Accounting for Investments

Investments are assets which represent a company’s right to receive cash from its stake in another company, government, etc. Investments are made through purchase of bonds or shares or other financial instruments of the investee. The intent behind making such investments is to generate investment income (interest and dividend) and to benefit from expected capital gain.

Investments are reported by the investing company on its balance sheet, classified into current and non-current portion. Investments which are expected to be sold within next 12 months are called short-term investments while investments other than short-term investments are called long-term investments. Some investments, which are can be easily converted to cash with negligible fluctuation in its value, are classified as cash equivalents.

Investments can be made in debt securities, equity securities, commodities, derivative securities, etc. Debt securities are financial instruments that represent right to a determined stream of cash flows for a definite period of time. For example, government bonds, corporate bonds, municipal bonds, notes receivable, etc. all have a pre-determined payout for a specific period. Equity instruments are securities that represent residual (ownership) interest in a company, for example, shares of common stock, etc. Derivative securities are financial instruments which ‘derive’ their value from other financial instruments. They are contracts whose value depend on another variable, for example, price of a common share of a company or its bond price or on price of a commodity, etc.

Debt securities

Traditionally debt securities have been classified into three categories:

However, new accounting standards (IFRS 9) require classifying debt investments into two categories: (a) investments carried at amortized cost and (b) those carried at fair value through profit and loss.

Equity securities

Accounting for equity investments depends on the extent of ownership:

Where the ownership is anywhere below 20%, the equity investment can be classified into any of the following categories:

New accounting standards have introduced a new classification framework for equity investments representing less than 20% ownership in companies. They require such equity investments to be accounted for either as (a) fair value through profit and loss or (b) fair value through other comprehensive income.

Example

You are a Treasury Accountant at Flow, Inc., a futuristic technology-enabled financial services company. Its cash and cash equivalents at 1 January 2015 stood at $2.2 billion. A newly appointed Treasury Manager embarked on an aggressive investment spree. During the year, the company entered into the following transactions:

At the year end, i.e. 31 December 2015, investment in Dots, Inc. dropped to $290 million, investment in Air, Inc. rose to $500 million while investment in Fiber, Inc. was valued at $350 million. The company earned dividends of $2 million from Dots, Inc., nothing from Air, Inc., nothing from the equity mutual fund and nothing from Fiber, Inc. Fiber, Inc. net income for financial year 2015 amounted to $15 million.

Classify the above investments into different traditional investment categories and outline the accounting treatment of related gains or losses.

Solution

  1. The 60% holding in Dots, Inc. should be consolidated in financial statements of Flow, Inc.
  2. The 18% stake in Air, Inc. should be classified as available for sale investment. The year-end unrealized gain of $50 million ($500 million - $450 million) should be classified as unrealized gain in other comprehensive income.
  3. The $55 million investment in equity mutual fund should be classified as trading investment and the realized gain of $5 million ($60 million - $55 million) should be included in income statement.
  4. The investment in government securities should be carried at amortized cost recognizing interest income in income statement. Any fair value changes in government securities are not recognized.
  5. The 35% holding in Fiber, Inc. should be accounted for using equity method since the investment resulted in significant influence.

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