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:

  • Held to maturity: this category includes debt securities which the investor has the capacity and willingness to hold till maturity. Held to maturity investments are recognized at fair value initially and subsequently measured at amortized cost using effective interest rate method.
  • Available for sale: includes debt securities that neither fall in held to maturity category nor held for trading category. Unrealized gains or losses related to available for sale debt securities is recognized as other comprehensive income. Interest income is recognized in the period in which it is earned.
  • Held for trading: includes debt securities which are are held for short-term trading, say 3 months. Held for trading investments are reported at fair value and any resulting gain or loss or interest income is recognized in income statement.

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:

  • Controlling interest: where Company A owns more than 50% equity of Company B, it has control over Company B and is required to prepare consolidated financial statements.
  • Significant influence: where Company A owns anywhere between 20% and 50% of equity of Company B, it has significant influence over Company B and is required to account for investment in Company B using the equity method.
  • No controlling interest and no significant influence: if Company A owns less than 20% of Company B’s equity, neither consolidation nor equity method is required.

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

  • Available for sale: includes all equity investments other than those in held for trading and fair value through profit and loss categories. Unrealized gains or losses is recognized in other comprehensive income. Realized gains and losses and dividends are recognized in profit and loss.
  • Held for trading: accounts for equity investments held for sale in short-term, say 3 months, carried at fair value. Dividend income is recognized in profit and loss.
  • Designated at fair value through profit and loss: is a classification allowed by accounting standards for equity investments that otherwise meet criteria for available for sale or held for trading categories; accounting treatment is similar to that for held for trading equity investments.

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:

  • 1 January 2015: obtained 60% holding in Dots, Inc. for $300 million.
  • 1 February 2015: purchased 18% of common stock of Air, Inc., a cutting-edge communication company for $450 million with intent to hold them for indefinite period.
  • 1 March 2015: invested $55 million in an equity mutual fund with intent to sell it in near future.
  • 30 June 2015: sold the equity mutual fund investment made on 1 March 2015 for $60 million.
  • 1 July 2015: invested in government bonds with face value of $350 million due by end of June 2020 carrying interest rate of 8% at par.
  • 1 September 2015: obtained 35% holding for $320 in Fiber, Inc.

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.

Written by Obaidullah Jan, ACA, CFAhire me at