Introduction to Accounting for Investments (Equity and Debt Securities)

Summary

This session explores why companies invest in others, such as for diversification or securing operating arrangements. Investments are categorized into debt (like bonds) and equity (like stocks). The accounting treatment varies based on intent and ownership level: held-to-maturity, trading, available-for-sale for bonds; fair value, equity method, or consolidation for equity. The presenter encourages using resources like farhatlectures.com for CPA exam preparation.

Takeaways

• 💼 Companies invest in other companies for various reasons such as entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, or simply because investing is their core business.
• 🌐 Microsoft's acquisition of LinkedIn is an example of a company investing in another to enter a new market.
• 💹 Diversification of investments is crucial to mitigate risks, especially when the core business might face downturns.
• 💰 Cash is considered the safest investment but offers the lowest return; hence, to earn more, companies invest in other ventures.
• 🔗 Investments can secure critical supply relationships, like electric car manufacturers investing in battery suppliers.
• 🏦 Companies like Berkshire Hathaway exist specifically to invest in other companies, showcasing investment as a standalone business model.
• 📈 Investments are categorized into debt (like bonds) and equity (like stocks), with each requiring different accounting treatments.
• 📉 Debt investments are classified as held-to-maturity, trading, or available-for-sale based on the company's intent.
• 📋 Held-to-maturity bonds are reported at amortized cost, ignoring fair value fluctuations since they are intended to be held until maturity.
• 📊 Trading investments are short-term and reported at fair value, reflecting unrealized gains and losses.
• 📖 The degree of ownership in an equity investment determines the accounting method: fair value for passive investors, equity method for significant influence, and consolidation for control.
• 📚 For a comprehensive understanding of accounting for investments, resources like Farhat Lectures offer additional materials aligned with CPA review courses.

Q & A

Why do companies invest in other companies?

Companies invest in other companies for various reasons such as investing in startups, entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, or simply because some companies exist to invest in other companies.

What is the difference between debt and equity investments?

Debt investments involve lending money to another company, typically by buying bonds. Equity investments involve owning a share of another company, typically by purchasing stocks.

What is the significance of the intent behind an investment?

The intent behind an investment determines how it is classified and accounted for. For example, if a bond is held to maturity, it is classified as held to maturity and reported at amortized cost.

What does it mean to classify an investment as held to maturity?

Classifying an investment as held to maturity means the investor has no plan to sell the bond and intends to hold it until it matures, reporting it at amortized cost.

What is amortized cost in the context of bond investments?

Amortized cost refers to the initial purchase price of a bond, adjusted for any premium or discount, and ignoring fair value fluctuations until maturity.

What are the three categories of debt investments?

The three categories of debt investments are held to maturity, trading, and available for sale.

What is the difference between trading and available for sale investments?

Trading investments are intended to be sold in the near future, while available for sale investments fall somewhere in between holding to maturity and trading, where the investor might sell if the price is right.

How does the degree of ownership affect how equity investments are accounted for?

The degree of ownership determines the level of control or influence the investor has over the investee company, which in turn affects the accounting method used, such as fair value, equity method, or consolidation.

What is the equity method of accounting for equity investments?

The equity method is used when an investor owns between 20% to 50% of a company, indicating significant influence over the investee, and the investment is accounted for based on the investor's share of the net income or losses of the investee.

What is the consolidation method in accounting for investments?

The consolidation method is used when an investor owns more than 50% of a company, indicating control, and the investee's financial statements are combined with the investor's.

What additional resources are recommended for understanding accounting for investments?

The script recommends visiting farhatlectures.com for additional resources, multiple-choice questions, and supplemental materials to enhance understanding of accounting for investments.

Outlines

00:00

💼 Accounting for Investments

This paragraph introduces the topic of accounting for investments in other companies. It explains why companies invest, including reasons such as entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, and being an investment company like Berkshire Hathaway. The speaker emphasizes the importance of understanding the intent behind the investment, which can be either debt or equity. Debt investments are when a company lends money by buying bonds, while equity investments are made through purchasing stocks. The intent could be to hold to maturity, which is the first classification discussed, where the investment is reported at amortized cost, ignoring fair value fluctuations since the bond will mature at face value.

05:02

📈 Classifications of Debt Investments

This paragraph delves into the classifications of debt investments. It explains that if the intent is to sell the bond, it must be reported at fair value, leading to unrealized gains and losses. There are three categories for bonds: held-to-maturity, trading, and available-for-sale. Held-to-maturity is for bonds intended to be held forever, trading is for bonds expected to be sold in the near future, and available-for-sale is for bonds that might be sold if the price is right. The paragraph also mentions various types of debt securities, focusing on corporate bonds for accounting students. It transitions to equity investments, explaining that the accounting treatment depends on the degree of ownership. For less than 20% ownership, the investment is considered passive, and fair value accounting is used. For between 20% and 50%, significant influence is assumed, leading to the equity method of accounting. Over 50% ownership results in control, necessitating consolidation.

10:02

🏛️ Consolidation and Further Study

The final paragraph summarizes the types of investments and their classifications, which include held-to-maturity, trading, and available-for-sale for debt, and fair value, equity method, and consolidation for equity. It encourages the audience to visit farhatlectures.com for additional resources and practice questions to understand how to account for investments. The speaker advises investing in one's own education, especially for those studying for the CPA exam, and emphasizes the long-term value of a CPA certification.

Keywords

💡Investments

Investments refer to the purchase of financial instruments or other assets with the expectation of generating an income or profit. In the context of the video, investments are discussed as a strategic move by companies to grow, diversify risk, or secure operational arrangements. For instance, Microsoft's acquisition of LinkedIn is mentioned as a way to enter a new market.

💡Accounting for Investments

This term pertains to the methods and practices used by companies to record and report their investment transactions in financial statements. The video focuses on explaining these accounting practices, particularly the classification of investments into debt and equity.

💡Debt Investments

Debt investments are financial instruments where the investor lends money to an entity, typically in exchange for periodic interest payments and the return of principal at maturity. The video explains that bonds are a form of debt investment, and the accounting treatment can vary based on the investor's intent.

💡Equity Investments

Equity investments involve purchasing shares of a company, thereby owning a piece of it. The degree of ownership and influence over the company is a key factor in how equity investments are accounted for. The video script discusses different levels of ownership and their accounting implications.

💡Held to Maturity (HTM)

HTM is a classification for debt investments where the investor has no intention of selling the investment before it reaches maturity. The video uses HTM to illustrate how investments can be reported at amortized cost, ignoring fair value fluctuations.

💡Amortized Cost

Amortized cost refers to the initial purchase price of a bond, adjusted for any premium or discount, and then further adjusted for interest and amortization of that premium or discount over the life of the bond. The video explains that investments held to maturity are reported at amortized cost.

💡Fair Value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The video discusses how investments not held to maturity are reported at fair value, which can result in unrealized gains or losses.

💡Trading Securities

Trading securities are debt or equity investments bought and held primarily for the purpose of selling them in the near term. The video script mentions that these are reported at fair value with changes in fair value recognized in the income statement.

💡Available-for-Sale Securities

Available-for-sale securities are debt or equity investments that do not meet the criteria for HTM or trading securities. The video indicates that these are also reported at fair value, but unrealized gains and losses are reported in other comprehensive income rather than the income statement.

💡Significant Influence

Significant influence in the context of equity investments means that the investor has the power to affect the financial and operating policies of the investee. The video explains that if an investor owns between 20% to 50% of a company, they are assumed to have significant influence and account for the investment using the equity method.

💡Consolidation

Consolidation in accounting refers to the process of combining the financial statements of a parent company and its subsidiaries into a single set of financial statements. The video mentions that when an investor owns more than 50% of another company, the two entities are consolidated for financial reporting purposes.

Highlights

Companies invest in other companies for various reasons, such as investing in a startup, diversifying risk, or securing operating arrangements.

Investing in a startup can be a way to buy into a promising new product or enter a new market.

Microsoft's acquisition of LinkedIn is cited as an example of a company entering a new market through investment.

Diversification of investments can help mitigate risk in case a company's core business declines.

Investments can be made to earn a higher rate of return than what is typically offered by cash.

Investing in a supplier can secure critical components or services needed for a company's operations.

Some companies, like Berkshire Hathaway, exist primarily to invest in other companies.

Investments are categorized into debt and equity for accounting purposes.

Bonds are a type of debt investment where the investor lends money to a company.

Equity investments involve purchasing stocks in another company.

The intent of the investment determines how it is classified and reported in financial statements.

Bonds held to maturity are reported at amortized cost, ignoring fair value fluctuations.

Trading investments are bonds that the investor plans to sell in the near future and are reported at fair value.

Available-for-sale investments fall between held-to-maturity and trading, with the possibility of selling if the price is right.

The degree of ownership in an equity investment affects how it is accounted for.

Passive investments in equity, with less than 20% ownership, are accounted for at fair value.

Investments with significant influence, typically between 20% and 50% ownership, are accounted for using the equity method.

Controlling interests, with more than 50% ownership, require the use of the consolidation method in financial reporting.

Farhat Lectures offers additional resources and courses to complement CPA review and accounting education.

The importance of investing in one's own education and practicing accounting skills is emphasized.

Transcripts

hello and welcome to this session in

which we'll discuss accounting for

investments well we're talking about

accounting for investments in other

companies so when one company buys

stocks and another company so why do

companies invest in another company well

there are many reasons why you would do

it but it's very important to get the

big picture why do they do it well one

one reason is to invest in a startup

maybe it's a new company maybe they have

a new product new promising product you

want to buy into that company or

enter a new market for example microsoft

when they wanted to have a social

network what they did rather than

starting one they bought linkedin and

i'm sure you you're both most like

likely a user of microsoft and linkedin

diversify your risk so if you're a

software company you may want to buy

some stocks in a construction company

maybe you want to buy some stocks and

companies that's not related to you

maybe retails

why

now you have some cash on the side and

you don't have any investment in your

company itself

you diversify your risk in case your

business went down your investments will

do well to earn a high rate of return

cash gives you the lowest return

practically zero because with cash you

take no risk so what you want to do if

you want to earn more you would have to

make an investment investment taken risk

you'll invest in other companies

you would also invest to secure what's

called operating arrangement sometime

you might be relied on one supplier on

one important supplier for example

specialized industries like the electric

cars they might have very unique product

very unique parts that they need to

secure from one supplier for example if

you're producing electric car you might

need that battery so what's going to

happen is you will buy you will invest

in your supplier you'll you'll buy some

of those stocks you will be an owner

that's why you would invest to secure

operating arrangement now you are part

of the company you know what's going on

you have a saying

and some companies exist to invest in

other companies that's their job like

berkshire hathaway the the ceo warren

buffett

their company that's all what they do

they take money and they invest that

money in other companies that's their

business and could it could be many

other reasons why company invest in

other companies for the sake of

intermediate accounting financial

accounting or the cpa exam we're gonna

break investments into two types so

we're gonna keep it simple debt and

equity and what we mean by that bonds

it's when you

lend money to another company by their

bond and when we mean by equity is

stocks now bear in mind

those are not the only two type of

investments you can invest in gold you

can invest in real estate you can invest

in cryptocurrency

it doesn't matter once you understand

how bonds and equity work you'll be able

to do accounting for investments for any

other investments so what do we need to

know about the types of of investments

if we are dealing with that the first

one the first thing we have to determine

is what is the intent of the company the

intent of the management when they buy

this bond and hopefully you know what a

bond is bond is when you lend money to

the company when you buy someone's bonus

you're giving them money and

in return they're giving you a piece of

paper they're going to give you this

money back plus interest the question is

you made this investments what is your

intent well it is if your intent

no plan to sell the bond well eventually

you're going to have to give it back to

the company but you have no plan to sell

it in other words you bought that bond

and you're going to hold it to maturity

guess what you classify it as hell to

maturity so health to maturity is the

first classification so when you make

an investment in a bond you can classify

it as health to maturity when do you do

so when you have no plan to sell it

also

how do you report this you would report

it at amortized cost what does amortized

cost mean it means whatever you bought

it at then you amortize the premium or

the discount what does that mean it

means you ignore any fair value

fluctuation bonds go up and down in

value if you plan if you have no plan to

sell it if you plan to hold it until it

mature it's held to maturity therefore

there's no reason to look at fair value

fluctuation why not because if you if we

know anything about bonds from the bonds

chapter

bonds at the end of the of of their life

they mature at face value therefore if

you keep up bringing it up and down

constantly and you're going to hold it

forever forever it's going to be the

face value so why waste your time and

waste your effort knowing you're going

to get the face value at the end of the

day so this is the first classification

of that securities now we're going to

have more classification and by the way

we're going to have a whole session

dealing with health to maturity in the

next session we would look at the

journal entries um when we buy them when

we sell them if they earn us interest so

on and so forth now we're going to look

at other categories of that investments

before we look at the other categories i

would like to remind you whether you are

a student or a cpa candidate to take a

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so what happened if you plan is to sell

the bond so you make an investment you

bought the bond but your plan is to sell

it well what does that mean well under

those circumstances you have to report

the investment and bond at fair value

what does fair value mean fair value

mean you're gonna get unrealized gains

and losses

well under unrealized gain and losses if

it's fair value you're gonna have two

categories you're going to have either

trading

or available for sale category so notice

we have health to maturity one category

trading is true

available for sale is three so those are

the three categories when you have a

bond bond investment or a debt

investment what is trading what's held

to maturity trading as the word trading

suggests you plan to sell it in the near

future trading flipping it that's that's

what that's what trading is well what is

available for sale well if we think

htm is on one end

trading on the other trading a short

term htm hold it forever available for

sale will be some someplace in between

you're not you don't plan to hold it

forever and you don't plan to flip it in

the near future well if the price is

right you might sell it that's available

for sale now let's talk about the type

of that securities that you could have

you can have many

you could have us government securities

those are

bonds debt securities municipal

securities corporate bonds convertible

that commercial paper now for our

purposes as an accounting student we

will deal with corporate bonds

on the other hand if you buy a stock or

equity how do you account for that

investment well it all depends on the

degree of ownership

degree of ownership it means how much do

you control how much do you control of

the company that you purchased

well you might own stocks i own stocks

but what is our controlled degree of

control practically zero because

public companies are extremely extremely

large so you need billions of dollars to

have a saying in those companies and

those major companies that i have right

here on this slide

not bitcoin bitcoin it's not a company

but you unilever apple nestle

proctor and gamble so on and so forth so

if you own if a company owns between

zero to 20 percent of the company we

consider this investment to be

basically minor or you are a passive

investor passive it means you have no

saying in the company if you own up to

20 from an accounting perspective you

have no saying now in the reward in some

companies if you own five percent you

could have a major stake but that's

beside the point from an accounting

perspective you're a passive investor

how do you account for your equity

investment if that's the case fair value

what does fair value mean it means

you're going to have unrealized holding

gains and losses we'll talk about this

in the next session because we're going

to have a session for each of these

categories this is just an introduction

what happened if you own more than 20

percent but up to 50 percent

under those circumstances we assume that

the investor has significant influence

what is significant influence

significant influence means you have a

saying in that company why because you

have enough shares to maybe vote

yourself or someone

your friend or an ally as a on the board

of directors and once you're on the once

you are

a part of the board of directors you

control the company you have some

control you have some saying therefore

you have a significant influence how do

we account for these investments we

account for this and for these

investments under a method called the

equity method and guess what to be

discussed this is going to be one whole

session about the equity method

what happened if you own

more than 50 50 percent plus well once

you own more than 50 percent of a public

company for financial accounting

purposes not for tax purposes for

financial accounting purposes you are in

control you own more than 50 percent

you own the company you can you you

you're the party in charge under those

circumstances you have to consolidate we

have to use the consolidation method now

how does the consolidation method works

well

there's one whole course called advanced

accounting and you'll have to learn how

to do the consolidation so we don't

discuss consolidation for the purpose of

intermediate accounting you need to know

that more than 50 percent gives you

control if you have control you have to

consolidate the investor and the

investee investor it's mean or sometime

it's the parent company the investor is

the parent company and the investor is

the subsidiaries you'll have to

the the subsidiary will be part of the

parent company overall financial

statement so this is what i wanted to

discuss at the beginning of this

introduction introductory session what

type of investments you could have debt

and equity and how do you classify them

well that it could be held to maturity

one

trading two let me just help to maturity

one trading two available for sale three

equity if you're less than twenty

percent you're a passive investment

passive investor we use the fair value

method if you own between 20 to 50 we

use the equity method if you have more

than 50 percent we use the control you

have control we use the consolidation

what should you do now go to farhat

lectures.com work multiple choice

questions look at additional resources

to understand how to account for

investments don't take your

accounting education lightly invest in

yourself learn it practice if you're

studying for the cpa exam invest in my

resources your your cpa is a long-term

investment don't shortchange yourself

good luck study hard and of course stay