FAS 115: Accounting for Certain FAS 115: Accounting for Certain Investments in Debt and Equity SecuritiesInvestments in Debt and Equity Securities

• Debt securities that the enterprise has the positive Debt securities that the enterprise has the positive intentintent & & abilityability to hold to maturity are classified as to hold to maturity are classified as held-to-maturity securitiesheld-to-maturity securities. Report at amortized cost.. Report at amortized cost.

• Debt & equity securities that are bought & held Debt & equity securities that are bought & held principally for the purpose of selling them in the near principally for the purpose of selling them in the near term are classified as term are classified as trading securities.trading securities. Reported at Reported at fair value, with unrealized gains & losses included in fair value, with unrealized gains & losses included in earnings.earnings.

• Debt & equity securities not classified as either Debt & equity securities not classified as either held-to-maturity securities or trading securities are held-to-maturity securities or trading securities are classified as classified as available-for-sale securities. available-for-sale securities. RReport at eport at fair value, with unrealized gains & losses fair value, with unrealized gains & losses excludedexcluded from earnings & reported in a separate component of from earnings & reported in a separate component of shareholders' equity.shareholders' equity.

Investments in Debt & Equity SecuritiesInvestments in Debt & Equity Securities

Category Category (based (based on intent)on intent)

Held-to-maturityHeld-to-maturityDebt securitiesDebt securities(intent & ability)(intent & ability)

Trading SecuritiesTrading Securities(short-term holdings(short-term holdingsOf debt or equity)Of debt or equity)

Available-for-SaleAvailable-for-Sale(intermediate to (intermediate to

longer term longer term holdings of debt holdings of debt or equity)or equity)

ValuationValuationAmortized CostAmortized Cost(amortize the (amortize the

discount or discount or premium)premium)

Fair ValueFair Value

Fair ValueFair Value

Unrealized Holding Unrealized Holding Gains or LossesGains or Losses

Do not recognizeDo not recognize

Recognize in net incomeRecognize in net income

Recognize as other Recognize as other comprehensive comprehensive income & as income & as separate component separate component of stockholders’ of stockholders’ equityequity

Other Income Other Income EffectsEffects

Interest when Interest when earned; gains earned; gains & losses from & losses from salesale

Interest when Interest when earned; gains earned; gains & losses from & losses from salesale

Interest when Interest when earned; gains earned; gains and losses from and losses from salesale

Account for held-to maturity Account for held-to maturity debt securities at amortized costdebt securities at amortized cost

Accounting for Held-to-Maturity Debt SecuritiesAccounting for Held-to-Maturity Debt Securities

(1st) Journalize Acquisition:(1st) Journalize Acquisition:

Dr Held-to-Maturity SecuritiesDr Held-to-Maturity Securities AmntPdAmntPd

Cr CashCr Cash AmntPdAmntPd

(2nd) Journalize Receipt of Interest Payment:(2nd) Journalize Receipt of Interest Payment:

Dr CashDr Cash AmntRecdAmntRecd

Dr Held-to-Maturity SecuritiesDr Held-to-Maturity Securities AmorDiscAmorDisc

Cr Held-to-Maturity SecuritiesCr Held-to-Maturity SecuritiesAmorPremAmorPrem

Cr Interest RevenueCr Interest Revenue EarnedEarned

(3rd) Adjusting Entry:(3rd) Adjusting Entry:

no “Mark to Market” adjustment …carry at amortized costno “Mark to Market” adjustment …carry at amortized cost

Held-to-Maturity Securities...Held-to-Maturity Securities...may lose this classification under some circumstances:may lose this classification under some circumstances:

a.a. Evidence of a significant deterioration in the issuer's Evidence of a significant deterioration in the issuer's creditworthiness creditworthiness

b.b. A change in tax law that eliminates or reduces the tax-exempt A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income)that revises the marginal tax rates applicable to interest income)

c.c. A major business combination or major disposition (such as sale A major business combination or major disposition (such as sale of a segment) that necessitates the sale or transfer of held-to-of a segment) that necessitates the sale or transfer of held-to-maturity securities to maintain the enterprise's existing interest maturity securities to maintain the enterprise's existing interest rate risk position or credit risk policyrate risk position or credit risk policy

d.d. A change in statutory or regulatory requirements significantly A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, maximum level of investments in certain kinds of securities, thereby causing an enterprise to dispose of a held-to-maturity thereby causing an enterprise to dispose of a held-to-maturity security security

e.e. A significant increase by the regulator in the industry's capital A significant increase by the regulator in the industry's capital requirements that causes the enterprise to downsize by selling requirements that causes the enterprise to downsize by selling held-to-maturity securities held-to-maturity securities

f.f. A significant increase in the risk weights of debt securities used A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.for regulatory risk-based capital purposes.

May not classify asMay not classify as Held-to-Maturity Securities … if ...Held-to-Maturity Securities … if ...

if the enterprise anticipates that the security would be if the enterprise anticipates that the security would be available to be sold in response to:available to be sold in response to:

a.a. Changes in market interest rates and related changes in the Changes in market interest rates and related changes in the security's prepayment risksecurity's prepayment risk

b.b. Needs for liquidity (for example, due to the withdrawal of Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims)policies, or payment of insurance claims)

c.c. Changes in the availability of and the yield on alternative Changes in the availability of and the yield on alternative investmentsinvestments

d.d. Changes in funding sources and termsChanges in funding sources and terms

e.e. Changes in foreign currency riskChanges in foreign currency risk

The following conditions do not loseThe following conditions do not lose Held-to-Maturity Classification… Held-to-Maturity Classification… ifif ... ...

a.a. The sale of a security occurs near enough to its maturity date (or The sale of a security occurs near enough to its maturity date (or

call date if exercise of the call is probable) that interest rate risk is call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor. That is, the date of substantially eliminated as a pricing factor. That is, the date of sale is so near the maturity or call date (for example, within 3 sale is so near the maturity or call date (for example, within 3 months) that changes in market interest rates would not have a months) that changes in market interest rates would not have a significant effect on the security's fair value.significant effect on the security's fair value.

b.b. The sale of a security occurs after the enterprise has already The sale of a security occurs after the enterprise has already collected a substantial portion (at least 85 percent) of the collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on principal outstanding at acquisition due either to prepayments on the debt security or to scheduled payments on a debt security the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its payable in equal installments (both principal and interest) over its term. For variable-rate securities, the scheduled payments need term. For variable-rate securities, the scheduled payments need

not be equal.not be equal.

Account for available-for-sale Account for available-for-sale & trading securities portfolios & trading securities portfolios

at fair valueat fair value

Investments in Available-for-Sale SecuritiesInvestments in Available-for-Sale Securities(debt or equity)(debt or equity)

(1st) Journalize Acquisition:(1st) Journalize Acquisition:Dr Available-for-Sale SecuritiesDr Available-for-Sale Securities AmntPdAmntPd

Cr CashCr Cash AmntPdAmntPd(2nd) Journalize Receipt of Interest/Dividend Payment:(2nd) Journalize Receipt of Interest/Dividend Payment:

Dr CashDr Cash AmntRecdAmntRecdDr Available-for-Sale SecuritiesDr Available-for-Sale Securities AmorDiscAmorDisc

Cr Available-for-Sale SecuritiesCr Available-for-Sale SecuritiesAmorPremAmorPrem

Cr Interest/Dividend RevenueCr Interest/Dividend Revenue EarnedEarned(3rd) Adjusting Entry -- Mark-to-Market against Equity:(3rd) Adjusting Entry -- Mark-to-Market against Equity:Securities Fair Value Adjustment—Available-for-SaleSecurities Fair Value Adjustment—Available-for-Sale $$$GAIN $$$GAIN

Unrealized Holding Gain or Loss—EquityUnrealized Holding Gain or Loss—Equity $$$GAIN$$$GAIN

Unrealized Holding Gain or Loss—EquityUnrealized Holding Gain or Loss—Equity $$$LOSS$$$LOSSSecurities Fair Value Adjustment—Available-for-SaleSecurities Fair Value Adjustment—Available-for-Sale $$$LOSS$$$LOSS

Investments in Trading SecuritiesInvestments in Trading Securities(debt or equity securities)(debt or equity securities)

(1st) Journalize Acquisition:(1st) Journalize Acquisition:

Dr Trading SecuritiesDr Trading Securities AmntPd AmntPd

Cr CashCr Cash AmntPdAmntPd

(2nd) Journalize Receipt of Interest/Dividend Payment:(2nd) Journalize Receipt of Interest/Dividend Payment:

Dr CashDr Cash AmntRecdAmntRecd

Cr Interest/dividend RevenueCr Interest/dividend RevenueAmntRecdAmntRecd

(3rd) Adjusting Entry -- Mark-to-Market against Income:(3rd) Adjusting Entry -- Mark-to-Market against Income:Securities Fair Value Adjustment—TradingSecurities Fair Value Adjustment—Trading $$$GAIN$$$GAIN

Unrealized Holding Gain or Loss—IncomeUnrealized Holding Gain or Loss—Income $$$GAIN$$$GAIN

Unrealized Holding Gain or Loss—IncomeUnrealized Holding Gain or Loss—Income $$$LOSS$$$LOSS

Securities Fair Value Adjustment—TradingSecurities Fair Value Adjustment—Trading $$$LOSS$$$LOSS

The 4 reasons to buy the The 4 reasons to buy the stocks of another company:stocks of another company:

• To make money -- fair value accountingTo make money -- fair value accounting• For influence ----- equity methodFor influence ----- equity method• For control -------- consolidate resultsFor control -------- consolidate results

(covered in advanced accounting)(covered in advanced accounting)

Account for securities held for the Account for securities held for the purpose of influence purpose of influence (20% - 50% interest)(20% - 50% interest)

using the using the equity methodequity method

The Investment AccountThe Investment Account

reflects the activity of the Equity Section on the reflects the activity of the Equity Section on the Investee CompanyInvestee Company

(adjusted for intercompany transactions)(adjusted for intercompany transactions)

(as if the net assets were revalued at fair value)(as if the net assets were revalued at fair value)

… … based on the percentage ownership acquiredbased on the percentage ownership acquired

A B CClassification: Trading Available-for-Sale 20-50% holdings

Purpose: Short-Term Gain Moderate to LT Gain For Influence

Valuation: Fair Value Fair Value Equity

Valuation Accounts:

Level of Influence None Little, if any Significant

Dividends Received Income Income Reduce Investment

Investee Net Income No Direct Impact No Direct Impact Increase Investment(net of intercompany gains &

losses & after amortization of the difthe dif between the Cost of the & theproportionate share of BV of assets)

Security Fair Value Adjustement (TS or AFS)Unrealized Gain or Loss - Income or Equity

Passive Interest

Accounting for Equity InvestmentsAccounting for Equity Investments

Investment in XYZ AccountInvestment in XYZ Account

• CostCost• Share of IncomeShare of Income

• Share of LossesShare of Losses• DividendsDividends• Amortizations (but no Amortizations (but no

amortization of any amortization of any implied goodwill!!!)implied goodwill!!!)

Accounting for Equity Securities Accounting for Equity Securities Using the Equity MethodUsing the Equity Method

Acquisition:Acquisition:Dr Investment in ABC Co.Dr Investment in ABC Co. CostCost

Cr CashCr Cash CostCostDividend Receipt:Dividend Receipt:Dr CashDr Cash AmntRec’dAmntRec’d

Cr Investment in ABC Co. Cr Investment in ABC Co. AmntRec’dAmntRec’dIncome of Investee:Income of Investee:

Dr Investment in ABC Co.Dr Investment in ABC Co. %NI%NI

Dr Loss from ABC Co. (extraordinary)Dr Loss from ABC Co. (extraordinary) %Extr%Extr

Cr Revenue from ABC Co.Cr Revenue from ABC Co. %NIBX%NIBX

Dr Revenue from ABC Co.Dr Revenue from ABC Co. AmortAmort

Cr Investment in ABC Co. (1/N (Cost-BV))Cr Investment in ABC Co. (1/N (Cost-BV)) AmortAmort

Adjusting Entry to Carry Investment at Fair Value:Adjusting Entry to Carry Investment at Fair Value:none … hold at Adjusted Cost (adjusted for Income & Add’l Depr)none … hold at Adjusted Cost (adjusted for Income & Add’l Depr)

Fair Value Accounting ControversyFair Value Accounting Controversy

1.1. Measurement is based on intent. A subjective Measurement is based on intent. A subjective evaluation which will result in arbitrary evaluation which will result in arbitrary classifications.classifications.2.2. Gains recorded are based on trading. Selling Gains recorded are based on trading. Selling "winners" and holding on to "losers.""winners" and holding on to "losers."3.3. Liabilities are recorded at cost, not fair value. Liabilities are recorded at cost, not fair value. Recognizing changes in asset values while ignoring Recognizing changes in asset values while ignoring similar changes in liabilities will lead to a high similar changes in liabilities will lead to a high degree of volatility in income and stockholders' degree of volatility in income and stockholders' equity.equity.4.4. There is a great deal of subjectivity in fair There is a great deal of subjectivity in fair values. Results in opportunity gains and losses values. Results in opportunity gains and losses being recognized in the financial statements… being recognized in the financial statements… which may quickly reverse.which may quickly reverse.

Transfers Between CategoriesTransfers Between Categories

1.1. Transfers between categories are accounted for Transfers between categories are accounted for at fair value.at fair value.

2.2. The "fair value rule" assures that a company The "fair value rule" assures that a company cannot escape recognition of fair value by simply cannot escape recognition of fair value by simply transferring securities to held-to-maturity.transferring securities to held-to-maturity.

3.3. Appendix 18A illustrates the accounting entries Appendix 18A illustrates the accounting entries to record the transfer of securities between categories. to record the transfer of securities between categories.

Impairment of Value.Impairment of Value. If the decline is judged If the decline is judged to be to be other than temporaryother than temporary, the cost basis of the , the cost basis of the

individual security is written down to a new cost basis. individual security is written down to a new cost basis. The amount of the write-down is accounted for as a The amount of the write-down is accounted for as a

realized lossrealized loss..

1.1. For debt securitiesFor debt securities, the impairment test is to determine , the impairment test is to determine whether it is probable that the investor will be unable to whether it is probable that the investor will be unable to collect all amounts due according to the contractual collect all amounts due according to the contractual terms.terms.

2.2. For equity securitiesFor equity securities, guidelines are less precise. Any , guidelines are less precise. Any time realizable value is lower than carrying amount, an time realizable value is lower than carrying amount, an impairment must be considered.impairment must be considered.

Financial Statement Presentation:Financial Statement Presentation:Comprehensive IncomeComprehensive Income

1.1. Changes in unrealized gains and losses related to Changes in unrealized gains and losses related to available-for-sale securities are reported as part of other available-for-sale securities are reported as part of other comprehensive income, and reflected as a separate comprehensive income, and reflected as a separate component of stockholders' equity. Comprehensive component of stockholders' equity. Comprehensive income may be reported in:income may be reported in:

(a)(a) a combined statement of income & comprehensive a combined statement of income & comprehensive income or,income or,

(b)(b) a separate statement of comprehensive income a separate statement of comprehensive income beginning with net income, orbeginning with net income, or

(c)(c) a statement of stockholders' equity.a statement of stockholders' equity.

A derivativeA derivative … is any financial … is any financial instrument that instrument that derivesderives its value from its value from an outside benchmark.an outside benchmark. For example, a For example, a stock option is a derivative in that the value stock option is a derivative in that the value of the option is derived from the underlying of the option is derived from the underlying price of the stock ... Specifically, the “option price of the stock ... Specifically, the “option premium” is the sum of its “intrinsic value” premium” is the sum of its “intrinsic value” (difference between its market price & its (difference between its market price & its strike price) & its “time value” (based on the strike price) & its “time value” (based on the possibility that the option will be “in the possibility that the option will be “in the money” before it expires).money” before it expires).

FASB’s definition of a “Derivative”

... “a derivative financial instrument is a futures, forward, swap, or option contract, or other financial instrument with similar characteristics.”

includes:• interest rate caps or floors• fixed rate loan commitments• letters of credit

... they provide the holder with benefits of favorable movements in the price of an underlying asset or index with limited or no exposure to losses from unfavorable price movements, generally in return for a premium paid...

FABB exposure draft April 14, 1994FABB exposure draft April 14, 1994

Example Derivatives:

Speculative Derivatives:• call options

Derivatives to Hedge Risk:

FAIR VALUE HEDGE• interest rate swap from fixed to

variable rate

CASH FLOW HEDGE• futures contracts - purchase side• interest rate swap from variable to

fixed rate

FAS 133: Accounting for DerivativesAccounting for the

Derivative• Fair Value, unrealized

holding G/L hit income

• Fair Value, unrealized holding G/L hit income

• Fair Value, unrealized holding G/L hit equity & are reclassified in income when the hedged transaction’s cash flow affects earnings

Accounting for the Hedge

• n/a

• Fair Value, G/L hit income

• Use other GAAP for the hedged item

Use

Speculation:

Fair Value

Hedge

Cash Flow

Hedge