CHAPTER 4

ACCOUNTING FOR INVESTMENTS IN EQUITY AND DEBT SECURITIES

Objective of the chapter
After studying this chapter, you should be able to:
 Describe the accounting framework for financial assets.
 Understand the accounting for debt investments at amortized cost.
 Understand the accounting for debt investments at fair value.
 Describe the accounting for the fair value option.
 Understand the accounting for equity investments at fair value.
 Explain the equity method of accounting and compare it to the fair value method for
equity investments.
 Discuss the accounting for impairments of debt investments.
 Describe the accounting for transfer of investments between categories.

4.1 ACCOUNTING FOR FINANCIAL ASSETS

A financial asset is cash, an equity investment of another company (e.g., ordinary or preference
shares), or a contractual right to receive cash from another party (e.g., loans, receivables, and
bonds).

IASB requires that companies classify financial assets into two measurement categories—
amortized cost and fair value—depending on the circumstances.
Measurement Basis—A Closer Look
IFRS requires that companies measure their financial assets based on two criteria:
 Company’s business model for managing its financial assets; and
 Contractual cash flow characteristics of the financial asset.
 Only debt investments such as receivables, loans, and bond investments that meet the
two criteria above are recorded at amortized cost. All other debt investments are
recorded and reported at fair value.
Equity investments are generally recorded and reported at fair value.

TABLE 4-1: Summary of Investment Accounting Approaches

4.2 DEBT INVESTMENTS

Debt investments are characterized by contractual payments on specified dates of
 principal and
 Interest on the principal amount outstanding.

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 Companies measure debt investments at
 amortized cost or
 Fair value.

Debt Investments—Amortized Cost

Illustration: Robinson Company purchased Br.100, 000 of 8% bonds of Evermaster
Corporation on January 1, 2015, at a discount, paying Br.92, 278. The bonds mature January 1,
2020 and yield 10%; interest is payable each July 1 and January 1. Robinson records the
investment as follows:
January 1, 2015
Debt Investments 92,278
Cash 92,278
Companies must amortize premiums or discounts using the effective-interest method. They
apply the effective-interest method to bond investments in a way similar to that for bonds
payable. To compute interest revenue, companies compute the effective-interest rate or yield at
the time of investment and apply that rate to the beginning carrying amount (book value) for
each interest period. The investment-carrying amount is increased by the amortized discount or
decreased by the amortized premium in each period.
Table 4.2 below shows the effect of the discount amortization on the interest revenue that
Robinson records each period for its investment in Evermaster bonds.

TABLE 4-2: Debt Investments—Amortized Cost

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Robinson Company records the receipt of the first semiannual interest payment on July 1,
2015, as follows:
Cash 4,000
Debt Investments 614
Interest Revenue 4,614
Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at
December 31, 2015, as
Interest Receivable 4,000
Debt Investments 645
Interest Revenue 4,645

Reporting of Bond Investment at Amortized Cost

Assume that Robinson Company sells its investment on November 1, 2017, at 99¾ plus
accrued interest. Robinson records this discount amortization as follows:
Debt Investments 522
Interest Revenue 522
(Br.783 x 4/6 = Br.522)

Computation Gain on Sale of Bonds

Cash 102,417
Interest Revenue (4/6 x Br.4,000) 2,667
Debt Investments 96,193
Gain on Sale of Debt Investments 3,557

Debt Investments—Fair Value

Debt investments at fair value follow the same accounting entries as debt investments held-
for-collection during the reporting period. That is, they are recorded at amortized cost.
However, at each reporting date, companies
 Adjust the amortized cost to fair value.
 Any unrealized holding gain or loss reported as part of net income (fair value
method).
Illustration: Robinson Company purchased Br.100, 000 of 8 percent bonds of Evermaster
Corporation on January 1, 2015, at a discount, paying Br.92, 278. The bonds mature January 1,
2020, and yield 10 percent; interest is payable each July 1 and January 1.
The journal entries in 2015 are, exactly the same as those for amortized cost.

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Entries are the same as those for amortized cost.

Illustration: Computation of Unrealized Gain on Fair Value Debt Investment (2015)

To apply the fair value approach, Robinson determines that, due to a decrease in interest rates,
the fair value of the debt investment increased to Br.95,000 at December 31, 2015.

Illustration: Computation of Unrealized Gain on Fair Value Debt Investment (2015)

Fair Value Adjustment 1,463
Unrealized Holding Gain or Loss—Income 1,463

Robinson uses a valuation account (Fair Value Adjustment) instead of debiting Debt
Investments to record the investment at fair value. The use of the Fair Value Adjustment
account enables Robinson to maintain a record at amortized cost in the accounts. Because the
valuation account has a debit balance, in this case the fair value of
Robinson’s debt investment is higher than its amortized cost.

The Unrealized Holding Gain or Loss—Income account is reported in the other income and
expense section of the income statement as part of net income. This account is closed to net
income each period. The Fair Value Adjustment account is not closed each period and is
simply adjusted each period to its proper valuation. The Fair Value Adjustment balance is not
shown on the statement of financial position but is simply used to restate the debt investment
account to fair value.

Robinson reports its investment in Evermaster bonds in its December 31, 2014, financial
statements as shown below in table 4.3

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TABLE 4-3: Financial Statement Presentation of Debt Investments at Fair Value

At December 31, 2016, assume that the fair value of the Evermaster debt investment is Br.94, 000.

TABLE 4-4: Computation of Unrealized Gain on Debt Investment (2016)

Unrealized Holding Gain or Loss—Income 2,388
Fair Value Adjustment 2,388

TABLE 4-5: Financial Statement Presentation of Debt Investments at Fair Value (2016)

Assume now that Robinson sells its investment in Evermaster bonds on November 1, 2017, at
99 ¾ plus accrued interest. The only difference occurs on December 31, 2017. Since the bonds
are no longer owned by Robinson, the Fair Value Adjustment account should now be reported
at zero. Robinson makes the following entry to record the elimination of the valuation account.
Fair Value Adjustment 925
Unrealized Holding Gain or Loss—Income 925

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Table 4.6: Income Effects on Debt Investment (2015-2017)
Illustration (Portfolio): Wang Corporation has two debt investments accounted for at fair
value. The following illustration identifies the amortized cost, fair value, and the amount of the
unrealized gain or loss.

TABLE 4-7: Computation of Fair Value Adjustment (2015)

Illustration (Portfolio): Wang makes an adjusting entry at December 31, 2015 to record the
decrease in value and to record the loss as follows.
Unrealized Holding Gain or Loss—Income 9,537
Fair Value Adjustment 9,537
Illustration (Sale of Debt Investments): Wang Corporation sold the Watson bonds (from
Illustration 4-10) on July 1, 2016, for ¥90,000, at which time it had an amortized cost of
¥94,214.
Computation of Loss on Sale of Bonds:
Selling price of the Watson bond ------------------ ¥90,000
Less: Carrying value of the bond ------------------ 94,214
Gain or loss on sale of bond ------------------------ ¥ (4,214)
Cash 90,000
Loss on Sale of Debt Investments 4,214
Debt Investments 94,214
Wang reports this realized loss in the “Other income and expense” section of the income
statement. Assuming no other purchases and sales of bonds in 2016, Wang on December 31,
2016, prepares the information:
DEBT INVESTMENT PORTFOLIO
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 DECEMBER 31, 2016
Investments Amortized Fair Unrealized
Cost Value Gain (Loss)
Anacomp Corporation 10% bonds (total ¥200,000 ¥195,000 $(5,000)
portfolio)
Previous fair value adjustment balance--Cr. (9,537)
Fair value adjustment—Dr. $ 4,537
TABLE 4-8: Computation of Fair Value Adjustment (2016)
Wang records the following at December 31, 2016.
Fair Value Adjustment 4,537
Unrealized Holding Gain or Loss—Income 4,537
Financial Statement Presentation
Statement of Financial Position
Investments
Debt investments ¥195,000
Income Statement
Other revenues and gains
Interest revenue ¥ xxx
Loss on sale of investments 4,214
Unrealized holding gain or (loss) 4,537
TABLE 4-9: Reporting of Debt Investments at Fair Value

Fair Value Option

Companies have the option to report most financial assets at fair value. This option
 is applied on an instrument-by-instrument basis and
 is generally available only at the time a company first purchases the financial
asset or incurs a financial liability.
If a company chooses to use the fair value option, it measures this instrument at fair value until
the company no longer has ownership.
Illustration: Hardy Company purchases bonds issued by the German Central Bank. Hardy
plans to hold the debt investment until it matures in five years. At December 31, 2015, the
amortized cost of this investment is Br.100,000; its fair value at December 31, 2015, is
Br.113,000. If Hardy chooses the fair value option to account for this investment, it makes the
following entry at December 31, 2015.
Debt Investment (German bonds) 13,000
Unrealized Holding Gain or Loss—Income 13,000

4.3 EQUITY INVESTMENTS

Equity investment represents ownership of ordinary, preference, or other capital shares.
 Cost includes price of the security.
 Broker’s commissions and fees are recorded as expense.
The degree to which one corporation (investor) acquires an interest in the common stock of
another corporation (investee) generally determines the accounting treatment for the
investment subsequent to acquisition.

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To review, the classification of such investments depends on the percentage of the investee
voting shares that is held by the investor:
1. Holdings of less than 20 percent (fair value method)—investor has passive interest.
2. Holdings between 20 percent and 50 percent (equity method)—investor has significant
influence.
3. Holdings of more than 50 percent (consolidated statements)—investor has controlling
interest.
Percentage of 0% 20% 50% 100%
ownership
Level of Influence Little or None Significant Control
Valuation Method Fair Value Equity Method Consolidation
Method
TABLE 4-10: Levels of Influence Determine Accounting Methods

The accounting and reporting for equity investments therefore depend on the level of influence
and the type of security involved, as shown below in table 4.11
Category Valuation Unrealized holding gain or Other Income effects
losses
Holding less
than 20%
1.Trading Fair Value Recognized in net income Dividend declared; gain and
2. Non- Fair Value Recognized in “Other Dividend declared; gain and
Trading Comprehensive Income (OCI ) & losses from sale
as separate component of equity
Holding b/n Equity Not recognized Proportionate share of
20% & 50% investee’s net income

Holding more Consolidation Not Recognized Not Applicable

than 50%
Table 4-11: Accounting and Reporting for Equity Investments by Category

Holdings of Less Than 20%

Under IFRS, the presumption is that equity investments are held-for-trading.
General accounting and reporting rule:
 Investments valued at fair value.
 Record unrealized gains and losses in net income.
IFRS allows companies to classify some equity investments as non-trading.
General accounting and reporting rule:
 Investments valued at fair value.
 Record unrealized gains and losses in other comprehensive income.
Equity Investments—Trading (Income)
Illustration: November 3, 2015, Republic Corporation purchased ordinary shares of three
companies, each investment representing less than a 20 percent interest. These shares are held-
for-trading.

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Table 4.12: computation of total cost of equity investment
Republic records these investments as follows:
Equity Investments 718,550
Cash 718,550
On December 6, 2015, Republic receives a cash dividend of Br.4, 200 on its investment in the
ordinary shares of Nestlé.
Cash 4,200
Dividend Revenue 4,200
At December 31, 2015, Republic’s equity investment portfolio has the carrying value and fair
value shown.

TABLE 4-13: Computation of Fair Value Adjustment—Equity Investment Portfolio (2015)

Unrealized Holding Gain or Loss—Income 35,550
Fair Value Adjustment 35,550
On January 23, 2016, Republic sold all of its Burberry ordinary shares, receiving Br.287, 220.

TABLE 4-14: Computation of Gain on Sale of Burberry Shares

Cash 287,220
Equity Investments 259,700
Gain on Sale of Equity Investment 27,520

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In addition, assume that on February 10, 2016, Republic purchased Br.255,000 of Continental
Trucking ordinary shares (20,000 shares Br.12.75 per share), plus brokerage commissions of
Br.1,850. Republic’s equity investment portfolio as of December 31, 2016.
Equity Investment Portfolio December 31, 2016
Investments Carrying Value Fair Value Unrealized Gain (Loss)
Nestlé Br.317,500 Br.314,000 Br.(3,500)
St. Regis Pulp Co. 141,350 155,950 14,600
Continental Trucking 255,000 310,000 55,000
Total of portfolio Br.713,850 Br.779,950 Br.66,100
Previous fair value (35,550)
adjustment balance—Cr.
Fair value adjustment--Dr. Br.101,650
TABLE 4-15: Computation of Fair Value Adjustment—Equity Investment Portfolio (2016)
Republic records this adjustment as follows.
Fair Value Adjustment 101,650
Unrealized Holding Gain or Loss—Income 101,650

Equity Investments—Non-Trading
The accounting entries to record non-trading equity investments are the same as for trading
equity investments, except for recording the unrealized holding gain or loss.
Report the unrealized holding gain or loss as other comprehensive income.
Illustration: On December 10, 2015, Republic Corporation purchased 1,000 ordinary shares
of Hawthorne Company for Br.20.75 per share (total cost Br.20,750). The investment
represents less than a 20 percent interest. Hawthorne is a distributor for Republic products in
certain locales, the laws of which require a minimum level of share ownership of a company in
that region. The investment in Hawthorne meets this regulatory requirement. Republic
accounts for this investment at fair value.
Equity Investments 20,750
Cash 20,750
On December 27, 2015, Republic receives a cash dividend of Br.450 on its investment in the
ordinary shares of Hawthorne Company. It records the cash dividend as follows.
Cash 450
Dividend Revenue 450
At December 31, 2015, Republic’s investment in Hawthorne has the carrying value and fair
value shown.

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TABLE 4-16: Computation of Fair Value Adjustment—Non-Trading Equity Investment
(2015)
Republic records this adjustment as follows.
Fair Value Adjustment 3,250
Unrealized Holding Gain or Loss—Equity 3,250

TABLE 4-17: Financial Statement Presentation

On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares receiving
net proceeds of Br.22,500.
Computation of Gain on Sale of Shares
Net proceeds from sale Br. 22,500
Cost of Hawthorne shares 20,750
Gain on sale of shares Br. 1,750
Republic records the sale as follows.
Cash 22,500
Equity Investments 20,750
Gain on Sale of Equity Investment 1,750
Because Republic no longer holds any equity investments, it makes the following entry to
eliminate the Fair Value Adjustment account.
Dec 31, 2016
Unrealized Holding Gain or Loss—Equity 3,250
Fair Value Adjustment 3,250

Holdings Between 20% and 50%

An investment (direct or indirect) of 20 percent or more of the voting shares of an investee
should lead to a presumption that in the absence of evidence to the contrary, an investor has the
ability to exercise significant influence over an investee.
In instances of “significant influence,” the investor must account for the investment using the
equity method.

Equity Method
Record the investment at cost and subsequently adjust the amount each period for
 The investor’s proportionate share of the earnings (losses) and
 Dividends received by the investor.
If investor’s share of investee’s losses exceeds the carrying amount of the investment, the
investor ordinarily should discontinue applying the equity method.

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Illustration: Comparison of Fair Value Method and Equity Method
Assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the
fair value method in this example, assume that Maxi does not have the ability to exercise
significant influence, and classifies the securities as trading security. Where this example
applies the equity method, assume that the 20 percent interest permits Maxi to exercise
significant influence.

ENTRIES BY MAXI COMPANY

On January 2, 2014, Maxi Company acquired 48,000 shares (20% of Mini Company common
stock) at a cost of $10 a share.
Fair Value Method Equity Method
Equity Investments 480,000 Equity Investments 480,000
Cash 480,000 Cash 480,000
Table 4.18: Comparison of Fair Value Method and Equity Method
For the year 2014, Mini Company reported net income of $200,000; Maxi Company’s share is
20%, or $40,000.
Fair Value Method Equity Method
No Entry Equity Investments 40,000
Investment Income 40,000
TABLE 4-19: Comparison of Fair Value Method and Equity Method
At December 31, 2014, the 48,000 shares of Mini Company have a fair value (market price) of
$12 a share, or $576,000.
Fair Value Method Equity Method
Fair Value Adjustment 96,000 No Entry
Unrealized holding Gain or Loss 96,000*
*576,000-480,000= $ 96,000
TABLE 4-20: Comparison of Fair Value Method and Equity Method
On January 28, 2015, Mini Company announced and paid a cash dividend of $100,000; Maxi
Company received 20%, or $20,000.
Fair Value Method Equity Method
Cash $ 20,000 Cash $ 20,000
Dividend Revenue 20,000 Equity Investments 20,000
TABLE 4-21: Comparison of Fair Value Method and Equity Method
For the year 2015, Mini reported a net loss of $50,000; Maxi Company’s share is 20%, or
$10,000.
Fair Value Method Equity Method
No Entry Investment Loss $10,000
Equity Investments 10,000
TABLE 4-22: Comparison of Fair Value Method and Equity Method

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At December 31, 2015, the Mini Company 48,000 shares have a fair value (market price) of
$11 a share, or $528,000.

Fair Value Method Equity Method

Unrealized holding Gain or Loss 48,000* No Entry

Fair Value Adjustment 48,000
TABLE 4-23: Comparison of Fair Value Method and Equity Method

Fair Value Adjustment*

$ 96,000 ???

48,000#
#48,000= 528,000-480,000
???= 96,000-48,000= $48,000

Holdings of More Than 50%

Controlling Interest - When one corporation acquires a voting interest of more than 50
percent in another corporation.
 Investor is referred to as the parent.
 Investee is referred to as the subsidiary.
 Investment in the subsidiary is reported on the parent’s books as a long-term
investment.
 Parent generally prepares consolidated financial statements.

4.4 OTHER REPORTING ISSUES

Impairment of Value
For debt investments, a company uses the impairment test to determine whether “it is
probable that the investor will be unable to collect all amounts due according to the contractual
terms.”
This impairment loss is calculated as the difference between the carrying amount plus accrued
interest and the expected future cash flows discounted at the investment’s historical effective-
interest rate.
Illustration: At December 31, 2013, Mayhew Company has a debt investment in Bellovary
Inc., purchased at par for ¥200,000 (amounts in thousands). The investment has a term of four
years, with annual interest payments at 10 percent, paid at the end of each year (the historical
effective-interest rate is 10 percent). This debt investment is classified as held-for-collection.
Unfortunately, Bellovary is experiencing significant financial difficulty and indicates that it
will be unable to make all payments according to the contractual terms. Mayhew uses the
present value method for measuring the required impairment loss. Table 4.24 shows the cash
flow schedule prepared for this analysis.

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Using the following information record the loss on impairment.

TABLE 4-24: Investment Cash Flows

As indicated, the expected cash flows of $264,000 are less than the contractual cash flows of
$280,000. The amount of the impairment to be recorded equals the difference between the
recorded investment of $200,000 and the present value of the expected cash flows, as shown in
table 4.25.

TABLE 4-25: Computation of Impairment Loss

The loss due to the impairment is $12,680. Why isn’t it $16,000 ($280,000 2$264,000)? A loss
of $12,680 is recorded because Mayhew must measure the loss at a present value amount, not
at an undiscounted amount. Mayhew recognizes an impairment loss of $12,680 by debiting
Loss on Impairment for the expected loss. At the same time, it reduces the overall value of the
investment. The journal entry to record the loss is therefore as follows.
Loss on Impairment 12,680
Debt Investments 12,680
Recovery of Impairment Loss
If subsequently the impairment loss decreases, some or all of the previously recognized
impairment loss shall be reversed with a
 debit to the Debt Investments account and
 Crediting Recovery of Impairment Loss.
Reversal of impairment losses shall not result in a carrying amount of the investment that
exceeds the amortized cost that would have been reported had the impairment not been
recognized.

Transfers between Categories (Reading assignment)

Transferring an investment from one classification to another
 Should occur only when the business model for managing the investment changes.
 IASB expects such changes to be rare.

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  Companies account for transfers between classifications prospectively, at the
beginning of the accounting period after the change in the business model.
Illustration: British Sky Broadcasting Group plc (GBR) has a portfolio of debt investments
that are classified as trading; that is, the debt investments are not held-for-collection but
managed to profit from interest rate changes. As a result, it accounts for these investments at
fair value. At December 31, 2014, British Sky has the following balances related to these
securities.

Illustration: As part of its strategic planning process, completed in the fourth quarter of 2014,
British Sky management decides to move from its prior strategy—which requires active
management—to a held-for-collection strategy for these debt investments. British Sky makes
the following entry to transfer these securities to the held-for-collection classification.
Debt Investments 125,000
Fair Value Adjustment 125,000

4.5 Reporting Treatment of Investments

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TABLE 4-26: Summary of Investment Accounting Approaches

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