💰Intermediate Financial Accounting I Unit 10 – Investments

What Are Investments?

• Investments represent assets acquired by a company with the intention of generating income, capital appreciation, or both
• Investments can be in various forms such as stocks, bonds, real estate, or other financial instruments
• Companies invest excess cash to earn a return higher than what they would receive from holding cash
• Investments are classified based on the company's intention and ability to hold the investment (trading, available-for-sale, or held-to-maturity)
• The accounting treatment for investments depends on their classification and the company's business model
• Investments can provide diversification benefits by spreading risk across different asset classes and industries
• The value of investments can fluctuate based on market conditions, interest rates, and other economic factors

Types of Investments

• Debt investments include bonds, notes, and other fixed-income securities that provide a stream of interest payments and a return of principal at maturity
  • Government bonds are issued by national governments and are considered low-risk investments (U.S. Treasury bonds)
  • Corporate bonds are issued by companies and offer higher yields but also carry higher credit risk (investment-grade bonds, high-yield bonds)
• Equity investments represent ownership interests in other companies through the purchase of common or preferred stock
  • Common stock provides voting rights and the potential for capital appreciation and dividends (Apple Inc. common stock)
  • Preferred stock offers a fixed dividend and priority over common stockholders in the event of liquidation (Berkshire Hathaway Class A preferred stock)
• Derivative investments are financial contracts whose value is derived from an underlying asset, such as options, futures, and swaps
• Real estate investments involve the purchase of property for rental income, capital appreciation, or both (commercial real estate, residential properties)
• Mutual funds and exchange-traded funds (ETFs) pool money from multiple investors to invest in a diversified portfolio of securities
• Alternative investments include hedge funds, private equity, and venture capital, which often have higher risk and return potential

Initial Recognition and Measurement

• Investments are initially recognized at their acquisition cost, which includes the purchase price and any directly attributable transaction costs (brokerage fees, commissions)
• The cost of an investment is determined using the specific identification method or the weighted average cost method
  • Specific identification assigns the actual cost to each individual security
  • Weighted average cost calculates the average cost of all securities in the portfolio
• For debt investments, any premium or discount on acquisition is amortized over the life of the investment using the effective interest method
• Equity investments are initially recorded at cost, which represents the fair value of the consideration given
• Derivative investments are initially measured at fair value, with any transaction costs expensed as incurred
• The initial measurement of investments establishes the basis for subsequent accounting and reporting

Subsequent Measurement and Valuation

• Subsequent measurement of investments depends on their classification and the company's business model
• Trading securities are measured at fair value, with changes in fair value recognized in the income statement
  • Fair value is determined using quoted market prices or valuation techniques (discounted cash flow analysis)
• Available-for-sale securities are measured at fair value, with changes in fair value recognized in other comprehensive income (OCI) until the investment is sold or impaired
  • Realized gains or losses on the sale of available-for-sale securities are recognized in the income statement
• Held-to-maturity securities are measured at amortized cost using the effective interest method
  • Amortized cost adjusts the initial cost for any premium or discount and recognizes interest income over the life of the investment
• Equity method investments are initially recorded at cost and subsequently adjusted for the investor's share of the investee's net income or loss and dividends received
  • The equity method is used when the investor has significant influence over the investee (typically 20-50% ownership)
• Fair value option allows companies to measure certain investments at fair value, with changes in fair value recognized in the income statement
• Impairment losses are recognized when there is a significant or prolonged decline in the fair value of an investment below its cost

Accounting for Investment Income

• Investment income includes interest, dividends, and realized gains or losses on the sale of investments
• Interest income from debt investments is recognized using the effective interest method, which allocates the interest over the life of the investment
  • The effective interest rate is the rate that discounts the estimated future cash flows to the initial carrying amount of the investment
• Dividend income from equity investments is recognized when the shareholder's right to receive payment is established
  • Cash dividends are recorded as a reduction in the investment account and an increase in cash
  • Stock dividends are recorded as an increase in the number of shares owned, with no change in the carrying amount of the investment
• Realized gains or losses on the sale of investments are calculated as the difference between the selling price and the carrying amount of the investment
  • Gains or losses on trading securities are recognized in the income statement
  • Gains or losses on available-for-sale securities are reclassified from OCI to the income statement upon sale
• Unrealized gains or losses represent the change in fair value of investments that have not been sold
  • Unrealized gains or losses on trading securities and investments measured at fair value are recognized in the income statement
  • Unrealized gains or losses on available-for-sale securities are recognized in OCI

Impairment of Investments

• Impairment occurs when the fair value of an investment declines below its carrying amount and the decline is considered to be significant or prolonged
• For available-for-sale and held-to-maturity debt securities, an impairment loss is recognized in the income statement if the decline in fair value is due to credit losses
  • The impairment loss is measured as the difference between the investment's amortized cost and its fair value
  • If the fair value of the investment subsequently increases, the previously recognized impairment loss may be reversed through the income statement
• For equity investments, an impairment loss is recognized in the income statement if the decline in fair value is considered to be significant or prolonged
  • The impairment loss is measured as the difference between the investment's cost and its fair value
  • Impairment losses on equity investments cannot be reversed through the income statement
• Impairment assessment requires judgment and consideration of various factors, such as the financial condition of the investee, industry trends, and market conditions
• Regular review of investments for impairment is necessary to ensure that the carrying amounts are not overstated and that any impairment losses are recognized on a timely basis

Disclosure Requirements

• Companies are required to disclose information about their investments in the financial statements to provide transparency and help users make informed decisions
• Disclosure requirements vary depending on the type of investment and its significance to the company's financial position and performance
• For each category of investments (trading, available-for-sale, held-to-maturity), companies should disclose:
  • The carrying amount and fair value of investments
  • Gross unrealized gains and losses
  • Maturities of debt securities
  • The basis for determining fair value (quoted market prices, valuation techniques)
• For equity method investments, companies should disclose:
  • The name and ownership percentage of significant investees
  • Summarized financial information of the investees
  • The investor's share of the investee's net income or loss and other comprehensive income
• Companies should also disclose any significant concentrations of credit risk, such as investments in a particular industry or geographic region
• Impairment losses and reversals of impairment losses should be disclosed separately, along with the reasons for the impairment
• Transfers between investment categories (e.g., from available-for-sale to held-to-maturity) should be disclosed, along with the reasons for the transfer and its impact on the financial statements

Special Topics in Investment Accounting

• Investment property is property held for rental income or capital appreciation, rather than for use in the company's operations
  • Investment property is initially measured at cost and subsequently measured at fair value or cost less accumulated depreciation
  • Changes in the fair value of investment property are recognized in the income statement
• Investments in joint ventures are accounted for using the equity method or proportionate consolidation, depending on the level of control and the terms of the joint venture agreement
  • The equity method is used when the investor has significant influence over the joint venture
  • Proportionate consolidation recognizes the investor's share of the joint venture's assets, liabilities, income, and expenses
• Investments in associates are accounted for using the equity method, as the investor has significant influence but not control over the associate
• Investments in special purpose entities (SPEs) or variable interest entities (VIEs) require careful analysis to determine the appropriate accounting treatment
  • SPEs or VIEs are often used for securitization transactions or to isolate certain assets or liabilities
  • The primary beneficiary of an SPE or VIE consolidates the entity, while other investors account for their interests using the equity method or as investments
• Investments in foreign entities require consideration of foreign currency translation and the potential impact of exchange rate fluctuations on the financial statements
  • The functional currency of the foreign entity is determined based on the primary economic environment in which it operates
  • Translation adjustments arising from changes in exchange rates are recognized in other comprehensive income