Investments
This chapter covers the accounting for financial instruments, including debt securities, equity securities, and equity method investments. Classification drives measurement — understanding which category an investment falls into is essential to determining its balance-sheet value and income-statement impact.
Financial Instruments Overview
A financial instrument is any contract that creates a financial asset for one entity and a financial liability (or equity instrument) for another.
| Category | Examples |
|---|---|
| Financial assets | Cash, receivables, debt securities, equity securities |
| Financial liabilities | Accounts payable, bonds payable, notes payable |
Debt Securities
Debt securities are instruments representing a creditor relationship (e.g., government bonds, corporate bonds, notes receivable). Under ASC 320, debt investments are classified into three categories based on management's intent and ability.
Trading Securities
- Reported at fair value on the balance sheet.
- Unrealized gains and losses are recognized in net income each period.
- Classified as current assets. Example — Bear Co. purchases bonds for trading purposes:
Year-end — fair value increases to $53,000:
Available-for-Sale (AFS) Securities
- Reported at fair value on the balance sheet.
- Under the CECL model (ASC 326), credit losses are recognized through an allowance charged to net income.
- Non-credit-related unrealized gains and losses are reported in other comprehensive income (OCI) — part of the "PUFI" mnemonic (Pension adjustments, Unrealized gains/losses on AFS, Foreign currency translation, effective cash flow hedgIng). Example — Gies Co. purchases AFS bonds at par ($100,000):
Year-end — fair value drops to $92,000; $5,000 attributed to credit loss:
The total decline is $8,000. The credit portion ($5,000) flows through the income statement; the remaining $3,000 flows through OCI on the balance sheet.
Held-to-Maturity (HTM) Securities
- Reported at amortized cost on the balance sheet.
- Purchased at a premium or discount — the difference is amortized over the life of the security using the effective interest method.
- Under CECL, an allowance for credit losses is established if collection of all amounts due is not expected.
- Classified as noncurrent assets (unless maturing within one year). Example — MAS Inc. purchases a $100,000, 5-year, 6% bond at $95,735 (effective rate 7%):
First interest receipt and discount amortization:
Debt Securities Summary
| Feature | Trading | AFS | HTM |
|---|---|---|---|
| Balance sheet | Fair value | Fair value | Amortized cost |
| Unrealized gains/losses | Net income | OCI (non-credit); Net income (credit) | N/A (allowance for credit losses) |
| Classification | Current | Current or noncurrent | Noncurrent (unless < 1 yr) |
Reclassification out of HTM is rare and may "taint" the entire HTM portfolio — the CPA exam tests whether specific scenarios justify reclassification.
Equity Securities
Under ASC 321, equity securities (stocks) that do not give the investor significant influence or control are generally measured at fair value through net income (FVTNI).
Fair Value Through Net Income (Default)
Year-end — fair value rises to $34,000:
Practicability Exception
For equity securities without readily determinable fair values, an entity may elect to measure at:
This election is made per investment and applies when fair value is not readily determinable (e.g., private company stock).
Realized Gains and Losses
When equity securities are sold, the gain or loss equals the difference between the selling price and the carrying amount (which already reflects prior fair-value adjustments). BIF Partners sells equity securities (carrying value $34,000) for $37,000:
Equity Method Investments (20–50% Ownership)
When an investor holds 20–50% of the voting stock of an investee, a rebuttable presumption of significant influence exists. The investor applies the equity method under ASC 323.
Core Mechanics
- Initial investment recorded at cost.
- Pick up the investor's proportional share of the investee's net income (or loss).
- Reduce the investment for dividends received (return of investment, not income).
Basic Journal Entries — Kingfisher Industries
Kingfisher Industries acquires 30% of Illini Security for $600,000. During the year, Illini Security reports net income of $200,000 and pays dividends of $50,000. Acquisition:
Share of net income (30% × $200,000):
Dividends received (30% × $50,000):
Ending carrying value:
Excess of Cost Over Book Value
When the purchase price exceeds the investor's share of the investee's book value, the excess is allocated:
- To identifiable assets — based on the difference between fair market value (FMV) and book value of the investee's assets.
- Remaining excess → Goodwill.
Item Treatment Fixed assets (FMV > BV) Amortize excess depreciation over remaining useful life Land (FMV > BV) Not amortized (indefinite life) Goodwill Not amortized; tested for impairment Example — Excess allocation: Kingfisher pays $600,000 for 30% of Illini Security. Illini's book value is $1,500,000 (investor's share: $450,000). Illini's building has a FMV $200,000 above book value (remaining life: 10 years). Component Amount ----------- -------- Cost $600,000 Share of book value (30% × $1,500,000) ($450,000) Total excess $150,000 Allocated to building (30% × $200,000) ($60,000) Goodwill $90,000 Annual excess depreciation adjustment (building: $60,000 ÷ 10 years):
This adjustment reduces the investor's equity earnings each year — it represents additional depreciation the investee's books do not reflect.
Fair Value vs. Equity Method Comparison
| Feature | Fair Value (FVTNI) | Equity Method |
|---|---|---|
| Ownership level | < 20% (typically) | 20–50% |
| Balance sheet | Fair value | Cost ± earnings ± dividends |
| Income recognition | Unrealized G/L in net income | Share of investee's net income |
| Dividends | Dividend income | Reduce carrying value |
| Goodwill | Not applicable | May arise on purchase |
Transition to the Equity Method
When an investor's ownership increases to the 20–50% range (e.g., through additional share purchases), the equity method is applied prospectively from the date significant influence is achieved. If the investment was previously classified as AFS, any unrealized holding gains or losses accumulated in OCI are recognized in income at the date of transition. Example — Bear Co. increases its stake from 15% to 25%:
From this point forward, Bear Co. records its share of the investee's earnings and reduces the investment for dividends — fair value adjustments cease.
Disclosure Requirements
Under U.S. GAAP, entities must disclose:
- Concentrations of credit risk — including the nature and maximum exposure
- Methods and assumptions used to estimate fair values
- Significant terms of financial instruments (maturity, interest rates, collateral)
- Unrealized gains and losses on AFS securities in the notes or financial statements
warning
Concentrations of credit risk must be disclosed regardless of whether a loss has occurred — the potential for loss is sufficient to trigger the requirement.
Summary
| Investment Type | Measurement | Income Effect |
|---|---|---|
| Trading debt | Fair value | Unrealized G/L → Net income |
| AFS debt | Fair value | Credit losses → Net income; Other → OCI |
| HTM debt | Amortized cost | Interest revenue; Credit loss allowance |
| Equity (default) | FVTNI | Unrealized G/L → Net income |
| Equity (no fair value) | Cost ± observable changes | Adjust for observable transactions and impairment |
| Equity method (20–50%) | Cost ± earnings − dividends | Share of investee net income |