MUH214U-ACCOUNTING II
Chapter 3: Investments
Why Companies Invest
A company may temporarily have excess cash that is not needed for use in its current operations. companies may invest their idle or excess funds in securities such
1. Debt securities, which are notes and bonds that pay interest and have a fixed maturity date.
2. Equity securities, which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.
A “security” represents the issuer’s share, participation or other interest in an entity or issuer’s obligation that:
(a) either is represented by an instrument issued in bearer or registered from; or (b) dealt in on securities exchanges or used as a medium for investment; or (c) divisible into a class of shares, participations or obligations.
The purpose of investment (temporary or long term) might be different, but the same debt or equity securities will be used in both temporary and long term investments. The primary objective of temporary investments is to:
• earn interest revenue. • receive dividends. • realize gains from increases in the market price of the securities.
For purposes of valuation and reporting at a financial statement date, short-term and long-term investment be further classified as trading securities, available sale securities, or held-tomaturity securities.
• Trading securities are debt or equity securities bought and held principally for the purpose of being sold in the near term to generate incom short-term price differences. • Available-for-sale securities are debt or equity securities that do not meet the criteria for either trading or held-tomaturity securities. • Held-to-maturity securities are debt that the investor has an intend and ability to hold until their maturity date.
Investments in Debt Securities
The security that represents a credit relationship another entity upon issuance is called debt security. By investing in a debt security issued by another enterprise, a company plays the creditor role in the market.
Debt securities are classified in three groups based on the intention of a company on investing:
1. Held-to-maturity Securities 2. Available for sale Securities 3. Trading Securities
Held-to-Maturity (HTM) Securities
Held-to-maturity securities include only debt securities because equity securities do not have a maturity (consistent with going concern assumption). as: When a debt security is issued, an investor purchases it for a price and receives two types of cash flows in exchange; (i) interest, and (ii) face (nominal or par) value to be received at the maturity.
Face value is the amount written on a debt security to be paid by issuer upon delivery at maturity date.
If the price paid for security is equal to the face value, then the security is told to be sold at par. However, the purchase price generally differs from face value. If the security is sold at a price below the face value, it is sold at a discount. On the other hand, if the price exceeds the face value, security is sold at a premium.
The amounts of premium or discount represent the difference between the face value and the purchase price. These amounts are amortized during the life of security (until maturity), so that the total initial profit or loss (difference between purchase price paid and face value to be received at the end) is allocated to each period. Therefore, these securities are reported with their amortized costs in the financial statements instead of their fair (market) values.
Held-to-maturity securities are recorded using the s must amortized cost instead of fair values. Therefore, there is no -for- holding gain or loss to recognize in financial statements.
Fair Value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the e on measurement date.
An investor should use effective interest rate in order to calculate the amount of amortization for the period.
The effective interest rate is the interest rate that makes securities the present value of all future cash receipts equal to the purchase price of security.
Discount on bond is a contra-asset account, which is represented to disclose asset at amortized value.
with Example (Bond purchased at discount): On 1 January
2018, Investor Company has purchased the bonds of Debtor Company by paying 187,580 TL. The bonds have 200,000 TL face value with 4 years maturity and 10% interest rate declared on it. The interest will be paid semiannually. On January 1, market interest rate is 12%. ( See p.63).
Available for Sale Securities
Companies may invest in debt securities, which are held to be terminated in case of a cash need in the future. These securities are initially designated as available for sale securities, depending on the intention of the management to keep them.
Available for sale securities are usually recognized as non- investment does not represent a managerial role in current asset in balance sheet with their fair values (market invested company. In this case, depending on the intention prices). When the fair value of the security changes, the of management, the security can be reported either as value of investment changes, too. Therefore, company tradingsecurity or available for sale security. records “unrealized holding gain” account for an increase Trading Securities in value and “unrealized holding loss” account in case of a decrease in value. If the aim of management is to generate profit from price changes in short term, the security is recorded as trading Available for sale securities are measured with their fair security (same as in debt securities). Trading securities are values. Any change in value is reflected in balance sheets initially recorded with their acquisition costs (purchase with the help of unrealized holding gain or loss accounts. price plus other costs related to purchase). Example:On January 1, 2018,InvestorCompany has Example: On 12 November, 2018 Investor Company purchased the bonds of Debtor Company by paying purchased 1,200 shares of Equitor Corporation by paying 116,042 TL with the intention to get interest income as 1.50 TL/share. Investor also paid an additional 120 TL as well as protecting the company from a possible illiquidity brokerage commission for this transaction. On the problem in following years. The bonds have 120,000 TL balance sheet date, market price for each Equitor share is face value with 4 years maturity and 8% interest rate 2.00 TL. declared on it. The interest will be paid semiannually. On January 1, market interest rate is 9%. ( See p. 66). (See pages 70,71,72)
Trading Securities Available for Sale Securities
Trading refers to the purchase and resale of an item. When an investor company purchases less than 20% of Therefore, when a company purchases a debt security with another company without an initial intention to generate an aim of reselling for a higher price, this security is profit from price changes in short-term, the security is classified as trading security. classified as Available for Sale Security.
Capital (holding) gain is the profit generated from an Example: On December 12, Investor Company has investment arising from the change in value. purchased 2,000 shares of Equitor Corp. by paying 3.00
When a company purchases a debt security with the aim TL for each share. Additionally, the company paid 600 TL of reselling for a higher price, this security is classified as for brokerage fees, taxes and other fees, as well. (See trading security. pages 72,73)
Trading securities are reported in current assets at fair Mark-to-market rule states that marketable securities value, with any change in value being considered in the should be represented in financial statements with their calculation of net income. No discount or premium is market values as of the reporting date.
amortized. Holdings between 20 Percent and 50 Percent (Minority,
Example: On 5 May, 2018 Investor Company have Active Investments)
purchased a Treasury bill for 130,000 TL. The Treasury Companies may invest in other in the shares of the other bill has 180 days maturity and a face value of 150,000 TL companies’ shares at such a percentage that is enough to (See p. 68). join policy determination process but not to control the entity. Generally, it is assumed that having at least 20% of Investments in Equaty Securites the shares of a company gives an investor the right and Another option for companies to invest their excess funds power to participate in policy determination process. in is equity securities. Equity securities are the instruments representing the ownership interest in an entity, such as Significant influence can be defined as the power to common stocks, preferred stocks, etc. The initial value of participate and have affect on policy determination security to record in balance sheet includes purchase price process of investee.
and other incidental expenditures such as brokerage When an investor owns more than 20% but less than 50% commission and taxes. of invested company providing a significant influence, the
In an investment process, the investing party is called investee is reported as “affiliate” in the balance sheet. In “investor” while invested company is called as “investee”. this case, investors should initially recognize the affiliate with acquisition cost and use “equity method” 13 for Holdings of less than 20 Percent (Minority, Passive subsequent valuation for this investment, instead of fair Investments) value method used for the equity investments representing
When a company invests in another corporation up to 20% lower than 20% ownership. of total outstanding shares, it is assumed that the investor Example: On 23 February, 2018 Investor Company paid company does not possess an important role in 135,000 TL including brokerage commissions, taxes and determination of company policies. In other words, this
other fees and bought 35% of Equitor Corporation. (See p. 75)
Holdings of more than 50 Percent (Majority, Active Investments)
When the rate of ownership in invested company exceeds 50 percent, the investor is assumed to have control over the investee because in any case the decision is taken by the investor as more than half of the shares belongs to him. The investor company is called parent and the investee is subsidiary.
Consolidation means that parent company adds all financial statement items of the subsidiary to his own financial statements (after some eliminations and adjustments) and prepares a joint financial statement set combining the financial values of the both of the companies.
Claims of other owners are represented in the consolidated financial statement as “minority interest”.
Derivatives as Contractual Investments
Derivatives are the contracts that provide payoffs to investors depending on the values of other assets that they are derived from.
The two most common types of derivative instruments are options and forwards or futures contracts.
While a call option gives right to buy instruments, a put option provides the selling right.
Derivatives are recognized in balance sheet with their fair values. Profit/Loss from derivatives is reported in the income statement.
Transfers Between Categories
Independent from which investment alternative is initially chosen, companies may change their intentions to keep the securities. This change in intention may result in change in classification, too.
When securities are reclassified between the available for sale and trading categories, the unrealized holding gains or losses that incur at the transfer date are recognized in income statement and the securities are valued at fair value as the new cost basis.
In Turkey, it is forbidden to reclassify a security from trading securities to any other form.