Dr. M.D.

Chase Business Combinations Long Beach State University

Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 1
I. BACKGROUND
A. Prior to 1993 most investments of less than 20 percent of the voting marketable equity securities (and any amount of the non-voting securities)
were accounted for under the provisions of SFAS-12 (Cost Method) and investments of more than 20 percent followed APB-18, the equity method.
Note that these methods apply to marketable equity securities and not debt. ( Investments in debt securities were recorded and carried at cost)
B. Deregulation of Financial Institutions in the 1980's and 1990's placed accounting for debt under increasing scrutiny due to the number of failures of
banks and savings and loans. Accounting standards that allow financial statements to overstate significantly a business enterprise's underlying
economic value--as was the case with many failed banks and savings and loans-- were harshly criticized. Many believed that a shift away from cost
and toward market value accounting was the best way to address this issue.
C. Scope of this Review: This handout reviews the Cost (SFAS-12), Equity (APB-18) and Fair Value Methods (SFAS-115) of accounting for
investments in marketable equity securities and debt.

SFAS-12 is superseded by SFAS-115 and is reviewed here to provide background for those who will be auditing financial statements prepared under its
rules for the foreseeable future.

II. COST AND EQUITY METHOD REVIEW (APB-18/SFAS-12)

A. The Equity Method (APB-18)
General: (1) Includes stocks, bonds and special purpose funds that do not qualify as current assets.
(2) Must be separately disclosed on the Balance Sheet

Marketable Securities: Accounting treatment is dependent upon (1) type of stock (voting/non voting) and (2) % owned (Pre-SFAS 115 Rules)

GAAP Prior to SFAS 115 (Cost Method SFAS 12/Equity Method APB18)

Characteristics Level of Ownership Reporting Method

a. No significant Influence
Non-voting all levels Cost (SFAS 12)
Voting < 20% Cost (SFAS 12)
b. Significant Influence
Voting only 20 to 50% Equity (APB 18)

c. Investments in Debt (no formal GAAP) amortized cost amortized cost

d. Controlling Interest (>50%)
Voting: Control not exercised Equity Business Combinations (APB-16)
Voting: Control exercised Consolidation

Comparison of Cost and Equity methods

1. Recording the investment:

COST METHOD Investment Account EQUITY METHOD Investment Account
Record @ Full Cost Record @ Full Cost - % Sub Dividends
• changed + or – + % of investee income - amortization of cost > BV
only due to liq div - amortization of purchased GW
- % of investee net loss
2. Revenue Recognition:
Dividend Revenue Equity in Subsidiary Net Income
to cash dividends received + any nominal credit - any nominal debit to Sub
to Sub

ƒ under the cost method, the investment
account will rarely change
ƒ Under the cost method the recognition
of revenue does not effect the
investment account
Both: Record at full cost ;
Full cost is all cost normal and necessary to
complete the acquisition except SEC cost and
stock issuance cost (SEC and stock issuance
cost are expensed)
ƒ under the equity method, the
investment account is constantly
changing
ƒ Under the equity method, the
investment account is effected by the
recognition of investee revenue
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 2
Background of SFAS 115: The FASB Rationale and Dissenting Opinions

Prior to the issuance of FASB Statement No. 115, investments in marketable equity securities were accounted for by the lower of aggregate cost
or market (LACM) method (SFAS12). There were no defined GAAP for investments in debt securities.

The use of the LACM method was widely criticized for two reasons.
a. LACM was not a relevant value because it did not reflect the liquidity of MES when the FMV exceeded the cost; (therefore, more funds could
be obtained through a sale in the current market than was indicated by the balance sheet).
b. LACM allowed companies to engage in what was often referred to as "gains trading." Gains trading meant that companies would sell those
securities that had a FMV above cost so that the realized gain on the sale would be included in income.
SFAS 115 has sparked controversy over four issues: The Statement was adopted by a 5-to-2 majority . The dissenters argued that all three
categories should be reported at FMV with all unrealized holding gains and losses included in income. This summary looks at the controversial
areas of SFAS 115 and discusses the FASB's position and its' rationale.
FMV is Required for Trading Securities and Securities Available for Sale (but not for Securities Held to Maturity
FASB Rationale:
1. Reporting MES at FMV assists users in evaluating the performance of a company's investment strategies and increase the comparability of
balance sheets;
2. FMV of investments also provides a better indication of the financial flexibility, or solvency, of companies, particularly financial institutions
for which a large portion of their assets are such securities.
3. In a liquidity shortage, the FMV of investments is the amount available to cover a company's obligations.
4. FMV of debt securities held to maturity is not relevant. If a debt security is held to maturity, the maturity value will be realized and any
interim unrealized holding gains and losses will reverse, therefore no cash flow change has occurred. (two dissenting Board members
argued that FMV would be preferable for these debt securities).
5. The FASB made the held-to-maturity category restrictive.
a. the use of the amortized cost method must be justified by management for each investment in a debt security
b. each acquisition requires management to establish the positive intent and ability to hold the security to maturity (which is not the same
as the absence of an intent to sell) Note: the initial classification involves judgments by management that may prove to be incorrect;
the judgment may be changed in future periods by unforeseen circumstances and result in a reclassification of the security
ƒ FMV is not required for certain liabilities;
FASB Rationale:
1. The desirability of requiring certain liabilities to be reported at FMV because they are "mirror images" of the assets was supported by financial
institutions which manage their interest rate risk by coordinating their holdings of financial assets and liabilities. This position argued that
financial statements would provide a more relevant view of a company's exposure to risk if some liabilities were also reported at FMV. They
felt that recognizing FMV on only one side of their portfolio introduces an inappropriate bias into their financial statements.
2. The FASB rejected the FMV reporting of liabilities because:
(a) it could not be agreed which liabilities should be reported at FMV;
(b) difficulties in obtaining a reliable value of the liabilities the that do not trade in an established market;
nonfinancial companies do not manage risk in the same way, and use the proceeds from borrowing to invest in physical and intangible
assets that are not reported at FMV.
Note: The FASB admitted that this conclusion represents a compromise, and one dissenter voted against adoption of SFAS 115 partly for this
reason.
ƒ Reporting of Unrealized Gains and Losses (unrealized holding gains and losses are reported in the income statement for trading securities
but directly in stockholders' equity for securities available for sale)
FASB Rationale:
1. Because trading securities are actively managed, income measurement for those securities is more relevant if it includes the results of
changes in FMV (i.e. unrealized holding gains and losses). The result is that income includes the results of economic events that occur in the
period and provides a better measure of the company's return on investment.
2. Including unrealized holding gains and losses in income for securities available for sale would create an unnecessary volatility into reported
income. When the intent is to hold securities for a long period, it is likely that any unrealized holding gains and losses will offset before the sale
occurs. Therefore including those gains and losses in income would also create an unnecessary volatility in income. The FASB concluded that
unrealized holding gains and losses on securities available for sale should not be included in income but instead be reported as a component of
stockholders' equity.
ƒ Classification of Securities is Based on Management Intent.
Dissenters Argued:
1. Classifying securities into three categories (Trading, Available for Sale and Hold to Maturity), each of which has different accounting
principles, and using management intent as a criterion to distinguish among the categories may result in an inconsistent application of the
principles. Companies with three identical securities could account for those securities using three different accounting methods and may
create a lack of comparability between the financial statements.
2. Transfers between categories, also based partly on management intent and judgment, allow for management of earnings because the gain
(or loss) is included in income.
FASB Rationale:
1. Despite these points, the overall relevance of the financial statements would be improved as a result of securities being classified subject to
managerial intent and the resulting increase in comparability.
Potential Problem area: Two dissenters were concerned that SFAS 115 does not eliminate or address the possibility of "gains trading". The
realized gain on a sale is the difference between the selling price and the cost of the security, and is included in income. A company may tend to
avoid selling a security classified as available for sale when its FMV is less than its cost. That sale would result in the recognition of a realized loss
in the income statement, whereas if the company continues to hold the security, the decline in value is included in stockholders' equity. The
decision not to sell avoids any income recognition of the decline in value. Thus companies are still able to "manage" the amount of income
that they report by selecting which securities to sell. The two dissenters were concerned that the Statement does not prevent this practice.
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 3
B. The Cost Method (SFAS-12) Cost Method Example
Note in the following example that SFAS12 allowed an asset to be written up only to the extent that it had previously been decreased to LACM and then
only to original cost basis, SFAS 115 allows write up to FMV even if FMV is above original cost.
--on 1/1/1 X purchases 10% (5,000 shares) of the outstanding shares of Y common ($5 par) for $12/share
--on 1/1/1 X purchases 4000 shares of Z preferred (fully redeemable, $10 par) for $20/share
--The market values for the next three years was as follows:
12/31/a Y c/s $10.00 Z p/s $21.00
7/15/b unexpectedly sold 1000 shares of Z p/s at $24/share
12/31/b Y c/s $10.50 Z p/s $22.00
7/31/c Y c/s $ 5.00 clearly not a temporary decline
12/31/c Y c/s reclassified as short term with a market value of $4.00 per share
REQUIRED: Present all necessary journal entries and supporting computations.

SOLUTION: COST METHOD EXAMPLE

1/1/a Long term investments in equity securities...................................... 140,000
Cash................................................................................................ 140,000
To record long term investment in Y c/s (5,000 @ $12/sh = $60,000) and Z p/s (4000 @ $20/sh = $80,000)

12/31/a Unrealized loss on long term investments........................................ 6,000

Allowance to reduce long term investments to market.......................... 6,000
Adjust accounts to lower of aggregate cost or market

Security Shares Cost Market Unrealized Gain (loss)

Y 5,000 @ $12 $ 60,000 $ 50,000 ($10,000)
Z 4,000 @ $20 $ 80,000 $ 84,000 4,000
$140,000 $134,000 ($ 6,000)

7/15/b Cash........................................................................... 24,000

Long term investments in equity securities................................... 20,000
Gain on sale of long term investments........................................ 4,000
To record sale and realized gain on sale of 1000 shares of Z p/s @ $24

12/31/b Allowance to reduce long term investment to market............................4,500

Unrealized gain.............................................................. 4,500
Adjust accounts to lower of aggregate cost or market

Y 5000 @ $12 $ 60,000 $ 52,500 ($ 7,500)

Z 3000 @ $20 $ 60,000 66,000 6,000
($ 1,500)

NOTE: THE ADJUSTMENT REQUIRED IS THE AMOUNT TO GET THE ALLOWANCE ACCOUNT TO $1,500 FROM $6,000)

7/31/C Loss from permanent decline in market value of Y c/s.......................... 35,000

Long term investment in equity securities.................................... 35,000
To record permanent decline in MV of Y c/s (5000 x $12-$5)

12/31/c Short term investment in MES................................................... 20,000

Loss on reclassification of investment from LT to ST........................... 5,000
Long term investments in equity securities................................... 25,000
To record change in classification of investment from Lt to ST portfolio
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 4
EQUITY METHOD EXAMPLE
Upper purchased 40% of the outstanding common stock of Lower on 7/1/1 for $30,000. At that date Lower's Balance sheet
looked as follows:
Asset Book Value FMV
Cash $ 10,000 $ 10,000
Inventory 25,000 30,000
Equipment 40,000 50,000
$ 75,000 90,000
Equities
Liabilities $ 25,000 $ 25,000
Stockholder's Equity 50,000 _ 65,000
$ 75,000 $ 90,000
Lower's earnings were as follows:
Quarter Amount
1 $ 6,000
2 5,000
3 6,000
4 8,000

Lower uses FIFO inventory and all goods on hand were sold by 12/21/1. Lower depreciates its equipment at the rate of 10%
a year. Intangibles are amortized over the maximum time permitted by GAAP. Lower paid dividends of $5,000 on 12/31/1
REQUIRED: PREPARE ALL NECESSARY JOURNAL ENTRIES TO REFLECT THESE FACTS
EQUITY METHOD SOLUTION
1. Analyze the investment: Cost......................................... $ 30,000
Purchased book value (40% of $50,000)........ _ 20,000 FMV accounts must always be written up
to full FMV (always means there are not
Excess of cost over purchased book value..... $ 10,000
exceptions to this rule!)
Attributable as follows:
FMV accounts: (CA; Liabilities; MES)
Inventory (current assets)............ (.4)(30-25) $ 2,000
NCA:
Equipment (noncurrent Assets)........... .4)(50-40) 4,000
Balance to Goodwill...................... _ 4,000 NOTE: Excess accounted for (must
always balance)
10,000

2. Entry at acquisition: (always recorded at FULL COST under the 5. Entry to amortize excess equipment value:
equity method; Full cost= all normal & necessary costs
Equity in earnings of Lower................. 200
Investment in Lower.......................... 30,000
Investment in Lower.................... 200
Cash.................................... 30,000
$4,000 x 1/10 x 2 year
3. Entry to Record equity in Lower earnings:
Investment in Lower ......................... 5,600
6. Entry to amortize purchased goodwill:
Equity in earnings of Lower............. 5,600
Equity in earnings of Lower................. 50
$6,000 + $8,000 (.4) = $5,600
Investment in Lower.................... 50
4. Entry to amortize excess inventory cost:
$4,000 x 1/40 x 2 year
Equity in earnings of Lower................. 2,000
Investment in Lower.................... 2,000
7. Entry to record receipt of dividend:
Cash........................................ 2,000
Investment in Lower.................... 2,000

III SFAS 115: ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 5

Accounting For Investments under SFAS-115

Type of Investment Method of Accounting Reporting Unrealized Holding Gains

Equity Securities

No Significant Influence (<20%)

a. Trading SFAS-115 (Fair Value) Income Statement
b. Available for Sale SFAS-115 (Fair Value) Balance Sheet

Significant Influence (20%-50%)

a. Voting Securities APB-18 Equity Method Not recognized

Control (>50%) APB-16 Consolidation Not recognized

Debt Securities

Trading Fair Value Income Statement

Available for Sale Fair Value Stockholders' Equity
Hold to Maturity Amortized Cost Not Recognized

A. Approaches: There generally are three approaches to adopting market value accounting:
1. Accounting for only certain assets.
a. Requiring market value accounting for certain types of assets, but not for liabilities, is the easiest approach to implement but can result I
n misleading financial reporting.
To illustrate the problem of marking to market only certain assets, the Federal National Mortgage Association (Fannie May) performed several
calculations on its own portfolio of mortgage-backed securities.

Step 1: the change in market value of Fannie Mae's approximately $15.8 billion mortgage backed securities portfolio between September 30 and
December 31,1991, was determined. (This period was selected because it witnessed a substantial decline in interest rates.)

Step 2: the change in value on the liability side of the balance sheet was calculated for the same period. Because asset maturities at Fannie Mae are
funded with liabilities of similar duration (match-funded), a pro rata share of the change in value of liabilities equal to the $15.8 billion in assets generated
the following results:

Unrealized gain on assets $490,000,000

Unrealized loss on liabilities (450.000.000)
Net unrealized gain $ 40,000,000

Note:
1. If only the mortgage securities were marked to market in the fourth quarter of 1991, additional pretax income of approximately $490 million would have
been recorded. ( The unrealized gain would have represented a 93% increase in pretax earnings in that quarter).

2. The $450 million unrealized loss on liabilities would not have been reported during the same quarter, substantially overstating true economic earnings.
On the other hand, the $40 million net unrealized gain, which included marking to market a pro rata share of the liabilities, would have represented only
about 8% of Fannie Mae's fourth-quarter 1991 pretax earnings.
The Point:
1. Marking only selected assets results in inaccurate reporting for match-funded institutions and provides no insight into their level of interest rate risk.

2. As the example illustrates, valuing only assets could lead one to conclude an institution has a great deal of interest rate risk when in fact it has
relatively little.

2. Linking selected liabilities to selected asset.

a. concept: If only some investment assets are marked to market, it seems logical to link certain liabilities to them so they also can be marked to
market. However, this is easier said than done. There generally are two methods of linking liabilities to part of the investment portfolio.
Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 6
1. Specific identification method. Specific debt issuances and other liabilities are assumed to fund specific investment securities. However,
when asset and liability maturities are managed in the aggregate, allocating specific funding components to investment securities is
highly subjective.
a. As both assets and assigned liabilities amortize over time, reallocations inevitably must be made to balance the amount of liabilities
linked to the specific assets marked to market. Reallocation of debt requires an inordinate amount of record keeping. In addition,
deciding which debt should be added to or deleted from the portfolio funding specific investments is arbitrary and has considerable
potential for earnings manipulation.

2. Notional-pro-rata method. A less subjective way of matching liabilities to investment securities, at least from an accounting perspective, is
to calculate the market value of all liabilities and provide a valuation account for the pro rata share of liabilities equal to the same
aggregate balance as the assets marked to market (the method used in the example above). The advantage of this approach is it makes
determining asset and liability linkage less subjective.
a. A pro rata approach, however, assumes all funding is fungible and not related to specific assets, highlighting its primary weakness.
Pro rata debt allocation when the maturities of the specific assets being marked to market are significantly different from the
maturities of other financial assets can distort financial reporting and make it less relevant. This would be so, for example, in the
case of an institution that invests in both securities backed by fixed rate mortgages and adjustable-rate mortgage loans (ARMs);
long-term fixed-rate securities and ARMs are funded in significantly different ways.

b. Another liability valuation challenge concerns core deposits. A certain core portion of demand deposits often exhibits an inelastic
relationship to interest rate changes. Depository institutions economically benefit from funding longer maturity investments with
low-cost core deposit accounts. When interest rates increase and thereby reduce investment assets' market value, some argue the
recorded value of core deposits also should be reduced. The proposition that core deposits have intrinsic value seems to be
bolstered by the fact that when financial institutions are sold, the economic value of core deposits is considered in determining the
institution's purchase value.

Many CPA's have a fundamental problem with reducing the recorded value of any liability below its settlement price. In addition, determining the
appropriate method of calculating changes in the value of core deposits is a concern. If core deposits are not adjusted for interest rate changes,
depository institutions face the same financial reporting problems that the assets-only approach presents.

3. Comprehensive market value approach. Comprehensive use of market values as the only method of accounting for financial
instruments eliminates both the subjectivity in evaluating investment intent and the difficulty in linking liabilities to specific assets.
However, establishing a range of values for complex debt instruments, commercial loans, liabilities and off-balance sheet items not
actively traded remains subjective. Such valuations are based on financial models driven by theoretical assumptions that are subject to
second-guessing or manipulation.

a. One of the benefits often ascribed to market value accounting is its ability to measure interest rate risk. It's true such accounting
highlights significantly mismatched maturities of assets and liabilities during periods of interest rate volatility. However, it is an
effective barometer of historical interest rate risk only when rates change. At a balance sheet date and during periods of low rate
volatility, when market values remain relatively constant, market value accounting provides little new information about the future
level of interest rate risk.

b. Another fundamental problem often associated with full market value accounting is the seeming contradiction of accounting for a
going concern as if its assets will be sold and its liabilities settled. In addition, a business's intangible or franchise value, which is a
component of stock market valuations, is not considered by market value accounting.
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 7
B. SFAS 115
SFAS 115 Summary

Class of Investments Types of Securities Classification Accounting Method

Trading securities Debt and Equity Current Assets FMV (Gains/losses to I/S

Available-for-Sale Debt and Equity (must be less than Current or Long-term based on FMV (Gains/Losses to SHE)
20% voting interest) intent of management

Hold-to-Maturity Debt Only Long-term Amortized Cost

Voting Equity Interest 20-50% of Voting Stock Long-term Equity Method (APB-18)

Over 50% of Voting Stock Eliminated in Consolidated Consolidated Financial Statements

Statements

FMV is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than
in a forced liquidation sale.

1. Scope: SFAS 115 applies to all investments in debt securities and to equity securities with readily determinable fair values. It supersedes FASB
Statement no. 12, Accounting for Marketable Securities ( it does not apply to loans or liabilities) SFAS-115 is effective for fiscal years beginning after
12/15/93. The effect of applying SFAS-115 is reported as a change in accounting principle with one exception: the unrealized holding
gain/loss (net of tax) for securities available for sale at the beginning of the year of adoption is an adjustment to the Unrealized
increase/decrease account.

Note: Controversy about SFAS-115 focus on four issues:

1. Fair value is required in the balance sheet for trading securities and securities available for sale but amortized cost is used for securities hold to
maturity
2. fair value is not required for certain liabilities
3. Unrealized holding gains/losses are reported in the income statement for trading securities but directly to SHE for securities available for sale
4. Classification of securities is based on management intent.

2. Accounting Procedures: Under Statement no. 115, securities are classified into three categories:
a. Hold to maturity. Debt securities meeting the requirements for this category are reported at amortized cost. Debt securities not included in
this classification and equity securities with readily determinable market values are assigned to one of the following categories.

1. Debt securities qualify for the amortized cost method only if the investor has the ability and a positive intent to hold them to maturity.
a. Positive intent is undermined if securities are sold in response to certain events but not others. In most situations, however, once a
debt security is put in the hold-to-maturity category, it generally cannot be sold or transferred to another category. Otherwise, the
cost method might not be available for some or all of the investment securities included in the hold-to-maturity category
2. The sale or transfer of hold-to-maturity securities for one of the following changes in circumstances shall not be considered to be
inconsistent with it's original classification:
a. evidence of significant deterioration in the issuer's creditworthiness
b. changes in tax law that eliminates or reduces tax exempt status on interest (but not changes in tax laws that revise the marginal tax
ate)
c. major business combination or disposition (such as sale of a segment) that necessitates the sale or transfer of hold-to-maturity s
securities to maintain the enterprise's existing interest rate risk position or credit risk policy
d. change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the
maximum level of investments in certain kinds of securities, thereby causing an enterprise to dispose of hold-to-maturity securities.
e. Significant increase by the regulator in the industries capital requirements that causes the enterprise to downsize by selling hold-to-
maturity securities
f. Significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes
g. Other events that are so isolated, nonrecurring, that they could not have been reasonably anticipated
3. An enterprise shall not classify a debt security as hold-to-maturity if the enterprise has the intent to hold the security for only an indefinite
Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 8
period or sold in response to:
a. Changes in market interest rates and related changes in prepayment risks
b. Needs for liquidity
c. Changes in the availability and yield on alternative investments
d. Changes in finding sources and terms
e. Changes in foreign currency risk
4. Sales of securities that meet either of the following are considered maturities for purposes classification as hold-to-maturity
a. sale occurs so near maturity or call date (if call is probable) that interest rate risk is substantially eliminated as a pricing factor
b. sale occurs after the enterprise has already collected a substantial portion (at least 85%) of the principal outstanding at acquisition
due either to prepayments or scheduled payments.

b. Trading. Securities: Debt and equity securities in this category are reported at fair value; changes in unrealized gains and losses are
included in the income statement. These securities are bought and sold to make short-term profits as opposed to being held to realize
longer-term gains from capital appreciation.

c. Available for sale. Debt and equity securities not assigned to one of the above categories are included here. These investments also are
reported at fair value, but unrealized gains and losses (net of tax effects) are reported in a separate component of shareholders' equity.

Key Provisions of Statement no. 115:

Dividend and interest income, including amortization of premium and discount, continue to be included in income for all three categories of investment.

All realized gains and losses resulting from sales of any of the three categories of investments are included in income.

Investments may be written up above cost.

A write-down to a new cost basis will be recorded in earnings for securities classified as either available for sale or held to maturity that have an other
than temporary decline in fair market value below amortized cost. (Permanent Decline)

Mortgage-backed securities held for sale in conjunction with mortgage banking activities, currently accounted for at the lower of cost or market under
FASB Statement no. 65, Accounting for Certain Mortgage Banking Activities, are classified as trading securities. Other mortgage-backed securities are
classified based on the other criteria discussed previously.

Not-for-profit organizations, entities already reporting substantially all investments at fair value, investments in equity securities accounted for under the
equity method and investments in consolidated subsidiaries are excluded.

Financial Statement Presentation Disclosure Requirements:

Trading Securities: presented as current assets a. Securities classified as available-for-sale and hold-to-
Available-for-sale and hold-to-maturity: classified as current or non-current maturity:
as appropriate 1. aggregate fair value
Cash Flow Presentation 2. gross unrealized holding gains/losses
a. Trading Securities: Classified as operating activities 3. amortized cost basis by major security type as of each
1. purchases dated for which financial statements are presented
2. sales b. Financial institutions (banks, S&L's, credit unions, finance
3. maturities of hold-to-maturity securities companies etc) shall disclose at least the following major
security types:
b. Investing Activities Classified as investing activities 1. Equity securities
1. purchases 2. US Govt debt securities
2. sales 3. State debt securities
3. maturities of hold-to-maturity securities 4. Foreign Govt debt securities
5. Corporate debt securities
6. Mortgage debt securities
7. Other debt securities
 Dr. M.D. Chase Business Combinations Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 9
Summary of Disclosure Requirements Under the Provisions SFAS 115

Balance Sheet Disclosures:

Balances: For securities classified as available for sale or hold to maturity, disclosure is made (as of each balance sheet date and for each major
security type) of
Aggregate fair value.
Gross unrealized holding gains.
Gross unrealized holding losses.
Amortized cost basis.

Maturities: As of the date of the most recent financial statement presented, information must be disclosed about contractual maturities. Financial
institutions must disclose separately for securities classified as available for sale and those classified as hold to maturity the fair value and amortized cost
based on at least four maturity groupings:

Within 1 year.
After 1 year through 5 years.
After 5 years through 10 years.
Over 10 years.

Securities not due at a single date (such as mortgage-backed securities) may be disclosed separately rather than allocated among several groupings. If
they are allocated, however, the basis of allocation must be disclosed.

Income statement Disclosures:

• For each period an income statement is presented, the following disclosures are made:
• Proceeds from sale of available-for-sale securities and the gross realized gains and losses on those sales.
• The cost basis (specific identification, average cost, etc.) used in computing realized gains and losses.
• Gross gains and losses included in earnings resulting from transfers from available for sale to trading.
• The change during the period in net unrealized holding gain or loss on available-for-sale securities included in shareholders' equity.
• The change during the period in net unrealized holding gain or loss on trading securities included in earnings.
• For any hold-to-maturity securities sold (or transferred to another category), the security's amortized cost, the resulting realized or unrealized
gain or loss and the circumstances leading to the decision to sell or transfer are disclosed.

6. Transfers among investment categories: Special consideration must be given to transfers among the three categories of investment. These issues
are summarized below:

Summary of Accounting for Gains/Losses for Transfers Among Investment Classifications

General Rule: Transfers among the three categories are accounted for as sales and repurchases at fair value. The unrealized gain or loss at the transfer
date is accounted for as follows:

Transfers from trading. There is no reversal of an unrealized gain or loss that is already recognized in earnings.

Transfers into trading. Any unrealized gain or loss is recognized in earnings immediately.

Transfers from hold to maturity to available for sale. Any unrealized gain or loss is recognized immediately as a separate component of shareholders'
equity.

Transfers from available for sale to hold to maturity. The unrealized gain or loss already reflected in a separate component of shareholders' equity at
the date of transfer is not reclassified but is amortized over the remaining life of the security as a yield adjustment consistent with the method of
amortizing any related premium or discount.
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 10
Important Definitions

Debt security: Any security representing a creditor relationship with an enterprise. It also includes (a) preferred stock that by its terms either must be
redeemed by the issuing enterprise or is redeemable at the option of the investor and (b) a collateralized mortgage obligation (CMO) (or other instrument)
that is issued in equity form but is required to be accounted for as a nonequity instrument regardless of how that instrument is classified (that is, whether
equity or debt) in the issuer's statement of financial position. However, it excludes option contracts, financial futures contracts, forward contracts, and
lease contracts.
Thus, the term debt security includes, among other items, U.S. Treasury securities, U.S. government agency securities, municipal securities, corporate
bonds, convertible debt, commercial paper, all securitized debt instruments, such as CMOs and real estate mortgage investment conduits (REMICs), and
interest-only and principal-only strips.

Trade accounts receivable arising from sales on credit by industrial or commercial enterprises and loans receivable arising from consumer, commercial,
and real estate lending activities of financial institutions are examples of receivables that do not meet the definition of security; thus those receivables are
not debt securities (unless they have been securitized, in which case they would meet the definition).

Equity security: Any security representing an ownership interest in an enterprise (for example, common, preferred, or other capital stock) or the right to
acquire (for example, warrants, rights, and call options) or dispose of (for example, put options) an ownership interest in an enterprise at fixed or
determinable prices. However, the term does not include convertible debt or preferred stock that by its terms either must be
redeemed by the issuing enterprise or is redeemable at the option of the investor.

Fair value: The amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or
liquidation sale. If a quoted market price is available for an instrument, the fair value to be used in applying this Statement is the product of the number of
trading units of the instrument times its market price.

Holding gain or loss: The net change in fair value of a security exclusive of dividend or interest income recognized but not yet received and exclusive of
any write downs for other-than-temporary impairment.

Security: A share, participation, or other interest in property or in an enterprise of the issuer or an obligation of the issuer that (a) either is represented by
an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on
behalf of the issuer, (b) is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly
recognized in any area in which it is issued or dealt in as a medium for investment, and (c) either is one of a class or series or by its terms is divisible into
a class or series of shares, participation, interests, or obligations.

Trading Security: Securities that are bought and sold to make short-term profits as opposed to being held to realize longer-term gains from capital
appreciation.

Available-for Sale Security: Debt or equity securities that are not classified as either trading or hold-to-maturity

Hold to Maturity Security: Debt securities which the holder has both the intent and ability to hold until maturity

FMV Method Example

Example 1: INVESTMENTS IN DEBT AND EQUITY SECURITIES AVAILABLE FOR SALE
Assume that the LYC Company acquires the following securities on May 1, 19X5 as an investment in securities available for sale:

A Company common stock 100 shares at $50 per share (100 x $ 50= $ 5,000)
B Company common stock 300 shares at $80 per share (300 x $ 80= $24,000)
C Company preferred stock 200 shares at $120 per share (200 x $120= $24,000)
D Company 10% bonds with a face value of $15,000 at par plus accrued interest. $15,000)
$68,000
Interest on the bonds is payable on May 31 and November 30 each year.
A. Recording Initial Cost of Investments in Debt and Equity Securities
1. All investments in securities are recorded initially at full cost (all cost normal and necessary to get asset ready for intended use).

Investment in Securities Available for Sale 68,000

Interest Revenue ($15,000 x 0.10 x 5/12) 625
Cash 68,625
B. Recording Interest (on debt securities) and Dividend Revenue (on Equity Securities)
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 11
1. Interest revenue is recorded as it is earned during the period. On May 31, 19x5, the semiannual interest on the D Company bonds is received and
recorded as follows:

Cash 750
Interest Revenue ($15,000 x 0.10 x 1/12) 125
Interest Receivable ($15,000 x 0.10 x 5/12) 625

Because the LYC Company initially debited interest revenue for 5 months of accrued interest on the date of acquisition, it credits interest revenue for
the full 6 months of interest received. Therefore, by May 31 it has earned one month's interest and has that amount recorded in its accounting
system. If the D Company bonds were purchased at a premium or discount, the interest revenue would be computed using the effective interest
method and a portion of the premium or discount would be amortized.

For the year, the LYC has earned interest revenue for 8 months, or $1,000 ($15,000 x 0.10 x 8/12).

Dividend revenue is recorded when declared. So if the LYC Company receives dividends during 19x5 of $3,000 on its investments in the stock of A, B,
and C companies, it records the following:
Cash 3,000
Dividend Revenue 3,000

Recognition of Interest Revenue

It is technically more correct to record the Dividend Revenue when the dividends are declared by the investee company because that is the date on
which the investor has the right to receive them. If dividends have been declared at year-end but not received, then the investor should recognize
Dividends Receivable and Dividend Revenue (1) so as to recognize the appropriate asset values and income and (2) because the dividends
receivable affect the calculation of any unrealized holding gain or loss.

Difference in recognition of Interest Revenue and Dividend Revenue

Note the different recognition of interest revenue and dividend revenue. Interest revenue accrues continuously over time, whereas dividend revenue
is only recognized when dividends are declared.

C. Recognition of Unrealized Holding Gains and Losses on Securities Available For Sale
1.Unrealized gains and losses are result from changes in securities FMV when the securities are still part of the investment portfolio (i.e. the securities
have not been sold)
2. Securities available for sale are reported at FMV (at BS date) and unrealized holding gains and losses are included directly in stockholders' equity.
3. The fair values are determined by the year-end market prices on a securities exchange. To illustrate, assume that the total fair value of the securities
held by the LYC Company is $71,000 on December 31, 19x5 as follows:
Cumulative
12/31/x5 Change
Security Cost FMV in FMV*
100 shares of A Company common stock $ 5,000 $ 6,000 $1,000
300 shares of B Company common stock 24,000 23,500 (500)
200 shares of C Company preferred stock 24,000 26,000 2,000
$15,000 D Company 10% bonds 15,000 15,500 500
Totals $68,000 $71,000 $3,000

*Represents what the balance in the Allowance* for Change in Value of Investment Account should be.

Determining the” Cost" of Securities

If the bonds had been purchased at a premium or discount, the amortized cost (i.e., carrying value) would have been used in the "cost" column.

The $3,000 increase in the value of the securities is recorded as follows:

Allowance* for Change in Value of Investment 3,000
Unrealized Holding gains and Losses 3,000

The Nature of the Allowance and Unrealized Increase/Decrease Accounts

 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 12

The Allowance account is a contra account to Investment in Securities Available for Sale; (the use of an Allowance account to record the changes in
the fair values of the securities maintains the original cost of each security to facilitate the computation of the realized gain or loss on the sale of a
security)
Another reason for the use of a contra account is that the fair value method is not allowed for federal income tax purposes (cost information also has
to be retained for computing taxable income)
The Unrealized Holding Gains/Losses account is an adjunct/contra stockholders' equity account.

Subsequent increases or decreases in fair value are recognized in a similar way. Suppose that on December 31, 19x6, the fair value of the securities is
$66,000 as follows:

Cumulative 12/31/x6 Change

Security Cost FMV in FMV
100 shares of A Company common stock $ 5,000 $ 6,100 $1,100
300 shares of B Company common stock 24,000 2,700 (1,300)
200 shares of C Company preferred stock 24,000 23,200 (800)
$15,000 D Company 10% bonds 15,000 14,000 (1,000)
Totals $68,000 $ 66,000 $ (2,000)

Allowance for Change in Value of Investment

12/31/x5 (1/1/x6) BB 3,000
(5,000) Adjustment 12/31/x6
(2,000) EB 12/31/x6

Unrealized Holding gains and Losses 5,000

Allowance for Change in Value of Investment 5,000

Financial Statement Presentation

On its December 31, 19x6 balance sheet, the LYC Company reports the investment as an asset at the $66,000 fair value of the securities ($68,000
cost - $2,000 allowance) and the $2,000 cumulative unrealized decrease in value ($3,000 unrealized holding gain at 12/31/x5 - $5,000 unrealized
holding loss at 12/31/x6) as a reduction in stockholders' equity
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 13
D. Realized Gains and Losses on Sales of Securities Available for Sale
1. Realized gains/losses (the difference between the selling price and the cost of an equity security or the amortized cost of a debt security) result from
the sale of securities and are reported in the income statement.
2. Because the security is no longer in the portfolio of securities available for sale, the cumulative balance in the allowance account and the cumulative
unrealized holding gains/losses reported at the previous balance sheet date must be "reversed" out of the accounts.

To illustrate, suppose that in 19x7 the LYC Company sold the 100 shares of A Company common stock for $6,000. The cost of the securities was $5,000
and the fair value at the previous balance sheet was $6,100 as follows:
12/31/x6 Change
Security Cost FMV in FMV
100 shares of A Company common stock $ 5,000 $ 6,100 $1,100

The company recognizes a gain of $1,000 ($6,000 selling price - $5,000 cost) and eliminates the $1,100 cumulative unrealized increase (and allowance)
on the A company stock. The company records the sale as follows:

Cash (Sales Price) 6,000

Unrealized Holding Gains/Losses (Balance per last BS date) 1,100
Investment in Securities Available for Sale (original cost) 5,000
Allowance for Change in Value of Investment (Balance per last BS date) 1,100
Gain on Sale of Securities Available for Sale (Sales price - Original Cost) 1,000

To illustrate a loss on a sale, suppose that in 19x7 the LYC Company also sold the 300 shares of B Company common stock for $22,000. The cost of the
securities was $24,000 and the fair value at the previous balance sheet was $22,700 as follows:
12/31/x6 Change
Security Cost FMV in FMV
100 shares of A Company common stock $ 5,000 $ 6,100 $1,100
300 shares of B Company common stock 24,000 22,700 (1,300)

In this case, the company recognizes a loss of $2,000 ($22,000 selling price$24,000 cost) and eliminates the $1,300 cumulative unrealized decrease
(and allowance) on the B company stock. The company records the sale as follows:

Cash (Sales Price) 22,000

Unrealized Holding Gains/Losses (Balance per last BS date) 1,300
Loss on Sale of Securities Available for Sale (Sales price - Original Cost) 2,000
Investment in Securities Available for Sale (original cost) 24,000
Allowance for Change in Value of Investment (Balance per last BS date) 1,300

Example 2: INVESTMENTS IN DEBT SECURITIES HOLD TO MATURITY

A. Recording Initial Cost of Debt Securities Hold to Maturity

Assume that 9% bonds with a face value of $100,000 are purchased on August 1, 19X5 at 99 plus accrued interest. Interest on these bonds is paid
semiannually on May 31 and November 30. The journal entry on August 1, 19X5 to record this acquisition is:

Investment in Debt Securities Held to Maturity ($100,000 x .99) 99,000*

Interest Receivable ($100,000 x 0.09 x 2/12) 1,500
Cash 100,500

* Note that the investment is recorded at full cost (not face as in the case of a bond payable). the $1,000 discount is included directly in the Investment
account and is amortized as an adjustment to interest revenue.
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 14

Recognition and Amortization of Bond Premiums and Discounts

Investments in debt securities hold to maturity that are purchased at a premium or discount result in an effective interest rate that is different than the
stated rate.
Premium amortization result in an effective interest rate lower than the stated rate, whereas discount amortization result in an effective interest rate
higher than the stated rate. Any premium or discount is amortized over the remaining life of the bonds in order to assign the proper amount of interest
revenue to each accounting period.
The effective interest and straight-line methods are the alternative procedures that are used to record interest revenue and account for premiums and
discounts. However, APB Opinion No. 21 requires use of the effective interest method, unless the use of the straight-line method does not result in a
material difference in the amount of interest revenue recognized in any year..

B. Accounting for Premiums and Discounts on Investments in Debt Securities Held to Maturity
1. Accounting for Premiums: Assume that Rhett Company acquires an investment in bonds that will be held to maturity with a face value of $100,000 for
$102,458.71 on January 1, 19X5(the interest date). These bonds carry a stated interest rate of 13% that is payable semiannually on June 30 and
December 31, mature on December 31, 19x7, and yield an effective interest rate of 12%. The journal entry on January 1, 19X5 to record the acquisition
is as follows:

Investment in Debt Securities Held to Maturity 102,458.71

Cash 102,458.71

The first interest receipt on June 30, 19X5 using the effective interest method for the bonds purchased at a premium is recorded as follows:

Cash 6,500.00
Investment in Debt Securities Held to Maturity (see amortization schedule) 352.48
Interest Revenue (.12 x 102,458.71 x 1/12) 6,147.52

2. Accounting for Discounts: Assume that Rhett acquired the bonds on the interest date at an amount that would produce a yield of 14%. Present the
necessary computations and journal entry:

Price paid by Rhett to make the bond investment yield 14%:

PV of $100,000 n=6; i=7 (100,000 x .666342) = $ 66,634.20

PV of $ 6,500 n=6; i=7 ( 6,500 x 4.766540) = 30,982.51
$ 97,616.71

Record the purchase of the bonds at a discount:

Investment in Debt Securities Held to Maturity 97,616.71*
Cash 97,616.71
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 15

3. Present the Effective Interest Amortization Table for the Bond Investment

Bond Amortization Table: Bonds Purchased on the Interest Date

Date Cash Effective Interest Amortization Carrying Value

Debit (Yield x Carrying Value)
(Stated Interest x Face)

1/1/x5 $ 97,616,71

6/30/x5 6,500 6,833.17 333.17 97,949.88

12/31/x5 6,500 6,856.49 356.49 98,306.37

6/30/x6 6,500 6,881.45 381.45 98,687.82

12/31/x6 6,500 6,908.15 408.15 99,095.97

6/30/97 6,500 6,936.72 436.72 99,532.69

12/31/97 6,500 6,967.31 467.31 100,000.00

C. Amortization for Bonds Acquired Between Interest Dates

• Assume that 13% bonds with a face value of $200,000 are purchased by the Dallas Company at a price to yield 12% on April 3, 19X5.
• Interest on these bonds is payable June 30 and December 31.
• The bonds mature December 31, 19x7 (33 months after the date of purchase).
Present the necessary journal entries to record the purchase and subsequent interest receipts.

Price paid by Rhett to make the bond investment yield 12%:

Sum: PV of $200,000 n=5.4882* i=.06 1(200,000 x .7263005) = $ 145,260.10
Annuity: PV n=.5; i=.06 of PV of $ 13,000 n=5; i=.06 (13,000 x 4.212363846)(.97128581) = 53,188.32
PV of first annuity payment to be received in 3 mos n=.5; i=.6 (.97128581)(13,000) = 12,626.72
Price Paid for the Bond to Yield 12%: $ 211,075.14

Investment in Debt Securities Held to Maturity (211,075.14 - Interest receivable) 204,575.14

Interest Receivable ($200,000 x 0.13 x 3/12) 6,500.00
Cash 211,075.14
Premiums/Discounts and Interest Revenue/Expense
The $4,575.14 premium is amortized over the remaining 33-month life of the bond issue using the effective interest method.
The effect of purchasing at a premium is to render the yield less than the stated rate
The effect of purchasing at a discount is to render the yield greater than the stated rate.
 Dr. M.D. Chase Long Beach State University
Advanced Accounting-130 Review of Cost/Equity/Fair Value Methods Page 16

Amortization Table (Bonds Purchased Between Interest Dates)

Date Cash Effective Interest Amortization Carrying Value

Debit (Yield x Carrying Value)
(Stated Interest x Face)

4/3//x5 $204,575.14

6/30/x5 13,000 12,637.25* 362.75 204,212.39

12/31/x5 13,000 12,252.74 747.26 203,465.14

6/30/x6 13,000 12,207.91 792.09 202,673.05

12/31/x6 13,000 12,160.38 839.62 201,833.43

6/30/97 13,000 12,110.01 889.94 200,943.43

12/31/97 13,000 12,056.61 943.43 200,000.00

Receipt of Interest Payments
June 30, 19X5

Cash 13,000
Interest Receivable 6,500.00
Interest Revenue (per table) 12,637.25
Investment in Debt Securities Held to Maturity (per table) 362.75

December 31, 19X5

Cash 13,000
Interest Revenue (per table) 12,252.74
Investment in Debt Securities Held to Maturity (per table) 747.26

D. Sale of Investment in Bonds Before Maturity

Sales prior to the maturity date of bonds being held to maturity will be rare because the sale will violate the original intent behind the acquisition and the
valuation procedures underlying that intent. However, changes in circumstances are not inconsistent with the original intent.
When such a sale occurs, it is necessary to record any gain or loss from the transaction. Also, the Investment account is eliminated, and any interest
earned since the last interest date is collected from the purchaser.
Prior to computing the gain or loss on the sale of an investment, premiums and discounts on the bond are amortized from the last interest date to the
sale date. This procedure is necessary to ensure that the correct amount of interest revenue has been recorded, and to determine the carrying value of
the investment on the date of the sale.

Assume that the $100,000 of 13% bonds purchased for $97,616.71 discussed in part B above were sold on March 31, 19x6 for $102,000 plus accrued
interest. The following journal entries are made on March 31, 19x6

Amortize Premium from last payment to date of sale to Bring the carrying Value of the Investment up to date:
Investment in Debt Securities Held to Maturity (6,500/2) -(98,306.37 x .07 x3/6) 190.07
Interest Revenue (Payment for period covered- effective interest for period) 190.07
Record Sale of the Bond Investment
Cash ($102,000 + $3,250) 105,250
Interest Revenue ($100,000 x .065 x 3/6) 3,250.00
Investment in Debt Securities Held to Maturity ($98,306.37 per table + $190.07) 98,496.44
Gain on Sale of Debt Securities 3503.56