investment over its face value. A premium increases the investment account to its amortized cost. A premium represents a reduction of interest revenue that will be recognized over the term of the bond investment.

• Fair value: The 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.

• Face value (or par value or stated value): Contractual cash flow receivable at a bond’s maturity date.

• Stated rate: Rate used to determine the cash interest receipts on a band investment. Stated as an annual percentage of face value.

• Market rate (or effective rate): Rate on a similar bond investment in the market involving similar risk and where the issuer has a similar credit rating. Stated as an annual percentage.

HTM at Amortized Cost

• recognize at amortized cost (par, discount, or premium)

• ignore changes in fair value

• recognize interest revenue in net income as earned (effective interest method or straight-line interest method)

• recognize realized gain or loss from a sale in net income

Bonds Sell at Premium, Face Value, or Discount

Bond Sells at a Premium (Market rate<Stated Rate)

Bond Sells at Face Value (Market rate = Stated Rate)

Bond sells at a Discount (Market rate>Stated Rate)

Effective Interest Method

Investor receives cash interest based on the STATED rate

Investor recognizes interest revenue based on the MARKET rate

Effective interest method

• Interest revenue = market rate at bond purchase x amortized cost at the beginning of period

• bond premium is amortized over the bond term (reduces interest revenue)

  • in the case of a premium, interest revenue per period decreases as bond moves towards the face value

• bond discount is amortized over the bond term (increases interest revenue)

  • in the case of a discount, interest revenue per period increases as bond moves towards face value

HTM Investment purchased at a Discount:

1. PMT: Cash interest = Face value x Stated rate

2. RATE: Market rate

3. cash (stated Interest) = Bond face value x Stated rate

4. Interest Revenue (market interest) = Market rate x bond amortized cost, beginning of year

5. Discount Amortization = Market Interest - Stated interest

6. Bond Investment, net (amortized cost) = Bond amortized cost, beginning of year + discounted amortization

HTM Investment Purchased at a Premium

1. cash (stated interest) = bond face value x stated rate

2. interest revenue (market interest) = bond amortized cost, beginning of year x market rate

3. premium amortization = stated interest - market interest

4. Bond investment, net (amortized costs) = bond amortized cost, beginning of year - premium amortization

Straight-Line Method

• amortize discount or premium evenly over the bond term

• as a result, interest revenue will be the same each period

• straight-line method is allowed if results are not materially different from results under the effective interest method

HTM Investment Purchased at a Discount [Straight-Line Method]

1. Cash (Stated interest) = Bond face value x Stated rate

2. Discount Amortization = Total discount / Number of periods

3. Interest Revenue = Stated Interest + Discount amortization

4. Bond amortized cost, beginning of year + Discount amortization

HTM Investment Purchased at a Premium [Straight-Line Method]

1. cash (stated interest) = Bond face value x stated rate

2. Premium Amortization = Total premium / Number of periods

3. Interest revenue (market interest) = stated interest - Premium amortization

4. Bond Investment, net (amortized cost) = Bond amortized cost, beginning of year - Premium amortization

14-2 Account for debt securities measured at FV-NI

• recognize interest earned in net income

• recognize adjustment to fair value (unrealized gain or loss) in net income

FV-NI Option to Account for Debt Securities

• FV-IN: Measure debt securities at fair value with adjustments reflected in net income (as an unrealized gain or loss)

  • Trading Securities (TS): Debt securities held primarily to be sold in the near term

  • Fair Value Option: Election to account for debt securities at FV-NI that would normally be accounted for at amortized cost or under FV-OCI

Trading Securities

ASC Glossary Trading Securities: Securities that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time. Trading generally reflects active and frequently buying and selling, and trading securities are generally used with the objective of generally profits on short-term difference in price.

FV-NI Financial Statement Presentation

• Balance sheet

  • Investment shown at fair value (net of Fair Value Adjustment (FVA), a valuation account)

    • This balance sheet account is debited for holding gains and credited for holding losses.

• Income statement

  • Recognize the change in the period in the unrealized holding gain or loss or the difference between amortized cost and fair value

  • Recognize interest revenue earned in the period

Adjusting Trading Securities to Fair Value

• Investors must adjust trading securities to fair value at reporting dates, but procedurally, companies may adjust more frequently (even daily)

• If trading securities are adjusted to fair value continually, there would be no gain or loss to record upon sale.

• Net impact on the financial statements is the same no matter what procedure is used.

Adjusting Trading Securities to Fair Value

1. Compute the gain or loss on sale as the difference between the cash received and the amortized cost of the investment, adjust the Fair Value Adjustment account only at year-end.

2. Adjust the investment to fair value at the date of sale using FV-NI; then, record the sale, eliminating the associated Fair Value Adjustment account balance.

Fair Value Option

• Election applies to debt securities otherwise recognized at amortized cost at FV-
  OCI

• Adjust securities to fair value through FV-NI

• While fair value option is not applicable for TS (as it’s already recorded at FV-NI), the accounting treatment under the fair value option is similar to that of TS.

• Election must be made on purchase date

• Election applies to individual assets

• Decision is generally irrevocable

Study Tips: Accounting treatment #1

• If purchase price is not provided, first calculate purchase price and determine whether the bond was purchased at par, a discount or a premium

• Watch for a bond purchased between interest payment dates

  • Decrease Cash and increase Interest Receivable for interest accrued from last interest payment date to bond purchase date

• At period-end, amortize any discount or premium

• At period-end, adjust the investment to fair value through the Unrealized Gain or Loss-Income and the Fair Value Adjustment account

1. Adjust FVA at Year-End

• When an investment is sold:

  • At the sale date

    • Dr. Cash for sales proceeds

    • Cr. Investment at the amortized cost

    • Balance the entry with a Loss (Dr.) or a Gain (Cr.)

  • At period-end

    • Adjust the Fair Value Adjustment account to its desired ending balance through an adjustment to net income

Fair Value Option

• Voluntary election

• Account for investments under FV-NI that would normally be accounted for at amortized cost or under FV-OCI

Study Tips: Accounting treatment #2

• If purchase price is not provided, first calculate purchase price and determine whether the bond was purchased at par, a discount or a premium

• Watch for bond purchased between interest payment dates

  • Decrease Cash and increase Interest Receivable for interest accrued from last interest payment date to bond purchase date

• At period-end, amortize any discount or premium

• At period-end, adjust the investment to fair value through the Unrealized Gain or Loss-Income and the Fair Value Adjustment account

• At the sale date:

  • First, adjust the investment to fair value through the Unrealized Gain or Loss-Income and the Fair Value adjustment account

  • Next, record the sale

    • Dr. Cash for the sales proceeds

    • Cr. Investment at the amortized cost

    • Eliminate the related balance in the Fair Value Adjustment account

Fair value option

• voluntary election

• account for investments under FV-NI that would normally be accounted for at amortized cost or under FV-OCI

14-3 Account for debt securities measured at FV-OCI

• Recognize interest earned in net income

• Recognize adjustment to fair value (unrealized gain or loss) in OCI

• Recognize realized gain or loss from a sale in net income

FV-OCI Option to Account for Debt Securities

• FV-OCI: Measure at fair value with adjustments reflected in OCI (unrealized gain or loss)

  • Available-for-sale securities (AFS): Debt securities not classified as HTM or TS

Financial Statement Presentation

• Balance Sheet

  • Investment shown at fair value (net of Fair Value Adjustment (FVA), a valuation account)

  • Classified as Current or nonconcurrent depending on investor's intent and ability to hold the investment for less or greater than one year

• Comprehensive income statement

  • recognize in OCI the change in the period in the unrealized holding gain or loss or the difference between amortized cost and fair value

    • This presentation avoids volatility in net income

• Recognize interest revenue earned in the period in net income

Adjusting AFS Securities to Fair Value

1. Compute the gain or loss on sale as the difference between the cash received and the amortized cost of the investment; adjust the Fair Value Adjustment account only at year-end.

2. Adjust the investment to fair value at the date of sale using FV-OCI; then, record the sale, including the reclassification of holding gains or losses in AOCI to net income and the elimination of the associated Fair Value Adjustment account balance.

Study Tips Accounting Treatment #1

• If the purchase price is not provided, first calculate purchase price and determine whether the bond was purchased at par, a discount, or a premium

• At period-end, amortize any discount or premium

• At period-end, adjust the investment to fair value through the Unrealized Gain or Loss-OCI and the Fair Value Adjustment account

1. Adjust FVA at Year-End

• When an investment is sold:

  • At the sale date

    • Dr. Cash for the sales proceeds

    • Cr. Investment at the amortized cost

    • Balance the entry with a Loss (Dr.) or a Gain (Cr.)

  • At period-end

    • Adjust the Fair Value Adjustment account to its desired ending balance through an adjustment to OCI

Review of Accounting for Debt Securities

Purchase of debt security

Receipt of interest for debt security purchased at par

Receipt of interest for debt security purchased at a discount

Receipt of interest for debt security purchased at a premium

Adjust debt security to fair value with a gain

Adjust debt security to fair value with a loss

14-4 Account for equity securities measured at FV-NI

• Adjust to fair value

• Recognize adjustments to fair value (unrealized gain or loss) in net income

• Recognize dividends declared in net income

• Record sale of investment

• Record no adjustment to FVA at time OR

  Adjust and eliminate FVA at time of sale

FV-NI Option to Account for Equity Securities

• FV-NI: Measure equity securities at fair value with adjustments reflected in net income (as an unrealized gain or loss)

  • Investor lacks significant influence over the investee and the fair value of the investment is readily determinable

Financial Statement Presentation

• Balance sheet

  • Equity investment shown at fai rvalue (net of fair Value Adjustment (FVA), a valuation account).

  • Equity investment classified as current or noncurrent depending on investor’s intent and ability to sell the investment within the next year

• Income statement

  • recognize the change in the unrealized holding gain or loss in the period

  • recognize dividends declared as revenue

Measured at FV-NI to Fair Value

• Investors must adjust equity securities to fair value at reporting dates, but procedurally, companies may adjust to fair value only at reporting dates or more frequently (even daily).

• If securities are adjusted to fair value continually, there would be no gain or loss to record upon a sale

Adjusting Equity Investment to Fair Value

1. Compute the gain or loss on sale as the difference between the cash received and the amortized cost of the investment; adjust the Fair Value Adjustment account only at year-end.

2. Adjust the investment to fair value at the date of sale using FV_NI; then, record the sale, eliminating the associated Fair Value Adjustment account balance

Study Tips: Accounting Treatment #1

• Record the investment purchase

• Record dividend revenue if applicable

• At period-end, adjust the investment to fair value though the Unrealized Gain or Loss-Income-Income and the Fair Value Adjustment account

• When an investment is sold:

  • At the sale date

    • Dr. Cash for the sale proceeds

    • Cr. Investment at the original cost

    • Balance the entry with a Loss (Dr.) or a Gain (Cr.)

  • At period-end

    • Adjust the Fair Value Adjustment account to its desired ending balance trhough an adjustment to NI

Study Tips: Accounting Treatment #2

• Record the investment purchase

• Record dividend revenue if applicable

• At period-end, adjust the investment to fair value through the Unrealized Gain or Loss-Income and the Fair Value Adjustment account

• At the sale date:

  • First, Adjust the investment to fair value though through the Unrealized Gain or Loss Income and the Fair Value Adjustment account

  • Next, record the sale

    • Dr Cash for the sales proceeds

    • Cr. Investment at the original cost

    • Eliminate the related balance in the Fair Value Adjustment account

Account for e

14-5 Account for equity securities following the equity method

• Adjust investment and net income for proportionate share of investee’s net income (loss)

  • Remember that the Investor has SIGNIFICANT Influence— thus it can control the amount and timing of dividends declared

• Record expense adjustment related to a basis difference when applicable

  • Fair value of depreciable assets > Book value of depreciable assets

• Decrease investment for proportionate share of dividends declared

• Ignore changes in fair value of the security unless impaired

Equity Method to Account for Equity Securities

• Equity Method: Recognize a proportionate share of net income of the investee

  • Investor has a significant influence over the investee

Fair Value Option

• Election is available for equity method securities

• Adjust securities to fair value through FV-NI

• Election must be made on purchase date

• Election applies to individual investments

• Decision is generally irrevocable

Review of Accounting for Equity Securities

14-6 Adjusting debt and equity securities for impairment

• Evaluate HTM, AIFS, and equity method securities for impairment

• Recognize impairment losses in net income

Impairment of Investments

• Impairment testing in this section applies to investments accounted for other than at fair value with adjustments affecting net income:

  • HTM securities

  • AFS securities

  • Equity method securities

Impairment of HTM Securities

• Use Current Expected Credit Loss Model (CECL) to estimate impairment losses

  • Consider expected losses over the debt investment’s full term

  • Consider relevant information including

    • Past events and current conditions

    • Reasonable and supportable forecasts

• Accounting for impairment

  • Recognize loss in the income statement

  • Recognize investment less an allowance for credit losses on the balance sheet

  • Adjust allowance for subsequent changes in estimates

AFS Debt Security Model

Impairment of Equity Method Investments

• An other than temporary decline is recognized as a loss in the income statement and a reduction of the investment’s carrying value.

• Losses on impairment of equity method investments are not reversible in future periods