Investments

ACCOUNTING FOR INVESTMENT SECURITIES

There are two potential types of investments that a corporation might hold: investments in equity
securities and investments in debt securities. The type of investment has an impact on the
accounting treatment. In addition, managements intent with respect to the holding of the
investment affects how the investment is accounted for in the financial statements. The following
is a schedule of the accounting treatment based on the type of investment and managements
intentions.

Reporting
Control Category Management Intent Type of Security
< 20% Held-to-Maturity Positive intent and ability to hold Debt
< 20% Available-for-Sale Sale subject to market factors and Debt or Equity
company financial requirements
< 20% Trading Subject to immediate sale Debt or Equity
20% - 50% Equity Method Significant influence Equity
> 50% Consolidation Control Equity

Securities to Be Held to Maturity

Debt securities that are classified as held-to-maturity indicate that the company has both the
ability and intent to hold the securities until maturity. The investor company does not have any
influence over the operating or financial policies of the investee company. The investment in
debt securities that are held-to-maturity are recorded at the market value (original cost) on the
date of acquisition.

Example: Spencer Company purchased $40,000 of the 8%, 5-year bonds of Alexander
Company for $43,412, which provides a 6% return. The bonds pay interest semiannually.
Spencer Company has both the ability and intent to hold the securities until the maturity date.
The journal entry to record the investment would be as follows:

Date Account Debit Credit

1/1/00 Investment in bonds $40,000
Premium on bonds 3,412
Cash $43,412
To record the purchase of held-to-maturity bonds

The following amortization table has been prepared to assist in the discussion related to the
recording of interim interest revenue and reporting the investment on the balance sheet at the end
of the accounting period.

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Amortization Schedule, 8% 5-Year Bonds to Yield 6%

Amortization Carrying
Date Payment Interest of Premium Amount
1/1/00 $43,412
6/30/00 $1,600 $1,302 $298 43,114
12/31/00 1,600 1,293 307 42,807
6/30/01 1,600 1,284 316 42,491
12/31/01 1,600 1,275 325 42,166
6/30/02 1,600 1,265 335 41,831
12/31/02 1,600 1,255 345 41,486
6/30/03 1,600 1,245 355 41,131
12/31/03 1,600 1,234 366 40,765
6/30/04 1,600 1,223 377 40,388
12/31/04 1,600 1,212 388 40,000

We are assuming that the first interest payment will be received on June 30, 2000. The bond is
scheduled to pay $1,600 but the company paid a premium so the effective interest earned is
$1,302, the cash received net the amortization of the premium. The following journal entry
would be recorded to reflect this transaction.

Date Account Debit Credit

6/30/00 Cash $1,600
Premium on bonds $298
Interest revenue 1,302
To record interest received, amortization of premium, and interest rearned
on the first payment

The debt securities classified as held-to-maturity are carried in the accounting records at
amortized cost (face amount plus premium/less discount). No interim unrealized gains or losses
are recognized. If Spencer Company prepares financial statements at December 31, 2001 the
investment would be reported on the balance sheet as follows:

Held-to-Maturity Investments
Corporate bonds $40,000
Plus: unamortized premium 2,166
Book value (amortized cost) $42,166

Available-For-Sale Securities
Equity or debt securities that are classified as available-for-sale indicate that the company is
holding these securities for some purpose other than short-term trading. The timing of the
disposition of such securities would be dictated by changes in the market for the securities or
changes in the cash flow requirements of the investor company. At the end of each accounting

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period these securities are marked-to-market. Because the securities are held for an unspecified
period, the resulting gain or loss is recorded in a special equity account, Unrealized holding
gain/loss on investments-Equity. When a company has a portfolio of investments it can be
difficult to keep track of the original or amortized cost of investments. To maintain a clean
record a separate account is established to record the resulting adjustment to the asset account,
Available-for-Sale Investments. This is an accretion or contra-asset account, Available-for-
Sale Securities Fair Value Adjustment, depending on whether the adjustment increases or
decreases the carrying amount of the investment.

Example: Spencer Company purchased $50,000 of the 9%, 5-year bonds of Alexander
Company $46,304, which provides an 11% return. Management intends to hold this debt
security until there is a change in interest rates or the company requires the cash. The fair value
of the bonds at year-end is $47,200. To record the original purchase the company would prepare
the following journal entry.

Date Account Debit Credit

1/1/00 Investment in bonds $50,000
Discount on bonds $3,696
Cash 46,304
To record the purchase of available-for-sale bonds

The following amortization table has been prepared to assist in the discussion related to the
recording of interim interest revenue, recording unrealized gains (or losses) at the end of the
accounting period, reporting the investment at market on the balance sheet at year-end.

Amortization Schedule, 9% 5-Year Bonds to Yield 11%

Amortization Carrying
Date Payment Interest of Discount Amount
1/1/00 $46,304
1/1/01 $4,500 $5,093 $593 46,897
1/1/02 4,500 5,159 659 47,556
1/1/03 4,500 5,231 731 48,287
1/1/04 4,500 5,312 812 49,099
1/1/05 4,500 5,401 901 50,000

We are assuming that the first interest payment will be made on January 1, 2001. In order to
prepare the year end financial statements for December 31, 2000 the company will have to
accrue the interest that will be received on the first day of 2001. The following journal entry will
accomplish this.

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Date Account Debit Credit

12/31/00 Interest receivable $4,500
Discount on bonds 593
Interest revenue $5,093
To record interest receivable, amortization of discount, and interest rearned
on the first payment at December 31, 2000.

Available-for-sale securities are marked-to-market for financial reporting purposes. If we

assume that the fair value of the bonds at year-end are $47,200 then the following journal entry
needs to be made in order to properly reflect the fair value of the securities for financial reporting
purposes.

Date Account Debit Credit

12/31/00 Unrealized holding loss on AFS investments $303
FVA, AFS investments $303
To mark-to-market the available-for-sale securities at year-end

Analysis of unrealized holding gain (loss)

Market value, December 31, 2000 $47,200
Carrying value 46,897
Unrealized holding gain (loss) $303

T-Account: Fair value adjustment, AFS debt securities

Date Description Debit Credit
1/1/00 Beginning balance $0
12/31/00 Required AJE 303
12/31/00 Ending balance $303

T-Account: Unrealized holding (gain) loss, equity

Date Description Debit Credit
1/1/00 Beginning balance 0
12/31/00 Required AJE $303
12/31/00 Ending balance $303

To calculate this year-end adjustment, refer to the amortization table above. The carrying
amount of the investment is $46,897 and the fair market value is $47,200. The difference of
$300 increases the carrying value of the investment and end up separately stated in the equity
section of the balance sheet as presented below:

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ASSETS
Available-for-Sale Debt Securities:
Corporate bonds $50,000
Less: unamortized discount 3,103
Carrying value (amortized cost) 46,897
Fair value adjustment, AFS investments 303
Investment at fair value $47,200

SHAREHOLDERS' EQUITY
Unrealized holding gain on AFS investments $303

If the ownership of available-for-sale investments continues for several accounting periods the
accounting for unrealized gains or losses becomes a little more complicated. The change in
market value is recorded from the end of the previous accounting period.

Example: At December 31, 2000, Spencer Company had the following balances in its available-
for-sale investment account and the related available-for-sale securities adjustment, and
unrealized holding gain accounts.

Original Unrealized
Available-for-Sale Equity Securities: Cost Fair Value Gain (Loss)
Baker Equipment, common stock $103,000 $101,000 ($2,000)
Sizemore Corporation, common stock 45,000 51,000 6,000
Totals $148,000 $152,000 $4,000

T-Account: Fair value adjustment, AFS equity securities

Date Description Debit Credit
1/1/00 Beginning balance $0
12/31/00 Required AJE 4,000
12/31/00 Ending balance $4,000

T-Account: Unrealized holding (gain) loss, equity

Date Description Debit Credit
1/1/00 Beginning balance $0
12/31/00 Required AJE 4,000
12/31/00 Ending balance $4,000

The journal entry to record this fair value adjustment is as follows:

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Date Account Debit Credit

12/31/00 Fair value adjustment, AFS equity securities $4,000
Unrealized holding gain, AFS equity securities $4,000
To mark-to-market the available-for-sale securities at December 31, 2000

No available-for-sale investments have been purchased or sold during 2001. As of December 31,
2001 the fair market values of the two equity investments are as follows:

Baker Equipment, common stock $97,500

Sizemore Corporation, common stock 44,000
Total market value $141,500

In order to prepare the December 31, 2001 financial statements the available-for-sale
investments account and related available-for-sale securities adjustment and unrealized holding
gain accounts need to be adjusted to reflect the new fair values of the equity investments. The
following provides such an analysis:

Original Unrealized
Available-for-Sale Equity Securities: Cost Fair Value Gain (Loss)
Baker Equipment, common stock $103,000 $97,500 ($5,500)
Sizemore Corporation, common stock 45,000 44,000 (1,000)
Totals $148,000 $141,500 ($6,500)

T-Account: Fair value adjustment, AFS equity securities

Date Description Debit Credit
1/1/01 Beginning balance $4,000
12/31/01 Required AJE $10,500
12/31/01 Ending balance $6,500

T-Account: Unrealized holding (gain) loss, equity

Date Description Debit Credit
1/1/01 Beginning balance $4,000
12/31/01 Required AJE $10,500
12/31/01 Ending balance $6,500

The required adjusting journal entry at the end of December 31, 2001 is as follows:

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Date Account Debit Credit

12/31/01 Unrealized holding loss, AFS equity securities $10,500
Fair value adjustment, AFS equity securities $10,500
To mark-to-market the available-for-sale securities at December 31, 2001

If an available-for-sale security has been marked-to-market and then subsequently sold the sale
must be recorded by removing the marked-to-market amounts in the available-for-sale securities
adjustment and unrealized holding gains/losses accounts. For example, if on January 1, 2002
Spencer Company sold the stock in Baker Equipment for $100,000 the following journal entry
would be prepared to record the transaction.

Original Unrealized
Available-for-Sale Equity Securities: Cost Fair Value Gain (Loss)
Sizemore Corporation, common stock $45,000 $44,000 ($1,000)

T-Account: FVA, Available-for-Sale Securities

Date Description Debit Credit
1/1/02 Beginning balance $6,500
Required AJE $5,500
Ending balance $1,000

T-Account: Unrealized Holding Gain, Equity

Date Description Debit Credit
1/1/02 Beginning balance $6,500
Required AJE $5,500
Ending balance $1,000

Date Account Debit Credit

1/1/02 Cash $100,000
FVA, available-for-sale securities 5,500
Loss on sale of investments 3,000
Investment in AFS, Baker Equipment $103,000
Unrealized holding loss on AFS securities 5,500
To record the sale of Baker Equipment stock and remove the allocation of
unrealized holding losses from the FVA, available-for-sale securities and
the unrealized holding loss on AFS equity accounts on January 1, 2002.

As with impairment losses on plant, property and equipment or intangible assets, if the decline in
value of an available-for-sale investment is other than temporary, it is considered an impairment
and must be recognized in the accounting period discovered. The carrying value of the asset is
written down to the market value and recorded in the income statement.

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Trading Securities
Equity and debt securities that are classified as trading securities indicate that the company has
purchased the securities for the purposes of making a short term profit. These securities are not
being held for interest income but rather for short-term appreciation on the market price of the
security. At the end of each accounting period the securities are marked-to-market with the
resulting gains and losses reported in the income statement. A nominal account is used to report
such gains and losses, Unrealized holding gain/loss on investments-Income. Unlike the
available-for-sale investments the carrying value of the trading securities are actually written up
or down to their new market values, therefore there is no need for an accretion or contra-asset
account.

The purchase of trading securities is record at net cost. At the end of each accounting period the
market value is determined and the carrying value of the securities is marked-to-market.

Example: Spencer Company purchased the following securities during 2000.

Supreme Products, 490 shares stock $240,000

Alexander Company, 5,200 shares stock 132,800
Total cost of trading securities $372,800

At December 31, 2000 management determined that the fair market values of the trading
securities were as follows.

Original Unrealized
Trading Securities: Cost Fair Value Gain (Loss)
Supreme Products, 490 shares stock $245,000 $240,000 ($5,000)
Alexander Company, 5,200 shares stock 130,000 132,800 2,800
Totals $375,000 $372,800 ($2,200)

T-Account: FVA, Trading Securities

Date Description Debit Credit
1/1/00 Beginning balance $0
12/31/00 Required AJE $2,200
12/31/00 Ending balance $2,200

The company will record an adjusting journal entry to reflect this unrealized loss. The loss will
be reported on the income statement and the carrying value of the investments will be adjusted to
market value at December 31, 2000. Any realized gain or loss on the subsequent sale of the
investments will be based on the carrying value as of December 31, 2000. The journal entry
would be as follows:

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Date Account Debit Credit

12/31/00 Unrealized holding loss, income $2,200
FVA, trading securities $2,200
To record the unrealized holding loss on trading securities at December 31,
2000.

Transfers between Reporting Categories

If management decides to transfer an investment security from one category to another the
resulting unrealized gain or loss is recognized or deferred based on the follow schedule:

Transfer
From To Unearlized Gain or Loss from Transfer
Held-to-Maturity Available-for-Sale Unrealized Gain/Loss, Equity
Held-to-Maturity Trading Unrealized Gain/Loss, Income
Available-for-Sale Held-to-Maturity Amortize over remaining life of security
Available-for-Sale Trading Unrealized Gain/Loss, Income
Trading Available-for-Sale None, already at FMV
Trading Held-to-Maturity None, already at FMV

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