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APPENDIX E
Accounting for Investment Securities
TYPES OF INVESTMENT SECURITIES
A financial investment occurs when one entity provides assets or services to another
entity in exchange for a certificate known as a security. The entity that provides the
assets and receives the security certificate is called the investor. The entity that
receives the assets or services and gives the security certificate is called the
investee. This appendix discusses accounting practices that apply to securities held
by investors.
There are two primary types of investment securities: debt securities and equity
securities. An investor receives a debt security when assets are loaned to the investee. In
general, a debt security describes the investee’s obligation to return the assets and to pay
interest for the use of the assets. Common types of debt securities include bonds, notes,
certificates of deposit, and commercial paper.
An equity security is obtained when an investor acquires an ownership interest in the
investee. An equity security usually describes the rights of ownership, including the
right to influence the operations of the investee and to share in profits or losses that
accrue from those operations. The most common types of equity securities are common
stock and preferred stock. In summary, investment securities are certificates that describe
the rights and privileges that investors receive when they loan or give assets or services
to investees.
Transactions between the investor and the investee constitute the primary
securities market. There is a secondary securities market in which investors exchange
(buy and sell) investment securities with other investors. Securities that regularly
trade in established secondary markets are called marketable securities. Investee
companies are affected by secondary-market transactions only to the extent that
their obligations are transferred to a different party. For example, assume that Tom
Williams (investor) loans assets to American Can Company (investee). Williams
receives a bond (investment security) from American Can that describes American
Can’s obligation to return assets and pay interest to Williams. This exchange represents
a primary securities market transaction. Now assume that in a secondary-market
transaction Williams sells his investment security (bond) to Tina Tucker. American
Can Company is affected by this transaction only to the extent that the company’s
obligation transfers from Williams to Tucker. In other words, American Can’s obligation
to repay principal and interest does not change. The only thing that changes is the
party to whom American Can makes payments. An investee’s financial statements are
not affected when the securities it has issued to an investor are traded in the secondary
market.
The fair value, also called market value, is the amount that the investor would
receive if the securities are sold in an orderly transaction. More specifically, the fair
value is based on the amount that would be collected (an exit value) from the sale
of an asset as opposed to the cost necessary to acquire a comparable asset. For
a more detailed definition of fair value see FASB Statement No. 157. Whether
securities are reported at fair value or historical cost depends on whether the investor
intends to sell or hold the securities. Generally accepted accounting principles
require companies to classify their investment securities into one of three categories:
(1) held-to-maturity securities, (2) trading securities, and (3) available-for-sale
securities.
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Held-to-Maturity Securities
Since equity securities representing ownership interests have no maturity date, the
held-to-maturity classification applies only to debt securities. Debt securities should
be classified as held-to-maturity securities if the investor has a positive intent and the
ability to hold the securities until the maturity date. Held-to-maturity securities are
reported on the balance sheet at amortized historical cost.1
Trading Securities
Both debt and equity securities can be classified as trading securities. Trading securities
are bought and sold for the purpose of generating profits on the short-term appreciation
of stock or bond prices. They are usually traded within three months of when they are
acquired. Trading securities are reported on the investor’s balance sheet at their fair
value on the investor’s fiscal closing date.
Available-for-Sale Securities
All marketable securities that are not classified as held-to-maturity or trading securities
must be classified as available-for-sale securities. These securities are also reported on
the investor’s balance sheet at fair value as of the investor’s fiscal closing date.
Two of the three classifications, therefore, must be reported at fair value, which
is a clear exception to the historical cost concept. Other exceptions to the use of
historical cost measures for asset valuation are discussed in later sections of this
appendix.
REPORTING EVENTS THAT AFFECT
INVESTMENT SECURITIES
The effects on the investor’s financial statements of four distinct accounting events
involving marketable investment securities are illustrated in the following section. The
illustration assumes that the investor, Arapaho Company, started the accounting period
with cash of $10,000 and common stock of $10,000.
EVENT 1 Investment Purchase
Arapaho paid $9,000 cash to purchase marketable investment securities.
This event is an asset exchange. One asset (cash) decreases, and another asset
(investment securities) increases. The income statement is not affected. The $9,000
cash outflow is reported as either an operating activity or an investing activity,
depending on how the securities are classified. Since trading securities are shortterm assets that are regularly traded for the purpose of producing income, cash
flows from the purchase or sale of trading securities are reported in the operating
activities section of the statement of cash flows. In contrast, cash flows involving
the purchase or sale of securities classified as held to maturity or available for sale
are reported in the investing activities section of the statement of cash flows. The
only difference among the three alternatives lies in the classification of the cash
1
Debt securities are frequently purchased for amounts that are more or less than their face value (the amount of
principal due at the maturity date). If the purchase price is above the face value, the difference between the face
value and the purchase price is called a premium. If the purchase price is below the face value, the difference is
called a discount. Premiums and discounts increase or decrease the amount of interest revenue earned and affect
the carrying value of the bond investment reported on the balance sheet. The presentation in this section of the
text makes the simplifying assumption that the bonds are purchased at a price equal to their face value.
Accounting for discounts and premiums is discussed in Chapter 10.
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Appendix E
outflow reported on the statement of cash flows, as shown in the following
statements model:
Event
No.
Type
Assets
Cash
1
Inv. Sec.
5
Liab.
1
Equity
Rev.
2
Exp.
5
Net Inc.
Cash Flow
1
Held
(9,000)
1
9,000
5
NA
1
NA
NA
2
NA
5
NA
(9,000)
IA
1
Trading
(9,000)
1
9,000
5
NA
1
NA
NA
2
NA
5
NA
(9,000)
OA
1
Available
(9,000)
1
9,000
5
NA
1
NA
NA
2
NA
5
NA
(9,000)
IA
EVENT 2 Recognition of Investment Revenue
Arapaho earned $1,600 of cash investment revenue.
Investment revenue is reported the same way regardless of whether the investment securities
are classified as held to maturity, trading, or available for sale. Investment revenue
comes in two forms. Earnings from equity investments are called dividends. Revenue
from debt securities is called interest. Both forms have the same impact on the financial
statements. Recognizing the investment revenue increases both assets and stockholders’
equity. Revenue and net income increase. The cash inflow from investment revenue is
reported in the operating activities section of the statement of cash flows regardless of
how the investment securities are classified.
Event
No.
Assets
5
Cash
5
1,600
5
2
Liab.
Equity
1
Rev.
2
Exp.
5
Net Inc.
Cash Flow
1,600
2
NA
5
1,600
1,600 OA
Ret. Earn.
NA
1
1,600
EVENT 3 Sale of Investment Securities
Arapaho sold securities that cost $2,000 for $2,600 cash.
This event results in recognizing a $600 realized (actual) gain that increases both total
assets and stockholders’ equity. The asset cash increases by $2,600 and the asset investment securities decreases by $2,000, resulting in a $600 increase in total assets. The $600
realized gain is reported on the income statement, increasing net income and retained
earnings. The $600 gain does not appear on the statement of cash flows. Instead, the
entire $2,600 cash inflow is reported in one section of the statement of cash flows. Cash
inflows from the sale of held-to-maturity and available-for-sale securities are reported
as investing activities. Cash flows involving trading securities are reported as operating
activities. These effects are shown below.
Event
No.
Type
Assets
Cash
1
Inv. Sec.
5
Liab.
1
Equity
Rev. or
Gain
2
Exp. or
Loss
5
Net Inc.
Cash Flow
3
Held
2,600
1
(2,000)
5
NA
1
600
600
2
NA
5
600
2,600
IA
3
Trading
2,600
1
(2,000)
5
NA
1
600
600
2
NA
5
600
2,600
OA
3
Available
2,600
1
(2,000)
5
NA
1
600
600
2
NA
5
600
2,600
IA
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741
EVENT 4 Market Value Adjustment
Arapaho recognized a $700 unrealized gain.
After Event 3, the historical cost of Arapaho’s portfolio of remaining investment
securities is $7,000 ($9,000 purchased less $2,000 sold). Assume that at Arapaho’s
fiscal closing date, these securities have a fair value of $7,700, giving Arapaho a $700
unrealized gain on its investment. This type of gain (sometimes called a paper profit) is
classified as unrealized because the securities have not been sold. The treatment of
unrealized gains or losses in the financial statements depends on whether the securities
are classified as held to maturity, trading, or available for sale. Unrealized gains or
losses on securities classified as held to maturity are not recognized in the financial
statements; they have no effect on the balance sheet, income statement, and statement of
cash flows. Even so, many companies choose to disclose the market value of the securities
as part of the narrative description or in the footnotes that accompany the statements.
Whether or not the market value is disclosed, held-to-maturity securities are reported
on the balance sheet at amortized cost.
Investments classified as trading securities are reported in the financial statements
at fair value. Unrealized gains or losses on trading securities are recognized in net
income even though the securities have not been sold. In Arapaho’s case, the $700 gain
increases the carrying value of the investment securities. The gain increases net income,
which in turn increases retained earnings. Unrealized gains and losses have no effect on
cash flows.
Investments classified as available-for-sale securities are also reported in the financial statements at fair value. However, an important distinction exists with respect to
how the unrealized gains and losses affect the financial statements. Even though unrealized
gains or losses on available-for-sale securities are included in the assets on the balance
sheet, they are not recognized in determining net income.2 On Arapaho’s balance sheet,
the $700 gain increases the carrying value of the investment securities. A corresponding
increase is reported in a separate equity account called Unrealized Gain or Loss on
Available-for-Sale Securities. The statement of cash flows is not affected by recognizing
unrealized gains and losses on available-for-sale securities.
The effects of these alternative treatments of unrealized gains and losses on
Arapaho’s financial statements are shown here:
Event
No.
Type
Assets
5
Inv. Sec.
5
Liab.
Equity
1
Ret. Earn.
1
Unreal. Gain
Rev. or
Gain
2
Exp. or
Loss
5
Cash Flow
4
Held
NA
5
NA
1
NA
1
NA
NA
2
NA
5
NA
NA
4
Trading
700
5
NA
1
700
1
NA
700
2
NA
5
700
NA
4
Available
700
5
NA
1
NA
1
700
NA
2
NA
5
NA
NA
FINANCIAL STATEMENTS
As the preceding discussion implies, the financial statements of Arapaho Company are
affected by not only the business events relating to its security transactions but also the
accounting treatment used to report those events. In other words, the same economic
events are reflected differently in the financial statements depending on whether the
2
Net Inc.
Statement of Financial Accounting Standards No. 130 permits companies to report unrealized gains and losses on
available-for-sale securities as additions to or subtractions from net income with the result being titled comprehensive
income. Alternatively, the unrealized gains and losses can be reported on a separate statement or as part of the
statement of changes in stockholders’ equity.
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Appendix E
EXHIBIT E.1
ARAPAHO COMPANY
Comparative Financial Statements
Income Statements
Investment Securities Classified as
Investment revenue
Realized gain
Unrealized gain
Net income
Held
Trading
Available
$ 1,600
600
$ 1,600
600
$ 2,200
$ 1,600
600
700
$ 2,900
Held
Trading
Available
$ 5,200
7,000
$ 5,200
$ 5,200
$12,200
7,700
$12,900
7,700
$12,900
$10,000
2,200
$10,000
2,900
$12,200
$12,900
$10,000
2,200
700
$12,900
Held
Trading
Available
$ 1,600
$ 1,600
(9,000)
2,600
$ 1,600
$ 2,200
Balance Sheets
Assets
Cash
Investment securities, at cost (market value $7,700)
Investment securities, at market (cost $7,000)
Total assets
Stockholders’ equity
Common stock
Retained earnings
Unrealized gain on investment securities
Total stockholders’ equity
Statements of Cash Flows
Operating Activities
Cash inflow from investment revenue
Outflow to purchase securities
Inflow from sale of securities
Investing Activities
Outflow to purchase securities
Inflow from sale of securities
Financing Activities*
Net decrease in cash
Beginning cash balance
Ending cash balance
(9,000)
2,600
0
(4,800)
10,000
$ 5,200
0
(4,800)
10,000
$ 5,200
(9,000)
2,600
0
(4,800)
10,000
$ 5,200
*The $10,000 capital acquisition is assumed to have occurred prior to the start of the accounting period.
securities are classified as held to maturity, trading, or available for sale. Exhibit E.1
displays the financial statements for Arapaho under each investment classification
alternative.
The net income reported under the trading securities alternative is $700 higher than
that reported under the held-to-maturity and available-for-sale alternatives because
unrealized gains and losses on trading securities are recognized on the income statement.
Similarly, total assets and total stockholders’ equity are $700 higher under the trading
and available-for-sale alternatives than they are under the held-to-maturity category
because the $700 unrealized gain is recognized on the balance sheet for those two
classifications. The gain is not reported on the income statement for available-for-sale
securities; it is reported on the balance sheet in a special equity account called Unrealized
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EXHIBIT E.2
Investment
Category
Types of
Securities
Types of Revenue
Recognized
Reported on
Balance Sheet at
Recognition of
Unrealized Gains
and Losses on the
Income Statement
Held to maturity
Trading
Available for sale
Debt
Debt and equity
Debt and equity
Interest
Interest and dividends
Interest and dividends
Amortized cost
Market value
Market value
No
Yes
No
Gain on Investment Securities. The statements of cash flows report purchases and sales
of trading securities as operating activities while purchases and sales of available-for-sale
and held-to-maturity securities are investing activities. Exhibit E.2 summarizes the reporting differences among the three classifications of investment securities.
Alternative Reporting Practices for Equity Securities
If an investor owns 20 percent or more of an investee’s equity securities, the investor is
presumed able, unless there is evidence to the contrary, to exercise significant influence
over the investee company. Investors owning more than 50 percent of the stock of an
investee company are assumed to have control over the investee. The previous discussion
of accounting rules for equity securities assumed the investor did not significantly
influence or control the investee. Alternative accounting rules apply to securities owned
by investors who exercise significant influence or control over an investee company.
Accounting for equity investment securities differs depending on the level of the investor’s
ability to influence or control the operating, investing, and financing activities of the
investee.
As previously demonstrated, investors who do not have significant influence
(they own less than 20 percent of the stock of the investee) account for their investments
in equity securities at fair value. Investors exercising significant influence (they own
20 to 50 percent of the investee’s stock) must account for their investments using the
equity method. A detailed discussion of the equity method is beyond the scope of
this text. However, be aware that investments reported using the equity method represent
a measure of the book value of the investee rather than the cost or fair value of the
equity securities owned.
Investors who have a controlling interest (they own more than 50 percent of the
investee’s stock) in an investee company are required to issue consolidated financial
statements. The company that holds the controlling interest is referred to as the parent
company, and the company that is controlled is called the subsidiary company. Usually,
the parent and subsidiary companies maintain separate accounting records. However,
a parent company is also required to report to the public its accounting data along
with that of its subsidiaries in a single set of combined financial statements. These
consolidated statements represent a separate accounting entity composed of the parent
and its subsidiaries. A parent company that owns one subsidiary will produce three
sets of financial statements: statements for the parent company, statements for the
subsidiary company, and statements for the consolidated entity.
EXERCISES
Exercise E1 Identifying asset values for financial statements
Required
Indicate whether each of the following assets should be valued at fair market value (FMV), lower
of cost or market (LCM), or historical cost (HC) on the balance sheet. For certain assets,
historical cost may be called amortized cost (AC.)
Cash Flow from
Purchase or Sale
of Securities
Classified As
Investing activity
Operating activity
Investing activity
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Appendix E
Asset
FMV
LCM
HC/AC
Supplies
Land
Trading securities
Cash
Held-to-maturity securities
Buildings
Available-for-sale securities
Office equipment
Inventory
Exercise E2 Accounting for investment securities
Norris Bros. purchased $36,000 of marketable securities on March 1, 2009. On the company’s
fiscal year closing date, December 31, 2009, the securities had a market value of $27,000. During
2009, Norris recognized $10,000 of revenue and $2,000 of expenses.
Required
a. Record a 1, 2, or NA in a horizontal statements model to show how the purchase of the
securities affects the financial statements, assuming that the securities are classified as (1) held
to maturity, (2) trading, or (3) available for sale. In the Cash Flow column, indicate whether
the event is an operating activity (OA), investing activity (IA), or financing activity (FA).
Record only the effects of the purchase event.
Event
No.
Type
1
Held
2
Trading
3
Available
Cash
Inv. Sec.
1
5
Liab.
1
Equity
Rev.
2
Exp.
5
Net Inc.
Cash Flow
b. Determine the amount of net income that would be reported on the 2009 income statement,
assuming that the marketable securities are classified as (1) held to maturity, (2) trading, or
(3) available for sale.
Exercise E3 Effect of investment securities transactions on financial statements
The following information pertains to Butler Supply Co. for 2011.
1.
2.
3.
4.
Purchased $100,000 of marketable investment securities.
Earned $10,000 of cash investment revenue.
Sold for $30,000 securities that cost $25,000.
The fair value of the remaining securities at December 31, 2011, was $89,000.
Required
a. Record the four events in a statements model like the following one. Use a separate model for
each classification: (1) held to maturity, (2) trading, and (3) available for sale. The first event
for the first classification is shown as an example.
Held to Maturity
Event
No.
Cash
1
(100,000)
1 Inv. Sec.
5
Liab.
1
Ret. Earn.
1
Unreal.
Gain.
Rev. or
Gains
2
Exp. or
Loss
5
Net Inc.
Cash Flow
100,000
5
NA
1
NA
1
NA
NA
2
NA
5
NA
(100,000) IA
1
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745
b. What is the amount of net income under each of the three classifications?
c. What is the change in cash from operating activities under each of the three classifications?
d. Are the answers to Requirements b and c different for each of the classifications? Why or
why not?
Exercise E4 Preparing financial statements for investment securities
Wright, Inc., began 2012 with $100,000 in both cash and common stock. The company engaged
in the following investment transactions during 2012:
Purchased $20,000 of marketable investment securities.
Earned $600 cash from investment revenue.
Sold investment securities for $14,000 that cost $10,000.
Purchased $7,000 of additional marketable investment securities.
Determined that the investment securities had a fair value of $22,000 at the end of 2012.
1.
2.
3.
4.
5.
Required
Use a vertical statements model to prepare income statements, balance sheets, and statements
of cash flow for Wright, Inc., assuming the securities were (a) held to maturity, (b) trading, and
(c) available for sale.
Exercise E5 Differences among marketable investment securities classifications
Complete the following table for the three categories of marketable investment securities:
Investment
Category
Types of
Securities
Types of Revenue
Recognized
Value Reported on
Balance Sheet
Recognition of
Unrealized Gains
and Losses on the
Income Statement
Held to maturity
Trading
Available for sale
Debt
Interest
Amortized cost
No
Exercise E6 Effect of marketable investment securities transactions on financial
statements
The following transactions pertain to Harrison Imports for 2007:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Started business by acquiring $30,000 cash from the issue of common stock.
Provided $90,000 of services for cash.
Invested $35,000 in marketable investment securities.
Paid $18,000 of operating expense.
Received $500 of investment income from the securities.
Invested an additional $16,000 in marketable investment securities.
Paid a $2,000 cash dividend to the stockholders.
Sold investment securities that cost $8,000 for $14,000.
Received another $1,000 in investment income.
Determined the market value of the investment securities at the end of the year was $42,000.
Required
Use a vertical model to prepare a 2009 income statement, balance sheet, and statement of cash
flows, assuming that the marketable investment securities were classified as (a) held to maturity,
(b) trading, and (c) available for sale. (Hint: Record the events in T-accounts prior to preparing the
financial statements.)
Cash Flow from
Purchase or Sale
of Securities Is
Classified as
Investing activity
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Appendix E
Exercise E7 Comprehensive horizontal statements model
Woody’s Catering experienced the following independent events.
1.
2.
3.
4.
5.
6.
7.
8.
9.
Acquired cash from issuing common stock.
Purchased inventory on account.
Paid cash to purchase marketable securities classified as trading securities.
Recorded unrealized loss on marketable securities that were classified as trading securities.
Recorded unrealized loss on marketable securities that were classified as available-for-sale
securities.
Recorded unrealized loss on marketable securities that were classified as held-to-maturity
securities.
Wrote down inventory to comply with lower-of-cost-or-market rule. (Assume that the company
uses the perpetual inventory system.)
Recognized cost of goods sold under FIFO.
Recognized cost of goods sold under the weighted-average method.
Required
a. Show the effect of each event on the elements of the financial statements using a horizontal
statements model like the following one. Use 1 for increase, 2 for decrease, and NA for not
affected. In the Cash Flow column, indicate whether the item is an operating activity (OA),
investing activity (IA), or financing activity (FA). The first transaction is entered as an
example.
Event
No.
Assets
1
1
5
Liab.
NA
1
Equity
Rev. or
Gain
1
NA
2
Exp. or
Loss
NA
5
Net Inc.
NA
Cash Flow
1
FA
b. Explain why there is or is not a difference in the way Events 8 and 9 affect the financial statements
model.