OLC SUPPLEMENT – CHAPTER 7
ACCOUNTING FOR PASSIVE INVESTMENTS IN SECURITIES
NATURE OF INVESTMENTS IN SECURITIES
Many strategic factors motivate managers to invest in securities. A company that has extra cash and simply wants to earn a return on the idle funds can invest those funds in shares or debt securities issued by other companies, either short-term or long-term. These investments are passive because the managers have no intent to influence or control other companies whose securities they have purchased.
Sometimes a company decides to invest in another company with the purpose of influencing that company’s operating, investing, and financing activities. When management of one company decides to control another company, the investing company either purchases the target company outright or becomes its majority shareholder. In this case, the two companies must report their financial positions and the results of their operations in a single set of consolidated financial statements. For example, Dell Inc. (the focus company of Chapter 8) prepares a set of consolidated financial statements because it controls a number of companies that are listed in the notes to its financial statements. Dell’s balance sheet, shown in Exhibit 1, includes both short-term and long-term investments as at January 28, 2005.
EXIHBIT 1
DELL INC.
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (Partial)
(in millions of U.S. dollars)
January28, January30,
ASSETS 2005 2004
Current assets:Cash and cash equivalents / $ 4,747 / $ 4,317
Short-term investments / 5,060 / 835
Accounts receivable, net / 4,414 / 3,635
Inventories / 459 / 327
Other / 2,217 / 1,519
Total current assets / 16,897 / 10,633
Property, plant, and equipment, net / 1,691 / 1,517
Investments / 4,319 / 6,770
Other non-current assets / 308 / 391
Total assets / $23,215 / $19,311
This supplement discusses the measurement and reporting of passive investments and uses relevant disclosures by Dell Inc. for illustrative purposes.[1] First, we discuss the accounting for passive investments in bonds using the amortized cost method. Second, we examine the market value method of accounting for passive investments in shares.
PASSIVE INVESTMENTS IN DEBT AND EQUITY SECURITIES
Passive investments are made to earn a high rate of return on funds that may be needed for future short-term or long-term purposes. For example, Dell’s management has indicated in the Management Discussion and Analysis section of its 2005 annual report that its “investment policy is to manage its total cash and investments balances to preserve principal and liquidity while maximizing the return on the investment portfolio through the full investment of available funds.”
The classification and valuation of investments depend on the nature of the investment as well as management’s intent. Investments are classified as cash equivalents if they consist of highly liquid investments with original maturities of three months or less at the date of purchase, such as treasury bills issued by the Federal government or certificates of deposit. These are reported at cost plus accrued interest, which approximates fair market value.
Passive investments include both investments in debt (treasury bills, bonds[2] and notes) and equity securities (shares). Debt securities are always considered passive investments. If the company intends to hold the securities until they reach their maturity dates, the investments are measured and reported at amortized cost. If they are to be sold before maturity, they are reported using the market value method. For investments in equity securities, the investment is presumed passive if the investment company owns less than 20 percent of the outstanding voting shares of the other company. The market value method is used to measure and report such investments.
The accounting methods used to record passive investments are directly related to how much is owned and how long management intends to hold the investments. The various types of passive investments and the appropriate measuring and reporting methods can be summarized as follows:
Investments in Debt Securitiesof Another Company / Investments in Shares of Another Company
Level of Ownership / Held to
maturity / Not held to maturity / < 20% of outstanding
voting shares
Measuring and Reporting Method / Amortized cost
method / Market value
method
The accounting for passive investments is covered in Section 3855, Financial Instruments – Recognition and Measurement, of the CICA’s Accounting Handbook. The accounting treatment of short-term investments was previously covered in Section 3010, Temporary Investments, which has been removed from the Handbook in April 2005. Publicly traded Canadian companies are expected to apply the requirements of Section 3855 for fiscal years starting after September 30, 2006. Similar recognition and measurement requirements have been in effect in the United States since 1994. Hence, we use real world excerpts from the annual report of Dell Inc., which prepares its financial statements in accordance with US GAAP, in order to illustrate disclosures related to investments in debt and equity securities.
DEBT HELD TO MATURITY: AMORTIZED COST METHOD
When management plans to hold a bond (note) until its maturity date (when the principal is due), it is reported in an account appropriately called Held-to-Maturity Investments. Bonds should be classified as held-to-maturity investments if management has the intent and the ability to hold them until maturity. These investments in debt instruments are listed at cost adjusted for the amortization of any bond discount or premium, not at their fair market value.
Bond Purchases
On the date of purchase, a bond may be acquired at the maturity amount (at par), for less than the maturity amount (at a discount), or for more than the maturity amount (at a premium).[3] The total cost of the bond, including all incidental acquisition costs such as transfer fees and broker commissions, is debited to the Held-to-Maturity Investments account.
To illustrate accounting for bond investments, assume that on August 1, 2006, Dell paid a par value of $100,000[4] for 8 percent bonds that mature on July 31, 2011, with interest payable each July 31 and January 31. Management plans to hold the bond for five years, until maturity.
The journal entry to record the purchase of the bonds follows:
Held-to-maturity investments (+A)…………………… 100,000
Cash (-A)…………………………………………... 100,000
Assets / = / Liabilities / + / Shareholders’ EquityCash – 100,000
Held-to-maturity investments + 100,000
Interest Earned
The bonds in the illustration were purchased at par, or face value. Since no premium or discount needs to be amortized, the book value remains constant over the life of the investment. In this situation, revenue earned from the investment each period is measured as the amount of interest collected in cash or accrued at year-end. The following journal entry records the receipt of $4,000 ($100,000 x 8% x 6/12) in interest on January 31[5]:
Cash (+A)………………………………………………. 4,000
Interest revenue (+R, +SE)…..………………….. 4,000
Assets / = / Liabilities / + / Shareholders’ EquityCash +4,000 / Interest revenue +4,000
The same entry is made on succeeding interest payment dates.
Principal at Maturity
When the bonds mature on July 31, 2011, the journal entry to record receipt of the principal payment would be:
Cash (+A)…………………………………..…………… 100,000
Held-to-maturity investments (–A)……………….. 100,000
Assets / = / Liabilities / + / Shareholders’ EquityCash +100,000
Held-to-maturity investments –100,000
If the bond investment must be sold before maturity, any difference between market value (the proceeds from the sale) and net book value would be reported as a gain or loss on sale. If management intends to sell the bonds before the maturity date, they are treated in the same manner as investments in shares classified as securities available for sale, as discussed in the next section.
PASSIVE SHARE INVESTMENTS: THE MARKET VALUE METHOD
When the investing company owns less than 20 percent of the outstanding voting shares of another company, the investment is considered passive. Among the assets and liabilities on the balance sheet, only passive investments in marketable securities are reported using the market value method on the date of the balance sheet.[6] This violates the historical cost principle.
Before we discuss the specific accounting for these investments, we should consider the implications of using market value:
1. Why are passive investments reported at fair market value on the balance sheet? Two primary factors determine the answer to this question.
■ Relevance. Analysts who study financial statements often attempt to forecast a company’s future cash flows. They want to know how a company can generate cash for purposes such as expansion of the business, payment of dividends, or survival during an economic downturn. One source of cash is the sale of shares from the company’s passive investments portfolio. The best estimate of the cash that could be generated by the sale of these securities is their current market value.
■ Measurability. Accountants record only items that can be measured in dollar terms with a high degree of reliability (an unbiased and verifiable measurement). Determining the fair market value of most assets is very difficult because they are not actively traded. For example, the head office building of the Toronto Dominion Bank is an important part of the Toronto skyline. The balance sheet of the Toronto Dominion Bank reports the building in terms of its original cost less accumulated amortization in part because of the difficulty in determining an objective market value for it. Contrast the difficulty of determining the value of a building with the ease of determining the value of securities that TD Bank may own. A quick look at the National Post or an Internet financial service is all that is necessary to determine the current price of shares issues by many companies (e.g., Van Houtte, Gildan Activewear) because these securities are traded each day on established stock exchanges.
2. When an investment account is adjusted to reflect changes in fair market value, what other account is affected when the asset account is increased or decreased? Under the double-entry method of accounting, every journal entry affects at least two accounts. The first account is a valuation allowance that reflects changes in the fair market value of the investment. The account balance is added to or subtracted from the investment account, which is maintained at cost. The other account affected is unrealized holding gains or losses that are recorded whenever the fair market value of investments changes. There are unrealized because no actual sale has taken place; the value of the investment has changed while the shares are being held by the investing company. If the value of the investments increased by $100,000 during the year, an adjusting journal entry records the increase in the allowance account and an unrealized holding gain for $100,000. If the value of the investments decreased by $75,000 during the year, an adjusting journal entry records the decrease in the allowance account and an unrealized holding loss of $75,000. Recording an unrealized holding gain is a departure from the revenue principle that states that revenues and gains should be recorded when the company has completed the earnings process that generated them. However, recording an unrealized loss is consistent with the concept of conservatism. The financial statement treatment of unrealized holding gains or losses depends on the classification of the passive investments in shares.
Classifying Passive Investments in Shares
Depending on management’s intent, passive investments may be classified as securities held for trading or securities available for sale.
Securities Held for Trading
Securities held for trading are actively traded with the objective of generating profits on short-term changes in the price of the securities. This approach is similar to the one taken by many mutual funds. The portfolio manager actively seeks opportunities to buy and sell securities. Securities held for trading are classified as current assets on the balance sheet.
Securities Available for Sale
Most companies do not actively trade the securities of other companies. Instead, they invest to earn a return on funds they may need for future operating purposes. These investments are called securities available for sale. They are classified as current or noncurrent assets on the balance sheet depending on whether management intends to sell the securities during the next year.
Securities held for trading (SHT for short) are most commonly reported by financial institutions that actively buy and sell short-term investments to maximize returns. Most corporations, however, invest in short- and long-term securities available for sale (SAS for short). We will focus on this category in the next section by analyzing Dell’s investing activities.
Securities Available for Sale
The notes to Dell’s annual report contain the following information concerning its investment portfolio:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE1— Description of Business and Summary of Significant Accounting Policies
Investments— Dell’s investments in debt securities and publicly traded equity securities are classified as available-for-sale and are reported at fair market value (based on quoted market prices) using the specific identification method. Unrealized gains and losses, net of taxes, are reported as a component of stockholders’ equity. Realized gains and losses on investments are included in investment and other income, net when realized. All other investments are initially recorded at cost and charged against income when a decline in the fair market value of an individual security is determined to be other-than-temporary.
For simplification, let us assume that Dell had no passive investments at January 28, 2005. In the following illustration, we will apply the accounting policy used by Dell.
Purchase of Shares
At the beginning of fiscal year 2006, Dell purchases 10,000 shares of Computer Components Corporation’s (CCC for short) common shares for $60 per share[7]. There were 100,000 outstanding shares, so Dell owns 10 percent of CCC (10,000 ÷ 100,000), which is treated as a passive investment. Such investments are recorded initially at cost:
Investments in SAS (+A)………………....…………… 600,000
Cash (–A)………………………….……………….. 600,000
Assets / = / Liabilities / + / Shareholders’ EquityInvestment in SAS +600,000
Cash –600,000
Dividends Earned
Investments in equity securities earn a return from two sources: (1) price appreciation and (2) dividend income. Price increases (or decreases) are analyzed both at year-end and when a security is sold. Dividends earned are reported as investment income on the income statement and are included in the computation of net income for the period. Assume that during the fourth quarter of fiscal 2006, Dell received a cash dividend of $1 per share from CCC, which totals $10,000 ($1 x 10,000 shares). The journal entry and transactions effects are as follows: