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Chapter12: Investments

Securities Available-for-Sale

When you or I buy stock in a corporation, say Coca-Cola, we hope the market value will rise before we sell it. We also may look forward to the cash dividends Coca-Cola pays its shareholders every three months. We may even have planned when we will sell the stock, or we may intend to wait and see what happens to market prices. In either case, we aren't planning to trade the investment actively, but our investment is available to sell given the right combination of market factors and our own cash situation. These same considerations apply to companies that invest in the securities of other corporations or governmental entities. When a company acquires an investment, not for an active trading account (as a financial institution might) or to be held to maturity (which of course couldn't be stock because it has no maturity date), the company classifies its investment as securities available-for-sale (AFS)equity or debt securities the investor acquires, not for an active trading account or to be held to maturity.. Like trading securities, we report investments in AFS securities in the balance sheet at fair value. Unlike trading securities, though, unrealized holding gains and losses on AFS securities are not included in net income. Instead, they are reported in the statement of comprehensive income as other comprehensive income (OCI).

 

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Investments in available-for-sale securities are reported at their fair values.

Unrealized holding gains and losses on available-for-sale securities affect comprehensive income, but not net income.

p. 630

ILLUSTRATION 12-3

Reporting Trading Securities

For trading securities, fair value changes affect net income in the period in which they occur.

Trading securities are reported at fair value in the balance sheet.

Cash flows from buying and selling trading securities are classified as operating activities.

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a$121,664 is the sum of $46,664 interest revenue from Masterwear and $75,000 dividends from Arjent.
b$16,354 is the net unrealized loss from the 2011 fair value adjustment.
c$1,057 is the $1,354 net unrealized gain from the 2012 fair value adjustment minus the $297 loss realized on sale of investments during 2012 (the $297 net realized loss results from the $54,000 loss realized on sale of the Arjent stock and the $53,703 gain realized on sale of the Masterwear bonds).

COMPREHENSIVE INCOME.  You may recall from Chapter 4 that comprehensive income is a more all-encompassing view of changes in shareholders' equity, including not only net income but also all other changes in equity that do not arise from transactions with owners.12 Comprehensive income therefore includes net income and other comprehensive income (OCI). Both net income and OCI accumulate in shareholders' equity in the balance sheet, but in different accounts. While net income accumulates in retained earnings, OCI accumulates in accumulated other comprehensive income (AOCI).

Comprehensive income includes not only net income, but also other changes in equity that don’t arise from transactions with owners.

RATIONALE FOR AFS TREATMENT OF UNREALIZED HOLDING GAINS AND LOSSES.  Why use an approach for accounting for AFS securities that differs from that used for trading securities? The big concern is that including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than it really is. For example, many companies purchase AFS investments for the purpose of having the changes in fair value of those investments offset changes in the fair value of liabilities. This hedging insulates the company from risk and ensures that earnings are stable. However, if fair value changes for investments were to be recognized in income (as is the case with trading securities), but the offsetting fair value changes for liabilities were not recognized in income as well, we could end up with income appearing very volatile when in fact the underlying assets and liabilities are hedged effectively.13

 

FINANCIAL
Reporting Case

Q3p. 620

   More generally, because AFS securities are likely to be held for multiple reporting periods, one could argue that there is sufficient time for unrealized holding gains in some periods to balance out with unrealized holding losses in other periods, so including unrealized holding gains and losses in income would confuse investors by making income appear more volatile than it really is over the long run. Of course, one could counter-argue that these unrealized holding gains and losses still are relevant, given that each period an investor has discretion over whether or not to continue holding the security or sell that security to realize a gain or loss.

p. 631

   To consider accounting for AFS investments, refer to the facts shown in Illustration 12-2. Let's assume now that United classifies its investments as AFS rather than trading securities.

PURCHASE INVESTMENTS.  The journal entries to record the purchase of the investments are the same for AFS securities as they are for trading securities:

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All investment securities are initially recorded at cost.

RECOGNIZE INVESTMENT REVENUE.  The journal entries to record the receipt of investment revenue also are the same for AFS securities as they are for trading securities.

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Interest income and dividends on AFS investments are included in net income.

ADJUST AFS INVESTMENTS TO FAIR VALUE (2011).  Let's first recall the facts:

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   Like trading securities, AFS securities are adjusted to fair value at the end of each reporting period, which produces an unrealized holding gain or loss due to holding the securities while their fair values change. The journal entry to record United's unrealized holding loss is:

December 31, 2011
Net unrealized holding gains and losses—OCI14........................................................................
16,354
Fair value adjustment..........................................
16,354
 AFS securities are adjusted to their fair value at each reporting date.

   Notice that the amount of unrealized holding loss is the same as with trading securities. What differs is that the net unrealized holding loss of $16,354 is included in net income for trading securities and in OCI for AFS securities.15 At the end of the reporting period the net unrealized holding loss ends up being closed to a shareholders' equity account for both approaches. What differs is that it gets closed to retained earnings for trading securities and to AOCI for AFS securities.

 

For AFS securities, unrealized holding gains and losses from fair value changes are not included in net income, but instead are recorded as OCI.

p. 632

SELL AFS INVESTMENTS.  AFS investments require the same journal entry on the date of sale as is made to record the sale of trading securities. United simply records the receipt of cash, removes from the balance sheet any accounts that are directly associated with the investment, and calculates the difference to determine realized gain or loss.

 

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 Realized gain or loss for the difference between carrying value and the cash received from selling a trading security is included in net income.

   United also needs to adjust the fair value adjustment account and AOCI to remove any unrealized gains or losses previously recorded that relate to the sold investments. That is typically done at the end of the accounting period as part of the journal entry that adjusts the AFS investment portfolio to fair value, as we see below.

ADJUST AFS INVESTMENTS TO FAIR VALUE (2012).  The following table summarizes the situation at the end of 2012:

 

When AFS securities are sold, unrealized gains or losses that were recorded previously are removed from the fair value adjustment and OCI.

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   This analysis indicates that United needs to increase the fair value adjustment by $1,354 and record an unrealized gain of the same amount in OCI.

December 31, 2012
Fair value adjustment ....................................................................................
1,354
   Net unrealized holding gains and losses—OCI ...........................................
1,354

   This journal entry serves two purposes: it (a) accounts for new changes during 2012 in the fair value of investments that haven't been sold, and (b) removes amounts associated with investments that were sold during 2012.

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   Let's consider the two purposes separately.

p. 633

New Changes in the Fair Value of Investments Held.  The first purpose of the journal entry is to record in OCI any new unrealized gains or losses associated with investments that have not been sold. For United, that's the Bendac stock. The new unrealized gain or loss equals whatever amount is necessary to report the Bendac investment at fair value as of the end of 2012.

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If the 2012 journal entry had focused only on this first purpose, the journal entry would have been to recognize an unrealized holding loss of $5,000:

Net unrealized holding gains and losses-OCI................................................
5,000
   Fair value adjustment................................................................................
5,000

Reclassification Adjustment.  The second purpose of the journal entry is to remove from OCI any amounts associated with sold investments. What amounts must United consider? Last year, in 2011, United recorded a net unrealized loss of $6,354 on the Arjent and Masterwear investments as part of the $16,354 fair value adjustment made at the end of that year.

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   If the 2011 fair value adjustment had only included the net unrealized loss on the Arjent and Masterwear investments, it would have been:

Net unrealized holding gains and losses—OCI.....................
6,354
Fair value adjustment...........................................................
6,354

 

For AFS securities, unrealized gains and losses affect OCI and accumulate in AOCI until such time as the investment is sold.

   Because those investments have now been sold, United must reverse this entry in 2012 to remove their effects from OCI and the fair value adjustment. If the 2012 journal entry had focused only on this second purpose, it would have been:

Fair value adjustment.........................................................................
6,354
Net unrealized holding gains and losses—OCI.................................
6,354

   See how the two purposes combine to create the single journal entry we use to increase the fair value adjustment by $1,354 and recognize a net unrealized holding gain of that amount in OCI?

Fair value adjustment ($6,3545,000)...........................................
1,354
 Net unrealized holding gains and losses—OCI...........................................
1,354

   Now, why is this often referred to as a “reclassification adjustment”? Remember that United included a $6,354 unrealized loss in 2011 OCI (and therefore in AOCI). Then, in 2012, it backed out that amount from OCI (and AOCI) as part of the fair value adjustment entry, and included the realized gain or loss in net income (and therefore retained earnings). From the perspective of shareholders' equity, the amount was basically reclassified from AOCI to retained earnings in the period of sale.16

p. 634

   Note that we don't separately record the reclassification. That happens automatically as part of the fair value adjustment entry at the end of the period. What we do is report the reclassification in the statement of comprehensive income, as you will see in the next section.

FINANCIAL STATEMENT PRESENTATION.  We present AFS securities in the financial statements as follows:

 

Income Statement and Comprehensive Income Statement:Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold.

 

Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders' equity, and are reclassified out of AOCI in the periods in which securities are sold.

 

Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

    United's 2011 and 2012 financial statements will include the amounts shown in Illustration 12-4.

ILLUSTRATION 12-4

Reporting Available-for-Sale Securities

Only realized gains and losses are included in net income.

Other comprehensive income includes unrealized holding gains and losses that occur during the reporting period.

AFS securities are reported at fair value.

AOCI (in shareholders’ equity) includes net unrealized holding gains or losses accumulated over the current and prior periods.

Cash flows from buying and selling AFS securities are classified as investing activities.

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a$121,664 is the sum of $46,664 interest revenue from Masterwear and $75,000 dividends from Arjent.
b$16,354 is the net unrealized loss from the 2011 fair value adjustment.
c$297 is the loss realized on sale of investments during 2012, resulting from the $54,000 loss realized on sale of the Arjent stock and the $53,703 gain realized on sale of the Masterwear bonds.
d$5,000 is the new net unrealized loss included in the 2012 fair value adjustment for Bendac.
e$6,354 is the reclassification adjustment included in the 2012 fair value adjustment to remove from AOCI amounts associated with investments that now have been sold.

p. 635

   Individual securities available for sale are classified as either current or noncurrent assets, depending on how long they're likely to be held. An example from the 2009 annual report of Cisco Systems is shown in Graphic 12-5.

GRAPHIC 12-5

Investments in Securities Available-for-Sale—Cisco Systems

Real World Financials

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Comparison of HTM, TS, and AFS Approaches

Illustration 12-5 compares accounting for the Masterwear bonds under the three different approaches used when an investor lacks significant influence.

ILLUSTRATION 12-5

Comparison of HTM, TS, and AFS Approaches

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*Reported as a reclassification adjustment in the statement of comprehensive income.

   This side-by-side comparison highlights several aspects of these accounting approaches:

 

To record the purchase of an investment and the receipt of investment revenue, we use identical entries in all three approaches.

p. 636

 

To record changes in fair value, the entries we use for TS and AFS securities have the same effect on the investment (via the fair value adjustment valuation allowance) and the same eventual effect on shareholders' equity. What differs is whether the unrealized gain or loss is recognized in the income statement and then in retained earnings (TS) or recognized in OCI and then in AOCI (AFS).

 

To record the sale of the security, we use identical entries in all three approaches. For TS and AFS securities, the fair value adjustment and unrealized holding gains and losses associated with sold securities are dealt with automatically as part of the next adjustment to fair value.

 

Regardless of approach, the cash flows are the same, and the same total amount of gain or loss is recognized in the income statement (TS: $43,646 in 2011 + [$53,703 − $43,646] in 2012 = $53,703 total; AFS and HTM: $53,703 in 2012). Thus, the question is not how much total net income is recognized, but when that net income is recognized.

  
ADDITIONAL CONSIDERATION

Available-for-Sale Investments and Income Taxes

When comparing accounting for TS and AFS securities, we saw that total shareholders' equity ends up being the same amount, regardless of whether unrealized gains and losses are included in net income and closed to retained earnings in shareholders' equity (for TS) or included only in OCI and shown in AOCI in shareholders' equity (for AFS securities). But what about taxes? Tax expense affects net income, so retained earnings includes after-tax amounts. For AOCI to be equivalent to retained earnings, it also should include only after-tax amounts. Therefore, adjustments must be made to OCI and AOCI that include tax effects. Typically these adjustments also give rise to deferred tax assets and liabilities, as unrealized holding gains and losses rarely affect the current period's taxes payable.

  

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Accounting for Investments When Investor Lacks Significant Influence. Until recently, IAS No. 3918 was the standard that specified appropriate accounting for investments under IFRS. The primary categories in IAS No. 39 are similar to those in U.S. GAAP, consisting of “Fair Value through Profit & Loss” (“FVTPL,” similar to TS), HTM, and AFS.

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   IFRS No. 9,19 issued November 12, 2009, will be required after January 1, 2013, and earlier adoption is allowed, so in the time period between 2010 and 2012 either IAS No. 39 or IFRS No. 9 might be in effect for a particular company. IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. This has the general effect of pushing more investments into being accounted for at FVTPL, and thus having unrealized gains and losses included in net income. Specifically, under IFRS No. 9:

  

Investments in debt securities are classified as either “Amortized Cost” or FVTPL. Like the previous HTM classification, debt in the amortized cost classification is accounted for at (you guessed it) amortized cost. However, to be included in the amortized cost category, a debt investment has to meet both (a) the “cash flow characteristics” test (which requires that the debt instrument consist of only principal and interest payments) and (b) the “business model test” (which requires that the objective of the company's business model is to hold the investment to collect the contractual cash flows rather than to sell the investment at a gain). If debt isn't classified in “amortized cost,” it is classified in FVTPL—there is no equivalent to AFS accounting for debt under IFRS No. 9.

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Investments in equity securities are classified as either “FVTPL” or “FVTOCI” (“Fair Value through Other Comprehensive Income). If the equity is held for trading, it must be classified as FVTPL, but otherwise the company can irrevocably elect to classify it as FVTOCI. Like the previous AFS classification, equity in the FVTOCI category has unrealized gains and losses included in OCI. However, unlike AFS, realized gains and losses are not reclassified out of OCI and into net income when the investment is later sold. Rather, the accumulated gain or loss associated with a sold investment is just transferred from AOCI to retained earnings (both shareholders' equity accounts), without passing through the income statement.

One other difference between U.S. GAAP and IFRS is worth noting. U.S. GAAP allows specialized accounting (beyond the scope of this textbook) for particular industries like securities brokers/dealers, investment companies, and insurance companies. IFRS does not.




12Transactions with owners primarily include dividends and the sale or purchase of shares of the company's stock.

13The option to report in earnings changes in the fair value of liabilities was not permitted at the time the FASB wrote the initial standard (SFAS No. 115) that specified appropriate accounting for investments in debt and equity securities. As we will see in chapter 14 , that option now is allowed.

14We title this account “Net unrealized holding gains and losses—OCI” to highlight that, for available-for-sale securities, unrealized holding gains and losses are included in other comprehensive income (OCI) in the period in which they occur.

15As with trading securities, we could have not used a separate valuation allowance and simply adjusted the AFS investment account itself to fair value, and we also could set up separate valuation allowances and record separate journal entries for each AFS investment.

16Reclassification also avoids double accounting with respect to comprehensive income and equity. If United didn't back out the 2011 unrealized loss from 2012 OCI, it would end up having included it in comprehensive income twice, once in OCI (2011) and once in net income (2012), thereby overstating total shareholders' equity.

17As we discuss in more detail in chapter 18 , the statement of comprehensive income can be reported as a continuation of the income statement as shown here, or alternatively either in a separate statement or in the statement of shareholders' equity.

18“Financial Instruments: Recognition and Measurement,” International Accounting Standard No. 39 (IASCF), as amended effective January 1, 2009.

19“Financial Instruments,” International Financial Reporting Standard No. 9 (IASCF), November 12, 2009.

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