Review based on Intermediate Accounting (Part 1) by Kieso, Weygandt et al
ACCT 265 – Chapter 9 Review
COST/AMORTIZED MODEL:
This model is used for both debt & equity securities. Amortized model for debt securities and cost model
for equity securities
Equity Securities (Cost Model):
-
Acquisition: Record at purchase price. Add any commissions to cost. Assume you buy 100
shares of XYZ for $4, and pay commissions of 1%. Journal entry & calculation:
Investment in Shares[(4x100)+(4x100x0.01)]
Cash
-
$404
404
Dividends: Any dividends on shares are recorded as dividend income. Assume XYZ pays $1
dividend per share. Journal entry & calculation:
Cash
$100
Dividend Income [100x1]
-
100
Sale/Disposal: Upon disposal, debit (credit) any loss (gain). Loss (gain) is recorded if proceeds
from sale are lower (higher) than carrying amount. Assume you sell all XYZ shares for $5 and pay
commissions of 1%.
Cash [(100x5)-(100x5x0.01)]
Investment in Shares
Gain on Sale of Investments [495-404]
$495
404
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Debt Securities (Amortized Model):
-
Acquisition: The price of a bond is determined by several factors. Refer to text for more
st
information. Assume you buy a 10 year, 5%, $1000 bond for $926.3991 on January 1 . Market
st
yield on similar bonds is 6%. Bond pays annual interest on December 31 . This is a discount
bond. Journal entry:
Investment in Bond
Cash
-
st
Now assume you buy a 10 year, 5%, $1000 bond for $1081.109 on January 1 . Market yield on
st
similar bonds is 4%. Bond pays annual interest on December 31 . This is a premium bond.
Journal entry:
Investment in Bond
Cash
-
$936.3991
926.3991
$936.3991
926.3991
Interest Payments: Interest income on discount & premium bonds is calculated using the effective
interest method. Table 1 below shows the calculations for the discount bond. Journal entry below
it records the interest & discount amortization. The premium bond calculations are exactly the
same.
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Review based on Intermediate Accounting (Part 1) by Kieso, Weygandt et al
Cash
Received
Date
Interest Income
Discount(Premium)
Amortization
0
Bond
Balance
926.3991
1
50
55.5839
5.5839
931.9831
2
50
55.9190
5.9190
937.9021
3
50
56.2741
6.2741
944.1762
4
50
56.6506
6.6506
950.8268
5
50
57.0496
7.0496
957.8764
6
50
57.4726
7.4726
965.3489
7
50
57.9209
7.9209
973.2699
8
50
58.3962
8.3962
981.6661
9
50
58.9000
8.9000
990.5660
10
50
59.4340
9.4340
1000.0000
Table 1: Schedule of Interest Income on Discount bond
Calculations for Date 1:
Cash Received
Interest Income
Discount Amortization
Bond Balance
= Face value of bond x coupon rate of bond
= 1000 x 5% = 50
=Bond balance in prior year x market yield rate
=926.3991 x 6% = 55.5839
=Interest income – cash received
=55.5839 – 50 = 5.5839
=Bond balance in prior year + discount amortization
=926.3991 + 5.5839 = 931.9831
Journal entry:
Cash
Investment in Bond
Interest Income
$50
5.5839
55.5839
Note: When recording the interest payments of a premium bond, investment in bond is credited because
cash received is higher than the interest income recognized for the period.
-
Sale/Disposal: When selling the bond, loss(gain) is calculated by subtracting the carrying value of
the bond from the sale price. Assume you sell the discount bond on date 5 after receiving the
annual interest payment. The sale price for the bond is $955. Journal entry:
Cash
Loss on Sale of Bonds [957.8764 – 955]
Investment in Bond
[from table 1]
$955
2.8764
957.8764
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Review based on Intermediate Accounting (Part 1) by Kieso, Weygandt et al
FREQUENTLY ASKED QUESTIONS FOR COST/AMORTIZED MODEL:
-
Accrued Interest: Many students have asked about calculating accrued interest. One must first
understand the concept behind accrued interest. Interest is the return on your investment. It is
what the bond issuers pay you for using your money. Assume you buy the discount bond on July
st
1 from Investor A. The time line below summarizes this transaction:
01/01
07/01
12/31
|---------------------------------------------------|------------------------------------------------------|
Bond under Investor A
Purchase of bond
Interest payment
-
The red area on the time line is the period when Investor A held the bond and the black area is
the period you held the bond. You both held the bond for half a year. Therefore, Investor A
deserves half of the annual interest payment for that year, and you deserve the other half i.e. $25
each.
o However the bond issuer only pays interest to whoever the bond holder is on the
payment date of 12/31. This mean you will get the entire $50 of interest from the bond
issuer whereas you only deserve $25.
o Therefore, it is common practice amongst investors for the buyer (you) to pay any
accrued interest to the seller (Investor A) on the acquisition date i.e. give seller $25 in
addition to the purchase price. Suppose the purchase price of bond on 07/01 is
$929.1504. The journal entry for both parties look something like this:
You:
Investment in bond
Interest Receivable
Cash
$929.1504
50
979.1504
Investor A:
Cash
Investment in Bond
Interest Income
$979.1504
929.1504
50
FAIR VALUE THROUGH NET INCOME MODEL:
-
Acquisition: Record at purchase cost. Expense any transaction costs such as commissions.
Assume you buy 100 shares of XYZ for $4, and pay commissions of 1%. Journal entry &
calculation:
Temporary Investment [4x100]
Commissions Expense [4x100x0.01]
Cash
-
404
Measurement after Acquisition: Securities classified under this method are adjusted for their fair
value at the end of each fiscal period and just before the sale of the investment. Assume XYZ
shares at end of year 1 are selling for $5. Journal entry below is known as the fair value
adjustment:
Temporary Investment [(5-4)x100]
Investment Income
-
$400
4
$100
100
Dividends/Interest (reported with gain/loss on investment): Similar to the fair value adjustment
entry, any income (loss) in the securities is recorded in net income. Assume XYZ company
declares and pays out a $0.50 dividend/share. Journal entry:
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Review based on Intermediate Accounting (Part 1) by Kieso, Weygandt et al
Temporary Investment [0.50x100]
Investment Income
$50
50
-
Dividends/Interest (reported separately from gain/loss on investment): It is the management’s
choice whether to report dividend/interest income with gains/losses on investment. If they report it
separately, use different accounts than the gain/loss account i.e. dividend income/interest
income.
o The entry for dividends is the same as above except use dividend income account rather
than investment income account.
o The entry for interest becomes a bit more complicated. You must use the effective
interest method described above and shown in Table 1. You still record the
discount/premium amortization to adjust the carrying value of the bonds, and the interest
income. In addition to this you make the fair value adjustment at the end of the period.
-
Sale/Disposal: Same as the sale/disposal under FV-OCI model. See example under the next
section.
FAIR VALUE THROUGH OTHER COMPREHENSIVE INCOME MODEL:
-
Acquisition: Record the entry at purchase price. Add any transaction costs such as commissions.
Assume you buy 100 shares of XYZ for $4, and pay commissions of 1%. Journal entry &
calculation:
Investment in Shares [(4x100)+(4x100x0.01)]
Cash
-
$404
404
Measurement after Acquisition: Securities classified under this method are adjusted for their fair
value at the end of each fiscal period and just before the sale of the investment. However unlike
FV-NI model, gains/losses are recorded in Other Comprehensive Income using an account called
Holding Gain/Loss. Assume XYZ shares at end of year 1 are selling for $5:
Investment in Shares [(5-4)x100]
Holding Gain
$100
100
-
Dividend/Interest: Interest and dividends are recorded separately from holding gains/losses. The
process is similar to that described under FV-NI method (with separate reporting of income).
-
Sale/Disposal: On the sale/disposal date of the investment, the first step is to make the fair value
adjustment. The second step is to remove the investment from the books (by crediting the
investment account and debiting cash). The third step is removing the holding gain from OCI and
moving it to Net Income (with recycling) or Retained Earnings (without recycling). Assume you
sell the XYZ shares for $4.50.
Holding Loss
Investment in Shares [(4.50-5)x100]
$50
Cash [4.50 x 100]
Investment in Shares
$450
Holding Gain
Gain on Sale of Shares (with recycling)
$50*
Holding Gain
Retained Earnings (without recycling)
$50*
50
450
50
50
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Review based on Intermediate Accounting (Part 1) by Kieso, Weygandt et al
*NOTE: The net holding gain/loss account had a balance of 50; $100 holding gain from before subtract
holding loss of $50 just before the sale.
IMPAIRMENT
Under IFRS & GAAP, the entity must test for impairment at the end of every reporting period. There are
three possible models in use today:
-
Incurred Loss Model: An investment is considered impaired when there is evidence which might
indicate this. Examples of these indications include bankruptcy, default on payment etc. The
present value of future cash-flows of the investment is calculated. If the present value is less than
the carrying amount, the investment is considered impaired. An impairment loss is debited, and
the investment account is credited.
-
Expected Loss Model: Similar to the incurred loss model but the entity does not need evidence of
impairment to record an impairment loss. The present value of future-cash flows is calculated,
and compared with the carrying value of the investment.
-
Fair Value Loss Model: Like the incurred loss model, there must be an indication of impairment. If
so, the carrying amount is compared with the fair value of the investment, and adjusted
accordingly.
EQUITY METHOD BASIS
The equity method is used when management determines the investment to be strategic in nature i.e. will
the investing person/company be able to exercise significant influence in the investee company. The rule
of thumb is:
- Less than 20% ownership is not strategic
- More than 20% ownership might be strategic i.e. management determines if they will be able to
exercise significant influence
- 50% or more is strategic, and the investor has complete control of investee company.
-
Acquisition: At acquisition, record at cost of purchase. The journal entry is the same as any other
method explained above. Assume you bought 100 shares of XYZ for $4. This is 40% ownership
of the company. Journal entry:
Investment in shares [4x100]
Cash
$400
400
-
Measurement after Acquisition: Unlike the FV-NI and FV-OCI, you don’t record any fair value
adjustment under this method.
-
Dividends: Unlike the previous models, dividends are not recorded as income but rather recorded
as a return on investment. Assume XYZ pays a $0.50 per share.
Cash [0.50x100]
Investment in shares
-
$50
50
Income: Any net income reported by the investee company is not relevant for all other models.
However under the equity method basis net income is considered to be a gain in investment.
Assume investee company reports net income of $100.
Investment in shares [0.4x100]
Investment Income
$40
40
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