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Chapter 17
Investments
Two Types of Financial Assets
Debt investments. Equity investments.
Motivations for investing:
Earn a high rate of return. To secure certain operating or financing arrangements with another company (equity securities).
Financial assets are more liquid than real assets, i.e. they can be turned into cash more rapidly.
Financial Assets
Debt Investments
Held-for- collection and selling
Held-for- collection and selling
Trading
Equtiy Investments
Trading Non-Trading
Classification and Measurement of Financial Assets :
Debt investments are characterized by contractual payments on specified dates of
principal and interest on the principal amount outstanding.
Companies group debt investments into three categories:
Held-for-collection Illustration: Robinson SA purchased €100,000 of 8 percent bonds of Evermaster AG on January 1, 2019, at a discount, paying €92,278. The bonds mature January 1, 2024 and yield 10 percent; interest is payable each July 1 and January 1. Robinson records the investment as follows: A) The purchase process (the cash paid on 1/1/2019) January 1, 2019 Debt Investments 92, Cash 92,
Cash (€99,750 + €2,667) 102, Interest Revenue (4/6 x €4,000) 2, Debt Investments 96, Gain on Sale of Investments 3,
Held-for-Collection and Selling (HFCS) Debt investments held-for-collection and selling follow the same accounting entries as debt investments held-for-collection during the reporting period. That is, they are recorded at amortized cost. However, at each reporting date, companies Adjust the amortized cost to fair value. Any unrealized holding gain or loss is reported as part of other comprehensive income rather than in the profit and loss statement.
Illustration(Single Security): Graff plc purchases £100,000, 10 percent, five-year bonds on January 1, 2019, with interest payable on July 1 and January 1. The bonds sell for £108,111, which results in a bond premium of £8,111 and an effective-interest rate of 8 percent. Graff records the purchase of the bonds as follows.
January 1, 2019 Debt Investments 108, Cash 108,
The entry to record interest revenue on July 1, 2019, is as follows: Cash 5, Debt Investments 676 Interest Revenue 4,
At December 31, 2019, Graff makes the following entry to recognize interest revenue Interest Receivable 5, Debt Investments 703 Interest Revenue 4,
To apply the fair value method to these debt investments, assume that at December 31, 2019 the fair value of the bonds is £105,000. Graff makes the following entry. Unrealized Holding Gain or Loss — Equity 1, Fair Value Adjustment 1,
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Illustration (Portfolio of Securities): Webb AG has two debt securities classified as held- for-collection and selling. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.
Prepare the adjusting entry Webb would make on December 31, 2019 to record the loss. Unrealized Holding Gain or Loss — Equity 9, Fair Value Adjustment 9,
December 31, 2020 Fair Value Adjustment 4,
Unrealized Holding Gain or Loss — Equity 4,
December 31, 2021 Fair Value Adjustment (5000+2000) 7000
Unrealized Holding Gain or Loss — Equity 7000
Trading Investments Companies often hold debt investments with the intention of selling them in a short period of time. These debt investments are often referred to as trading investments.
Companies report trading securities
at fair value, with unrealized holding gains and losses reported as part of net income.
A holding gain or loss is 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.
Illustration: Assume that on December 31, 2019, Western Publishing determined its trading securities portfolio to be as shown. At the date of acquisition, Western Publishing recorded these trading securities at cost in the account entitled Debt Investments. This is the first valuation of this recently purchased portfolio.
At December 31 Fair Value Adjustment 3,
Unrealized Holding Gain or Loss — Income 3,
Fair Value Option
Companies have the option to report most financial assets at fair value, with all gains and losses related to changes in fair value reported in the income statement.
Applied on an instrument-by-instrument basis. Generally available only at the time a company first purchases the financial asset or incurs a financial liability. Company must measure this instrument at fair value until the company no longer has ownership.
Illustration: Hardy AG purchases bonds issued by the German Central Bank. Hardy plans to hold the debt investment until it matures in five years. At December 31, 2019, the amortized cost of this investment is €100,000; its fair value at December 31, 2019, is €113,000. If Hardy chooses the fair value option to account for this investment, it makes the following entry
At December 31, 2019. Debt Investment (German bonds) 13, Unrealized Holding Gain or Loss — Income 13,
Equity Investments
Equity investment represents
ownership interest, such as ordinary, preference, or other capital shares. rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants and rights.
Cost includes
Purchase price of the security. Broker’s commissions and fees are recorded as expense.
On December 6, 2019, Republic receives a cash dividend of €4,200 on its investment in the ordinary shares of Nestlé.
Cash 4, Dividend Revenue 4,
On December 31, 2019, Republic prepares an adjusting entry to record the decrease in fair value and to record the loss as follows.
Unrealized Holding Gain or Loss — Income 35,
Fair Value Adjustment 35, Statement of financial position
Investment
Equity Investment 718, Fair Value 35, Statement of Comprehensive Income
Other Income and expense
Unrealized Holding Gain or Loss 35,
On January 23, 2020, Republic sold all of its Burberry ordinary shares, receiving €287,220.
Cash 287,
Equity Investments 259, Gain on Sale of Investments 27,
In addition, assume that on February 10, 2020, Republic purchased €255,000 of Continental Trucking ordinary shares (20,000 shares €12.75 per share), plus brokerage commissions of €1,850. Republic’s equity investment portfolio as of December 31, 2020.
Republic records this adjustment on Dec. 31, 2020, as follows.
Fair Value Adjustment 101,
Unrealized Holding Gain or Loss — Income 101,
Non-Trading (Other Comprehensive Income)
Illustration: On December 10, 2019, Republic SA purchased 1,000 ordinary shares of Hawthorne Company for €20.75 per share (total cost €20,750). The investment represents less than a 20 percent interest. Hawthorne is a distributor for Republic products in certain locales, the laws of which require a minimum level of share ownership of a company in that region. The investment in Hawthorne meets this regulatory requirement. Republic accounts for this investment at fair value.
Equity Investments (Hawthorne) 20,
Cash 20,
On December 27, 2019, Republic receives a cash dividend of €450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows.
Cash 450
Dividend Revenue 450
At December 31, 2019, Republic’s investment in Hawthorne has the carrying value and fair value shown.
Equity Investment (Hawthorne) 3,
Unrealized Holding Gain or Loss — Equity 3,
Holdings of More Than 50%
Controlling Interest - When one company acquires a voting interest of more than 50 percent in another company.
Investor is referred to as the parent. Investee is referred to as the subsidiary. Investment in the subsidiary is reported on the parent’s books as a long-term investment. Parent generally prepares consolidated financial statements.
Impairment of Value
A company should evaluate every debt investment accounted for at amortized cost (Held for collection) to determine if it has suffered impairment—a loss in value such that the fair value of the investment is below its carrying value.
Illustration: At December 31, 2018, Mayhew Ltd. has a debt investment in Bao Group, purchased at par for ¥200,000 (amounts in thousands). The investment has a term of four years, with annual interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate is 10 percent). This debt investment is classified as held-for-collection.
Using the following information record the loss on impairment.
Loss on Impairment 12,
Allowance for Impaired Debt Investments 12,
Recovery of Impairment Loss
If subsequently the impairment loss decreases, some or all of the previously recognized
impairment loss shall be reversed with a
Debit to the Allowance for Impaired Debt Investments account and
Crediting Recovery of Impairment Loss.
For example, assume that on March 31, 2020, Mayhew determines that Bao’s credit risk has declined significantly. Mayhew therefore decides to reverse the impairment by making the following entry.
Allowance for Impaired Debt Investments 12,
Recovery of Loss on Impairment 12,
