1. The problems of accounting for investments involve measurement, recognition, and disclosure.
Investments are generally classified as either debt securities or equity securities. Chapter 18 covers both
temporary and long-term investments. The first section presents accounting for debt securities; the
second section covers accounting for equity securities; and the remainder of the chapter presents the
equity method of accounting, disclosure requirements, impairments, and accounting for the transfer of
investment securities between categories.
2. (S.O. 1) Debt Securities are instruments representing a creditor relationship with an
enterprise. Debt securities include U.S. government securities, municipal securities, corporate bonds,
convertible debt, commercial paper, and all securitized debt instruments.
3. Debt securities are grouped into the following three separate categories:
a. Held-to-maturity: Debt securities that the enterprise has the positive intent and ability
to hold to maturity.
b. Trading: Debt securities bought and held primarily for sale in the near term to generate
income on short-term price differences.
c. Available-for-sale: Debt securities not classified as held-to-maturity or trading
Held-to-Maturity Debt Securities
4. Held-to-maturity debt securities are accounted for at amortized cost, not fair value. A Held-to
Maturity Securities account is used to indicate the type of debt security purchased. Discounts and
premiums on long-term investments in bonds are amortized in a manner similar to discounts and
premiums on bonds payable. The effective interest method is required unless some other method--such
as straight-line--yields a similar result.
Available-for-Sale Debt Securities
5. Available-for-sale debt securities are reported at fair value. The unrealized gains and losses
related to changes in the fair value of available-for-sale debt securities are recorded in an unrealized
holding gain or loss account. This account is reported as other comprehensive income and as a separate
component of stockholders' equity until realized. A valuation account called "Securities Fair Value
Adjustment (Available-for-Sale)" is used instead of debiting or, crediting the Available-for-Sale
Securities account to enable the company to maintain a record of its amortized cost.
6. If bonds carried as investments in available-for-sale securities are sold before the maturity date,
entries must be made to amortize the discount or premium to the date of sale and to remove from the
Available-for-Sale Securities account the amortized cost of bonds sold. The realized gain or loss is
reported in the Other Revenues and Gains section or the Other Expenses and Losses section of the
*Note: All asterisked (*) items relate to material contained in the Appendices to the chapter.
All double asterisked (**) items relate to material contained on the John Wiley web site.
7. Trading securities are reported at fair value, with unrealized holding gains and losses reported
as part of net income. Any discount or premium is not amortized. A holding gain or loss is the net
change in the fair value of a security from one period to another, exclusive of dividend or interest
revenue recognized but not received. A valuation account called "Securities Fair Value Adjustment
(Trading)" is used instead of debiting or crediting the Trading Securities account.
8. (S.O. 2) Equity securities are described as securities representing ownership interest such as
common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership
interests at an agreed upon or determinable price such as warrants, rights, and call options or put options.
9. 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. Investments by one corporation in the common stock of another and the
accounting method to be used can be classified according to the percentage of the voting stock of the
investee held by the investor:
a. Less than 20% Fair Value Method
b. Between 20% and 50% Equity Method
C. More than 50% Consolidated Statements
Fair Value Method
10. When an investor has an interest of less than 20%, it is presumed that the investor has little or
no influence over the investee. If market prices are available, the investment is valued and reported
subsequent to acquisition using the fair value method. The fair value method requires that companies
classify equity securities at acquisition as available-for-sale securities or trading securities.
11. When acquired, available-for-sale equity securities are recorded at cost. Net income earned by
the investee is not considered a proper basis for recognizing income from the investment by the investor.
Therefore, net income is not considered earned by the investor until cash dividends are declared by the
investee. The net unrealized gains and losses related to changes in the fair value are recorded in an
Unrealized Holding Gain or Loss-Equity account that is reported as a part of other comprehensive
income and as a separate component of stockholders' equity until realized.
12. The accounting entries to record trading equity securities are the same as for available-for-sale
equity securities except for recording the unrealized holding gain or loss. For trading equity securities,
the unrealized holding gain or loss is reported as part of net income.
13. (S.O. 3) When an investor has a holding interest of between 20% and 50% in an investee
corporation, the investor is generally deemed to exercise significant influence over operating and
financial policies of the investee. The FASB has also listed other factors to consider in determining
whether an investor can exercise "significant influence" over an investee. In instances of "significant
influence," the investor is required to account for the investment using the equity method.
14. Under the equity method the investment's carrying amount is periodically increased
(decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by
all dividends received by the investor from the investee. The investor must record as separate
components the amount of ordinary and extraordinary income as reported by the investee.
15. Under the equity method, if an investor's share of the investee's losses exceeds the carrying
amount of the investment, the investor should discontinue applying the equity method and not recognize
additional losses (unless the investor's loss is not limited).
16. The following transactions illustrate the journal entries for an investment accounted for under
the equity method.
a. On 1/3/02 Workowski Corporation purchased 55,000 shares (26%) of Wendy
Company at a cost of $8 per share.
Investment in Wendy Company........................... 440,000
Cash ................................................................ 440,000
b. At the end of 2002 Wendy Company reported net income of $350,000 (all
ordinary). Workowski's share is $91,000 ($350,000 x .26).
Investment in Wendy Company........................... 91,000
Revenue from Investment ............................... 91,000
c. In early 2003, Wendy Company paid a $75,000 dividend. Workowski's share is
$19,500 ($75,000 x .26).
Cash ..................................................................... 19,500
Investment in Wendy Company ...................... 19,500
d. Wendy Company reported a $215,000 net loss (all ordinary) in 2003. Workowski's
share is $55,900.
Loss on Investment .............................................. 55,900
Investment in Wendy Company ...................... 55,900
Consolidated Financial Statements
17. When one corporation (the parent) acquires a voting interest of more than 50% in another
corporation (the subsidiary), the investor corporation is deemed to have a controlling interest. When
the parent treats the subsidiary as an investment, consolidated financial statements are generally
prepared instead of separate financial statements for the parent and the subsidiary. The subject of when
and how to prepare consolidated financial statements is discussed extensively in advanced accounting. If
the parent and the subsidiary prepare separate financial statements, the investment in the common stock
of the subsidiary is presented as a long-term investment on the financial statements of the parent under
the equity method.
Financial Statement Presentation of Investments
18. (S.O. 4) As indicated, unrealized holding gains and losses related to available-for-sale
securities are reported as part of other comprehensive income. The reporting of changes in unrealized
gains or losses in comprehensive income is straightforward unless securities are sold during the year--
then a reclassification adjustment is necessary.
19. Held-to-maturity, available-for-sale, and trading securities should be presented separately on
the balance sheet or in the related notes. Trading securities should be reported at aggregate fair value as
current assets. Individual held-to-maturity and available-for-sale securities are classified as current or
noncurrent depending upon the circumstances.
20. (S.O. 5) Each period every investment must be evaluated to determine if it has suffered a loss
in value that is other than temporary (an impairment). If an investment is deemed impaired, the cost
basis of the individual security is written down to a new cost basis. The amount of the writedown is
accounted for as a realized loss and, therefore, included in net income.
Transfers Between Categories
21. (S.O. 6) Transfers between any of the investment categories are accounted for at fair value.
When transferring from trading investments to available-for-sale investments, stockholders' equity and
net income are not affected. When transferring from available-for-sale investments to trading
investments, unrealized gains or losses reported in stockholders' equity are reversed and the gain or loss
is recognized in net income.
*22. (S.O. 7) Appendix 18-C discusses in detail the following special issues: (1) revenue from
investments in equity securities, (2) dividends received in stock, (3) stock rights, (4) cash surrender value
of life insurance, and (5) accounting for funds.
Dividends Received in Stock
*23. Shares received as a result of a stock dividend or stock split do not constitute revenue to the
recipients. The recipient of such additional shares would make no formal entry, but should make a
memorandum entry and record a notation in the investments account to show that additional shares have
*24. Stock Rights are issued to existing corporate stockholders when a corporation is about to sell
additional shares of an issue already outstanding. Upon receiving the rights, the carrying amount of the
original shares held is now the carrying amount of those shares plus the rights, and it should be allocated
between the two on the basis of their total market values at the time the rights are received.
*25. The investor who receives rights to purchase additional shares has three alternatives:
a. To exercise the rights by purchasing additional stock.
b. To sell the rights.
c. To permit them to expire without selling or using them.
*26. Assets set aside in special purpose funds are of two general types: (a) those in which cash is
set aside for meeting specific current obligations and (b) those that are not directly related to current
operations and are therefore in the nature of long-term investments. Examples of the first type include
Petty Cash Fund Payment of small expenditures, in currency
Payroll Cash Account Payment of salaries and wages
Dividends Cash Account Payment of dividends
Interest Fund Payment of interest on long-term debt
*27. Examples of funds not directly related to current operations and the purpose of each are:
Sinking Fund Payment of long-term indebtedness
Plant Expansion Fund Purchase or construction of additional plant
Stock Redemption Fund Retirement of capital stock (usually preferred stock)
Contingency Fund Payment of unforeseen obligations
*28. To keep track of the assets, revenues, and expenses of funds, it is desirable to maintain
separate accounts. If the securities purchased for the fund are to be held temporarily, they would be
treated in the accounts in the same manner as temporary investments.
*29. Although funds and reserves (appropriations) are not similar, they are sometimes confused
because they may be related and often have similar titles. A fund is always an asset and always has a
debit balance; a reserve is an appropriation of retained earnings, always has a credit balance, and is never
Accounting for Derivative Instruments
*30. (S.O. 8) In general derivatives are a product that has been developed to manage the risks due
to changes in market prices and include such things as interest-rate swaps and options and current futures
and options, stock-index future and options, cap, floors, commodity futures, swaptions, leaps, and
collaterized mortgage obligations. They are called derivatives because their value is derived from values
of other assets (for example stock, bonds, or commodities) or is related to a market-determined indicator
(for example, interest rates or the Standard and Poor's stock composite index).
*31. Any individual or company that wants to insure against different types of business risks often
can use derivative contracts to achieve this objective. Producers and consumers both find derivatives
useful so they can hedge their positions to ensure an acceptable financial result. A speculator is betting
that the change in the derivative value will go a certain way and therefore makes the purchase with the
purpose of gaining earnings based on their prediction. An arbitrageur purchases and sells derivatives in
an attempt to exploit inefficiencies in various derivative markets.
Basic Principles in Accounting for Derivatives
*32. (S.O. 9) Derivatives should be recognized in the financial statements as assets and liabilities
and should be reported in the balance sheet at fair value. On the income statement, any unrealized gain or
loss should be recognized in income if the derivative is used for speculation purposes. If the derivative is
used for hedging purposes, the accounting for any gain or loss depends on the type of hedge used.
*33. When distinguishing between the differences of traditional and derivative financial
instruments, a derivative financial instrument has the following three basic characteristics:
a. The instrument has (1) one or more underlyings and (2) an identified payment provision
(an underlying is a specified interest rate, security price, commodity price, index or prices
or rates, or other market-related variable).
b. The instrument requires little or no investment at the inception of the contract.
c. The instrument requires or permits net settlement (for example, a profit can be realized
without an actual purchase and sale of the underlying item).
Derivatives Used for HedgingFair Value Hedge
*34. (S.O. 11) In a fair value hedge, a derivative is used to hedge or offset the exposure to
changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment. In
accounting for fair value hedges, the derivative should be presented at its fair value on the balance sheet
with any gains and losses recorded in income.
Derivatives Used for HedgingCash Flow Hedge
*35. (S.O. 12) Cash flow hedges are used to hedge exposures to cash flow risk, which is exposure
to the variability in cash flows. In accounting for cash flow hedges, the derivative should be presented at
fair value on the balance sheet, but gains or losses are recorded in equity as a part of other comprehensive
Other Reporting Issues
*36. (S.O. 13) Hybrid securities have characteristics of both debt and equity and often are a
combination of traditional and derivative financial instruments. In some cases, a host security is
combined with an embedded derivative. When this occurs, the embedded derivative should be
separated from the host security and accounted for using the accounting for derivatives. This separation
process is referred to as bifurcation.
*37. For the special accounting of hedges to occur, certain criteria must first be met. The general
criteria relate to the following areas:
a. Designation, documentation, and risk management.
b. Effectiveness of the hedging relationship.
c. Effect on reported earnings of changes in fair value or cash flows.
*38. (S.O. 14) The primary requirements for disclosures related to financial instruments are as
a. A company should disclose the fair value and related carrying value of its financial
instruments in the body of the financial statements, in a note, or in a summary table that
makes it clear whether the amounts represent assets or liabilities.
b. The fair value disclosures should distinguish between financial instruments held or issued
for purposes other than trading. For derivative financial instruments, the firm should
disclose its objectives for holding or issuing those instruments (speculation or hedging),
the hedging context (fair value or cash flow), and its strategies for achieving risk
c. In disclosing fair values of financial instruments, a company should not combine,
aggregate, or net the fair value of separate financial instruments, even if those instruments
are considered to be related.
d. A company should display as a separate classification of other comprehensive income the
net gain or loss on derivative instruments designated in cash flow hedges.
e. Companies are encouraged, but not required, to provide quantitative information about
market risks of derivative financial instruments, and also of its other assets and liabilities,
that is consistent with the way the company manages and adjusts risks and that is useful
for comparing the results of its use of derivative financial instruments.
**Recording the Transfer of Securities
**39. (S.O. 15) When transferring from held-to-maturity debt securities to available-for-sale debt
securities, a Securities Fair Value Adjustment account is used to record the difference between cost and
fair value, other comprehensive income and stockholder's equity is increased (decreased) due to the
recognition of the unrealized holding gain (loss), but net income is not affected. When transferring from
available-for-sale debt securities to held-to-maturity debt securities, the amount in Securities Fair Value
Adjustment (Held-to-Maturity) is transferred to Unrealized Holding Gain or Loss--Equity, and the
Securities Fair Value Adjustment balance and the Unrealized Holding Gain (or Loss) are amortized over
the remaining life of the investments.