BA102A

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BA102A

• Short Term Investments
• Long Term Investments

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First, lets review the Balance Sheet

• Assets are grouped into
• Current assets
• Long term investments
• Property plant and equipment
• Intangibles
• Liabilities are divided into two groups
• Current liabilities
• Long term liabilities
• Equity for a corporation has three basic parts
• Stock
• Additional paid-in capital
• Retained earnings

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What is an investment?

• For most firms, the term Investment on the
  Balance Sheet refers to assets held to earn
  incidental income.
• The incidental income would be interest,
  dividends, and gains on sales of these assets, as
  opposed to sales and service revenues.
• Short term investments, or marketable securities,
  are in the Current Asset section of the Balance
  Sheet. They are those investments you intend to
  cash in or sell within one year.
• Long term investments appear in their own section
  of the asset side of the Balance Sheet. These
  are investments you intend to cash in or sell in
  more than one year, or plan to hold indefinitely.

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Some examples of investments

• Savings accounts (if used to pay bills, these
  accounts would be cash instead.)
• Buildings and land held for resale, for a company
  whose primary business is NOT selling buildings
  or land. Buildings or land used productively by
  the firm are classified as Property Plant and
  Equipment. In a firm whose primary business is
  selling buildings or land, they would be
  inventory.
• Treasury bills
• Stocks and bonds (also called Securities.)

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So, in this chapter we study investments, and we
concentrate on the accounting for stocks and
bonds, also known as securities. Short term
stocks and bonds are called Marketable Securities.

• There are three types of securities accounts, as
  classified by FASB
• Trading securities Those are stocks and bonds
  that your firm intends to hold for less than one
  year.
• Held to maturity securitiesThose are bonds that
  your firm intends to hold until they mature,
  which is the date the original loan is due.
  Stocks do not have a maturity date, so cannot be
  held to maturity.
• Available for sale securitiesThose are stocks
  and bonds that do not fall under either of the
  other two categories, except for equity method
  stock investments.

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• Most marketable (short term) securites are
  trading securites.
• Some marketable securities are held to maturity
  securities, if either
• The term of the loan is less than a year, or
• The securities were long term but the maturity
  date is now within one year from the Balance
  Sheet date.
• Almost no marketable securities are classified as
  available for sale. Why?

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Contrary to the Conservatism Principle, trading
securities are Marked to Market even if market
value has increased!
This means that

• you value the trading securities at their market
  value as of the Balance Sheet date, and not at
  their historical costs. You recognize gains and
  losses on the change in market value, and those
  gains and losses go on the current Income
  Statement.

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Trading Securities

• Can be stocks or bonds
• Are reported at market value on the Balance Sheet
• This violates Historical Cost
• However, this is more relevant to the users of
  Financial Statements
• The asset account for the investment is increased
  (or decreased) in value to market value (as of
  the Balance Sheet Date)
• The resulting gain or loss is reported on the
  Income Statement under other gains and losses.

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Here is an example
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If the value of the stock investment had
decreased, you would have recorded a loss at year
end rather than a gain
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Held to Maturity securites (bonds only) are NOT
adjusted for changes in market value.

• Trading securities are adjusted because their
  purpose is to be sold for gains.
• The purpose of a held to maturity investment is
  to earn interest. Gains and losses are
  irrelevant because these securities are not going
  to be sold.

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Available for Sale Securities

• Also can be stocks or bonds
• Are also reported at market value on the Balance
  Sheet
• This violates Historical Cost
• However, this is more relevant to the users of
  Financial Statements (b/c AFS investments will be
  sold!)
• The asset account for the investment is increased
  (or decreased) in value to market value (as of
  the Balance Sheet Date)
• The resulting gain or loss is reported on the
  Comprehensive Income Statement

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Example

• You buy 3,000 shares of Squiddix when it is
  selling for 20/share
• Investment in Squiddix TS or AFS 60,000
• Cash 60,000
• At fiscal year end it is worth 23/share
• Allowance to adjust Investment to Market 9,000
• Unrealized Gain on Market Value
• of Investment 9,000
• Or at fiscal year end it is worth 18/share
• Unrealized Loss on Market Value
• of Investment 6,000
• Allowance to adjust Investment to Market
  6,000

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These journal entries are appropriate for both
stocks and bonds, since both stocks and bonds can
be Trading Securities or Available For Sale
Securities.
So how do they differ? The gain or loss on
trading securities goes to the income statement,
but the gain or loss on available for sale
securities goes to the Comprehensive Income
statement.
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More About Stocks

• Equity method
• If you buy between 20 and 50 of the outstanding
  stock of a corporation
• AND
• If it is not a Trading Security,
• Then you use the EQUITY METHOD to account for
  this long term investment.
• Consolidation
• If you buy more than 50 of the outstanding stock
  of a corporation
• Then you use the CONSOLIDATION method to account
  for this long term investment.

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Equity MethodHow and Why

• If you own between 20-50 of a firms stock, you
  have significant influence over that firm.
• Thus, your Investment (asset) account represents
  YOUR share of their equity.
• Your Investment account will reflect changes in
  their equity account.
• If they earn income, which increases their
  equity, your Investment account will increase by
  your share of their earnings.
• If they pay (cash) dividends, which decreases
  their equity, your Investment account will
  decrease by your share of the dividends, which
  you receive in cash.

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Example of Equity Method
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And the accounts would look so
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Consolidations

• If you own more than 50 of the outstanding stock
  of its company, you are the majority shareholder,
  and if you are a firm you are called the PARENT.
• The firm you have invested in is called the
  SUBSIDIARY.
• You use the equity method to report your
  Investment account, and in addition, you report
  your financial statements combined with those of
  the subsidiary. This combination is called
  CONSOLIDATION.

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Bonds

• How are bonds different from stocks?
• Bondholders and stockholders both have
  investments, but bondholders are creditors and
  stockholders are owners.
• Bondholders receive a specific amount of interest
  every period based on a stated rate of interest
  and the face (par) value of the bond.
• The bond face value (principal) is repaid to the
  investor, unlike the investment in stock.
  Stockholders only get their money back if they
  sell the stock.
• Bonds may be repaid all at once on a maturity
  date (term bonds) or in installments (serial or
  installment bonds.)
• How are Investments in Bonds handled differently
  than investments in stocks?
• Short term investments in bonds are Trading
  Securities and are reported at market value (on
  Balance Sheet date.)
• Long term investments may be Available for Sale,
  but are usually Held to Maturity Bonds.
• How are you today?

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One More Time

• BONDS
• Short term are trading securites-reported at
  market value.
• Long term are usually Held to Maturity, reported
  at amortized historical cost.
• May also be Available for Sale, reported at
  market value

• STOCK
• Short term are trading securites-reported at
  market value.
• Long term are accounted for by equity method if
  greater than 20 of outstanding shares.
• Long term are accounted for as Available for
  Sale if less than 20 of outstanding shares.

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Because these are the most common, we are going
to concentrate on Held to Maturity term bonds.
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But what if we buy the bond for an amount other
than par?

• The market value of a bond depends on the stated
  rate, the maturity date, and the market rate of
  interest.
• The price of a bond (market value) is based on
  the Present Value of BOTH sets of cash flows
  (interest payments and principal repayment.
• Present Value is the discounted value of the cash
  flows (the amount before interest is earned.)

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Calculating the Price of a Bond
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When the discount is amortized, the adjustment
(debit) goes directly Into the Investment
account. The credit goes to Interest Revenue,
because the adjustment is just the difference
between what you actually receive in Cash and
what you earn in market interest.
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So by the time the bond is repaid, your
Investment account in your books will show the
correct amount to receive.
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And here are the related ledger accounts for your
investment
The carrying value of The investment will be The
balance in the Account at that point In time.
Of course the interest Revenue will close at
the End of each fiscal year.
100,000
0
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And here is the Bond Amortization Schedule
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Buying a bond that pays a higher interest rate
than the market has the opposite effect.

• If the market rate is below the stated rate, then
  the bond is desirable and you are willing to pay
  extra to get it.
• The extra you are willing to pay is called the
  premium.
• The premium increases the price of the bond, but
  must be amortized just like the discount.
• When the premium is amortized, it REDUCES the
  interest revenue because the market interest you
  earn is less than the actual cash you receive.

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Example of bond with premium.
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And the ledger accounts are
100000
The carrying value Of the Investment Account
will be the balance In the account at that
point In time.
Of course the Interest revenue Account will
close At the end of each Fiscal year.
0
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And here is the premium amortization schedule
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So lets review

• Bonds are just a form of borrowing.
• Most bonds have a stated interest rate and a
  specific maturity date.
• Most bonds are long term, whether to the issuer
  or the investor.
• Bonds that sell when the market rate is different
  from the stated rate will have a premium or
  discount.
• To the issuer, the premium or discount is
  recorded in a separate account (adjunct or
  contra,) and is AMORTIZED over the life of the
  bond.
• To the investor, the premium or discount is
  reflected in the historical cost of the
  investment, and is AMORTIZED over the life of the
  bond.
• Amortization of the premium or discount affects
  the interest (revenue or expense to investor or
  issuer, respectively) and so takes place at the
  time of interest payments and interest accruals.

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• Bonds, whether Trading Securities, Available for
  Sale Securities, or Held to Maturity Securities,
  will amortize the premium or discount.
• Trading and Available for Sale bonds will then be
  marked to market. The trading security
  unrealized gains/losses go to the Income
  Statement. The available for sale security
  unrealized gains/losses go to the Statement of
  Comprehensive Income.
• Held to maturity bonds are accounted for at
  amortized historical cost.
• Stocks cannot be held to maturity, but can be
  accounted for by the equity method. Equity
  method stocks are neither trading nor available
  for sale securities. They are accounted for at
  adjusted historical cost.
• Stocks not accounted for by the equity method are
  either trading securities or available for sale
  securities, and are accounted for at market value.

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Lots to Digest

• But thats all for this week.