Recall that “trading securities” are investments made with the intent of reselling them in the near future. Such investments are considered highly liquid and are classified on the balance sheet as current assets. They are carried at fair market value, and the changes in value are measured and included in the operating income of each period. However, other investments are acquired with the intent of holding them for an extended period. The accounting depends on the intent of the investment.
As this chapter will show, one company may acquire control of another, usually by buying more than 50% of the stock. In this case, the acquirer (sometimes known as the parent) must consolidate the accounts of the acquired subsidiary. Sometimes, one company may acquire a substantial amount of the stock of another without obtaining control. This situation generally arises when the ownership level rises above 20%, but stays below the 50% level. In these cases, the investor is deemed to have the ability to significantly influence the investee company. Accounting rules specify the “equity method” of accounting for such investments.
Not all investments are in stock. Sometimes a company may invest in a “bond” (as in the popular term “stocks and bonds”). A bond payable is a mere “promise” (i.e., bond) to “pay” (i.e., payable). Thus, the issuer of a bond payable receives money today from an investor in exchange for a promise to repay the money, plus interest, over the future. In a later chapter, bonds payable will be examined from the issuer’s perspective. In this chapter, the preliminary examination of bonds will be from the investor’s perspective. Often the bond investment would be acquired with the intent of holding it to maturity (its final payment date). These securities are known as “held-to-maturity” investments, and are afforded a special treatment generally known as the amortized cost approach.
The remaining category of investments is known as “available-for-sale.” When an investment is not trading, not held-to-maturity, not involving consolidation, and not involving the equity method, by default, it is considered to be an “available-for-sale” investment. Even though this is a default category, do not assume it to be unimportant. Many investments are classified as such.
The following table recaps the methods one will be familiar with by the conclusion of this chapter:
Fair Value Option
Companies may also elect to measure certain financial assets (and liabilities) at fair value. This option essentially allows many “available-for-sale” and “held-to-maturity” investments to instead be measured at fair value (with unrealized gains and losses reported in earnings), similar to the approach used for trading securities. This accounting option is indicative of a continuing evolution by the Financial Accounting Standards Board toward value-based accounting in lieu of traditional historical cost-based approaches. Importantly, the decision to apply the fair value option to a particular investment is irrevocable.
|Did you learn?|
|What are the general rules for deciding which method is used to account for an investment in the stock of another company?|
|Understand how intent influences the accounting technique for a particular investment.|
|Describe the basic accounting approaches and guidelines for assessment relating to different types of investments.|
|Know about the fair value option for measuring and reporting investments.|