Held to maturityg

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 future 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. Held-to-maturity investments are afforded a special treatment,
which is 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 relatively new 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.
Available-For-Sale Securities
The accounting for available-for-sale securities will look quite similar
to the accounting for trading securities from Chapter 6. In both cases, the investment asset
account will be reflected at fair value. But, there is one big difference pertaining to the recognition
of the changes in value. For trading securities, the changes in value are recorded in operating
income. However, for available-for-sale securities, the changes in value go into a special account
called Unrealized Gain/Loss - Other Comprehensive Income. It may be helpful to review the
Chapter 6 coverage of trading securities.
OCI
Other comprehensive income (OCI) is somewhat unique. Begin by recognizing that the
accounting profession embraces the all-inclusive approach to measuring income. This
essentially means that all transactions and events make their way through net income. This has
not always been the case; once only operational items were included in the income statement
(a current operating concept of income).
Despite the all-inclusive approach, there are a few circumstances where accounting rules provide
for special treatment. Such is the case with Unrealized Gain/Loss - OCI. The changes in value on
available-for-sale securities are recognized, not in operating income as with trading securities,
but instead in this unique account. There are two reporting options for OCI. Some companies
report OCI within a broader statement of comprehensive income, while others prepare a separate
schedule reconciling net income to total comprehensive income.
EXAMPLE
Assume that Webster acquired an investment in Merriam Corporation. The intent was not for
trading purposes, control, or to exert significant influence. Thus, the investment was classified as
available-for-sale. The following entry was needed on March 3, 20X6, the day Webster bought
stock of Merriam:

Next, assume that financial statements were being prepared on March 31. By that date,
Merriam's stock declined to $9 per share. Accounting rules require that the investment "be
written down" to current value, with a corresponding charge against OCI. The charge is recorded
as follows:
This charge reduces other comprehensive income. But, net income is not reduced, as there is no
charge to a "normal" income statement account. The rationale is that the net income is not
affected by temporary fluctuations in market value, given the intent to hold the investment for a
longer term. During April, the stock of Merriam bounced up $3 per share to $12. Webster's
adjustment is:
Notice that the three journal entries now have the available-for-sale securities valued at $60,000
($50,000 - $5,000 + $15,000). This is equal to their market value ($12 X 5,000 = $60,000). The
OCI has been adjusted for a total of $10,000 in credits ($5,000 debit and $15,000 credit). This
cumulative credit corresponds to the total increase in value of the original $50,000 investment.
As an alternative to directly adjusting the Available-for-Sale Securities account, some companies
may maintain a separate Valuation Adjustments account that is added to or subtracted from the
Available-for-Sale Securities account. The results are the same; the reasons for using the
alternative approach are to provide additional information that may be needed for more complex
accounting and tax purposes.
DIVIDENDS AND INTEREST
Dividend or interest income received on available-for-sale securities is included in net income:
ON THE INCOME STATEMENT
Assume that Webster's operations produced a $10,000 net income for April. The lower portion of
the resulting statement of comprehensive income would appear as follows:

ON THE BALANCE SHEET
The preceding events would result in the following balance sheet presentations of
available-for-sale securities at March 31 and April 30. To simplify the illustration, the only
accounts that are assumed to change during April relate to the fluctuation in value of Merriam's
stock and an assumed increase in cash and retained earnings because of the $10,000 net income.
In reviewing the following illustrations, note that available-for-sale securities are customarily
classified in the Long-term Investments section of the balance sheet. And, take note that the
accumulated OCI is appended to stockholders' equity.

Held-To-Maturity Securities
It was noted earlier that
certain types of financial instruments have a fixed maturity date; the most typical of such
instruments are "bonds." The held-to-maturitysecurities are normally accounted for by
the amortized cost method.

To elaborate, if an individual wishes to borrow money he or she would
typically approach a bank or other lender. But, a corporate giant's borrowing needs may exceed
the lending capacity of any single bank or lender. Therefore, the large corporate borrower may
instead issue "bonds," thereby splitting a large loan into many small units. For example, a bond
issuer may borrow $500,000,000 by issuing 500,000 individual bonds with a face amount of
$1,000 each (500,000 X $1,000 = $500,000,000). If an individual wished to loan some money to
that corporate giant, he or she could do so by simply buying ("investing in") one or more of the
bonds.
The specifics of bonds will be covered in greater detail in a subsequent chapter, where bonds are
examined from the issuer's perspective (i.e., borrower). For now bonds will be considered from
the investor perspective. Each bond has a "face value" (e.g., $1,000) that corresponds to the
amount of principal to be paid at maturity, a contract or stated interest rate (e.g., 5% -- meaning
that the bond pays interest each year equal to 5% of the face amount), and a term (e.g., 10 years
-- meaning the bond matures 10 years from the designated issue date). In other words, a $1,000,
5%, 10-year bond would pay $50 per year for 10 years (as interest), and then pay $1,000 at the
stated maturity date.
THE ISSUE PRICE
How much would one pay for a 5%, 10-year bond: Exactly $1,000, more than $1,000, or less
than $1,000? The answer to this question depends on many factors, including the
credit-worthiness of the issuer, the remaining time to maturity, and the overall market conditions.
If the "going rate" of interest for other bonds was 8%, one would likely avoid this 5% bond (or,
only buy it if it were issued at a deep discount). On the other hand, the 5% rate might look pretty
good if the "going rate" was 3% for other similar bonds (in which case one might actually pay a
premium to get the bond). So, bonds might have anissue price that is at face value (also
known as par), or above (at a premium) or below (at a discount) face. The price of a bond is
typically stated as percentage of face; for example 103 would mean 103% of face, or $1,030. The
specific calculations that are used to determine the price one would pay for a particular bond are
revealed in a subsequent chapter.
BONDS PURCHASED AT PAR
An Investment in Bonds account (at the purchase price plus brokerage fees and other incidental
acquisition costs) is established at the time of purchase. Premiums and discounts on bond
investments are not recorded in separate accounts:
The above entry reflects a bond purchase as described, while the following entry reflects the
correct accounting for the receipt of the first interest payment after 6 months.

The entry that is recorded on June 30 would be repeated with each subsequent interest payment,
continuing through the final interest payment on December 31, 20X5. In addition, at maturity,
when the bond principal is repaid, the investor would also make this final accounting entry:
BONDS PURCHASED AT A PREMIUM
When bonds are purchased at a premium, the investor pays more than the face value up front.
However, the bond's maturity value is unchanged; thus, the amount due at maturity is less than
the initial issue price! This may seem unfair, but consider that the investor is likely generating
higher annual interest receipts than on other available bonds. Assume the same facts as for the
preceding bond illustration, but this time imagine that the market rate of interest was something
less than 5%. Now, the 5% bonds would be very attractive, and entice investors to pay a
premium:
The above entry assumes the investor paid 106% of par ($5,000 X 106% = $5,300). However,
remember that only $5,000 will be repaid at maturity. Thus, the investor will be "out" $300 over
the life of the bond. Thus, accrual accounting dictates that this $300 "cost" be amortized
("recognized over the life of the bond") as a reduction of the interest income:
The preceding entry can be confusing and bears additional explanation. Even though $125 was
received, only $75 is being recorded as interest income. The other $50 is treated as a return of
the initial investment; it corresponds to the premium amortization ($300 premium allocated

evenly over the life of the bond: $300 X (6 months/36 months)). The premium amortization is
credited against the Investment in Bonds account. This process of premium amortization would
be repeated with each interest payment. Therefore, after three years, the Investment in Bonds
account would be reduced to $5,000 ($5,300 - ($50 amortization X 6 semiannual interest
recordings)).
This method of tracking amortized cost is called the straight-line method. There is another
conceptually superior approach to amortization, called the effective-interest method, which will
be revealed in later chapters. However, it is a bit more complex and the straight-line method
presented here is acceptable so long as its results are not materially different than would result
under the effective-interest method.
In addition, at maturity, when the bond principal is repaid, the investor would make this final
accounting entry:
In an attempt to make sense of the preceding, perhaps it is helpful to reflect on just the "cash
out" and the "cash in." How much cash did the investor pay out? It was $5,300; the amount of the
initial investment. How much cash did the investor get back? It was $5,750; $125 every 6
months for 3 years and $5,000 at maturity. What is the difference? It is $450 ($5,750 - $5,300).
This is equal to the income recognized via the journal entries ($75 every 6 months, for 3 years).
At its very essence, accounting measures the change in money as income. Bond accounting is no
exception, although it is sometimes illusive to see. The following "amortization" table reveals
certain facts about the bond investment accounting, and is worth studying closely. Be sure to
"tie" the amounts in the table to the illustrated journal entries.

Sometimes, complex transactions are easier to understand when one simply thinks about the
balance sheet impact. For example, on December 31 20X4, Cash is increased $125, but the
Investment in Bonds account is decreased by $50 (dropping from $5,150 to $5,100). Thus, total
assets increased by a net of $75. The balance sheet remains in balance because the
corresponding $75 of interest income causes a corresponding increase in retained earnings.
BONDS PURCHASED AT A DISCOUNT
The discount scenario is very similar to the premium, but "in reverse." When bonds are purchased
at a discount, the investor pays less than the face value up front. However, the bond's maturity
value is unchanged; thus, the amount due at maturity is more than the initial issue price! This
may seem like a bargain, but consider that the investor is likely getting lower annual interest
receipts than is available on other bonds.
Assume the same facts as for the previous bond illustration, except imagine that the market rate
of interest was something more than 5%. Now, the 5% bonds would not be very attractive, and
investors would only be willing to buy them at a discount:

The above entry assumes the investor paid 97% of par ($5,000 X 97% = $4,850). However,
remember that a full $5,000 will be repaid at maturity. Thus, the investor will get an additional
$150 over the life of the bond. Accrual accounting dictates that this $150 "benefit" be recognized
over the life of the bond as an increase in interest income:
The preceding entry would be repeated at each interest payment date. Again, further explanation
may prove helpful. In addition to the $125 received, another $25 of interest income is recorded.
The other $25 is added to the Investment in Bonds account, as it corresponds to the discount
amortization ($150 discount allocated evenly over the life of the bond: $150 X (6 months/36
months)=$25).
This process of discount amortization would be repeated with each interest payment. Therefore,
after three years, the Investment in Bonds account would be increased to $5,000 ($4,850 + ($25
amortization X 6 semiannual interest recordings)). This example again uses the straight-line
method of amortization since the amount of interest is the same each period. The alternative
effective-interest method demonstrated later in the book would be required if the results would
be materially different.
When the bond principal is repaid at maturity, the investor would also make this final entry:
Consider the "cash out" and the "cash in." How much cash did the investor pay out? It was $4,850;
the amount of the initial investment. How much cash did the investor get back? It is the same as
it was in the premium illustration: $5,750 ($125 every 6 months for 3 years and $5,000 at
maturity). What is the difference? It is $900 ($5,750 - $4,850). This is equal to the income
recognized ($150 every 6 months, for 3 years). Be sure to "tie" the amounts in the following
amortization table to the related entries.

What is the balance sheet impact on June 30, 20X5? Cash increased by $125, and the Investment
in Bonds account increased $25. Thus, total assets increased by $150. The balance sheet remains
in balance because the corresponding $150 of interest income causes a corresponding increase in
retained earnings.
The Equity Method Of Accounting
An investor may acquire enough ownership in the stock of another
company to permit the exercise of "significant influence" over the investee company. For
example, the investor has some direction over corporate policy and can sway the election of the
board of directors and other matters of corporate governance and decision making. Generally,
this is deemed to occur when one company owns more than 20% of the stock of the other.
However, the ultimate decision about the existence of significant influence remains a matter
of judgment based on an assessment of all facts and circumstances. Once significant influence is
present, generally accepted accounting principles require that the investment be accounted for

under the equity method. This differs from the methods previously discussed, such as those
applicable to trading securities or available-for-sale securities. Market-value adjustments are
usually not utilized when the equity method is employed. In global circles, the term "associate
investment" might be used to describe equity method investments.
With the equity method, the accounting for an investment tracks the
"equity" of the investee. That is, when the investee makes money (and experiences a
corresponding increase in equity), the investor will record its share of that profit (and vice-versa
for a loss). The initial accounting commences by recording the investment at cost:
Next, assume that Legg reports income for the three-month period ending June 30, 20X3, in the
amount of $10,000. The investor would simultaneously record its "share" of this reported income
as follows:
Importantly, this entry causes the Investment account to increase by the investor's share of the
investee's increase in its own equity (i.e., Legg's equity increased $10,000, and the entry causes
the investor's Investment account to increase by $2,500), thus the name "equity method."
Notice, too, that the credit causes the investor to recognize income of $2,500, again
corresponding to its share of Legg's reported income for the period. Of course, a loss would be
reported in the opposite fashion.
When Legg pays out dividends (and decreases its equity), the investor will need to reduce its
Investment account as shown below.
The above entry is based on the assumption that Legg declared and paid a $4,000 dividend. This
treats dividends as a return of the investment (not income, because the income is recorded as it
is earned rather than when distributed). In the case of dividends, consider that the investee's
equity reduction is met with a corresponding proportionate reduction of the Investment account
on the books of the investor.

Investments Requiring Consolidation
If one casually reviews the business news, it won't take long to notice a
story about one business buying another. Such acquisitions are common and number in the
thousands annually. There are many reasons for these transactions, and this helps to explain
their frequency. One business may acquire another to eliminate a competitor, to gain access to
critical technology, to insure a supply chain, to expand distribution networks, to reach a new
customer base, and so forth.
These transactions can be simple, or complex, but generally involve
the acquirer buying a majority of the stock of the target company. This majority position enables
the acquirer to exercise control over the other company. Control is ordinarily established once
ownership jumps over 50%, but management contracts and other similar arrangements may
allow control to occur at other levels.
ECONOMIC ENTITY CONCEPT AND CONTROL
A controlled company may continue to operate and maintain its own legal existence. Assume
Premier Tools Company bought 100% of the stock of Sledge Hammer Company. Sledge (now a
"subsidiary" of Premier the "parent") will continue to operate and maintain its own legal existence.
It will merely be under new ownership. Even though it is a separate legal entity, it is viewed by
accountants as part of a larger "economic entity." The intertwining of ownership means that
Parent and Sub are "one" as it relates to economic performance and outcomes. Therefore,
accounting rules require that parent companies "consolidate" their financial reports and include
all the assets, liabilities, and operating results of all controlled subsidiaries. For example, the
financial statements of a conglomerate like General Electric are actually a consolidated picture of
many separate companies controlled by GE.
ACCOUNTING ISSUES
Assume that Premier's "separate" (before consolidating) balance sheet immediately after
purchasing 100% of Sledge's stock appears below. Notice the highlighted Investment in Sledge
account. This asset reflects ownership of all of the stock of Sledge and that Premier paid
$400,000 for this investment.
Importantly, the $400,000 flowed from Premier to the former owners of Sledge (not directly to
Sledge). Sledge has a new owner, but is otherwise unaffected by the transaction. Sledge's
balance sheet appears at the bottom of the facing page. Notice that Sledge's total equity is
highlighted to call attention to its reported balance of $300,000.

It may seem odd that Premier's investment is reported at $400,000, while Sledge's equity is only
$300,000. However, this would actually be quite common. Consider what Premier got for its
$400,000. Premier became the sole owner of Sledge, which has assets that are reported on
Sledge's books at $450,000, and liabilities that are reported at $150,000. The resulting net book
value ($450,000 - $150,000 = $300,000) corresponds to Sledge's total stockholders' equity.
Premier paid $100,000 in excess of book value ($400,000 - $300,000). This excess is often called
"purchase differential" (the excess of the fair value over the net book value).

Purchase differential can be explained by many factors. Remember that assets and liabilities are
not necessarily reported at fair value. For example, the cost of land held by Sledge may differ
from its current value. Assume Sledge's land is worth $110,000, or $35,000 more than its
carrying value of $75,000. That would explain part of the purchase differential. Assume that all
other identifiable assets and liabilities are carried at fair value. What about the other $65,000 of
purchase differential ($100,000 total differential minus $35,000 attributable to land)?
GOODWILL
The remaining $65,000 is due to goodwill. Whenever one business buys another and pays more
than the fair value of all the identifiable pieces, the excess is termed goodwill. Goodwill only
arises from the acquisition of one business by another. Many companies may have implicit
goodwill, but it is not recorded until it arises from an actual acquisition transaction.
Why would someone be willing to pay for goodwill? There are many possible scenarios, but suffice
it to say that many businesses are worth more than their identifiable pieces. A rental store with
a favorable location and established customer base is perhaps worth more than its facilities and
equipment. A law firm is hopefully worth more than its desks, books, and computers. Consider
the value of a quality business reputation that has been established for years.
PROCESS
The process of consolidation can become complex, but the basic principles are not. Below is the
consolidated balance sheet for Premier and its subsidiary. Note that the Investment in Sledge
account is absent. It has been replaced with the assets and liabilities of Sledge! But, the assets
and liabilities are not necessarily the simple sum of the amounts reported by the parent and
subsidiary. For example, the $135,000 Land account reflects the parent's land plus the fair value
of the subsidiary's land ($25,000 + $110,000). Notice that the amount attributable to the land is
not $25,000 (from the parent's books) plus $75,000 (from subsidiary's books). Instead, the
consolidated amounts reflect the reported amounts for the parent's assets (and liabilities) plus
the values of the subsidiary's assets (and liabilities) as implicit in the acquisition price. Also, note
that consolidated equity amounts match Premier's separate balance sheet. This result is
expected since Premier's separate accounts include the ownership of Sledge via the Investment
in Sledge account (which has now been replaced by the actual assets and liabilities of Sledge).

INCOME STATEMENT
Be aware that the income statements of the parent and sub will be consolidated post-acquisition.
In future periods the consolidated income statement will reflect the revenues and expenses of
both the parent and sub added together. This process is ordinarily straightforward. But, an
occasional wrinkle will arise. For instance, if the parent paid a premium in the acquisition for
depreciable assets and/or inventory, the amount of consolidated depreciation expense and/or
cost of goods sold may need to be tweaked to reflect alternative amounts based on values
included in the consolidated balance sheet. And, if the parent and sub have done business with
one another, adjustments will be needed to avoid reporting intercompany transactions. Internal
transactions between affiliates should not be reported as actual sales.
WORKSHEET
An orderly worksheet can be used to demonstrate preparation of the consolidated balance sheet.
Such is shown below. Amounts from both Premier's and Sledge's balance sheets are incorporated
into the first two data columns. These values are the carrying amounts for assets and liabilities
taken directly from the separate accounting records of each company.
The Debit/Credit columns reflect a "worksheet only" entry that will be used to process the
elimination of the $400,000 Investment account against the $300,000 equity of the subsidiary
($200,000 capital stock and $100,000 retained earnings). The "purchase differential" is then
allocated to land ($35,000 to increase to fair value) and goodwill ($65,000). Adding across all of
the columns produces the consolidated amounts that correspond to the values shown in the
consolidated balance sheet.

In summary, understand that the consolidated balance sheet on the date of the acquisition
encompasses the assets (excluding the investment account), liabilities, and equity of the parent
at their dollar amounts reflected on the parent's books, along with the assets (including goodwill)
and liabilities of the sub adjusted to their fair values. In the event one of the affiliated companies
owes money to the other (i.e., there are intercompany payables/receivables), great care must be
taken to also eliminate those accounts from consolidated reports. It would be highly
inappropriate to show amounts that are in essence owed to yourself as an asset!

Held to maturityg

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