Accounting for Investments – Debt Securities

>>Today we’re going to be looking
at investments in debt securities. Debt securities for the most part are bonds
— corporate bonds, government bonds – and how we account for those investments. Now let’s take a look at
the slide together here. Notice that we assume you’ve read
this chapter, and you have some level of familiarity with investments, okay? So please review the chapter, and notice,
I’m not going to cover everything in there. I’m not going to cover what’s
called reclassification entries. Also you may want to review the
time value video that we have, and review your present value
calculations in particular, okay? So assuming that you’ve done
that, let’s go ahead and let’s start talking about debt securities. We have three classifications of
investments and debt securities: held-to-maturity, trading,
and available-for-sale. And you need to know the difference
between these definitions, because the accounting is
different for each one. Notice, held-to-maturity, the investor has
the ability and the intent to hold the bond or the investment until it matures. Maturity means we have to then get
our money back from the issuer. Of course, we’ll have been
collecting interest all along. Now trading securities, we the investor, think we’re going to sell the
investment within one year or less. And then available-for-sale is kind of
what I call a default classification. It’s in between the two. We don’t have immediate plans to tell the
investment within a year, but at the same time, we’re not committed to hanging on
to this investment until it matures. So it’s kind of in between the two, and
we classify that as available-for-sale. Now, when we calculate the fair
value of bonds – and by the way, these calculations will be the
same for when you’re looking at your long term debt chapter
on bond issuances. So this will help you in that chapter, as well. It’ll be what I call the mirror
image of the journal entry. Notice, when calculating the fair value,
we have two different interest rates. We have the contract rate or the stated rate,
and that’s stated on the bonds, themselves, the certificates, the bond
indenture, the prospectus. The information, it’s clearly stated that this
bond is going to pay this amount of interest on what’s called the face value of the bond. So the face value of the
bond, times the stated rate. Where contract rate gives you the
interest payment that we’ll receive. Now we also have a market rate, and the
market rate is determined by a lot of, what I’ll just say, macroeconomic
factors, which we’re not going to get into in this discussion, okay? So GDP, unemployment rates, inflation, the price
of oil, trade imbalances – all sorts of stuff that the Federal Reserve Bank takes into
account when setting the discount rate, from which all other rates come from. So all that aside, suffice it to say that market
rates are driven by a lot of factors outside of anybody’s control, and
they’re in constant motion. They’re drifting up; maybe
they’re drifting down. So it is normal for both the
contract rate and the market rate to be different on any given bond issuance. When the rates are different,
then we’re not going to invest the same amount
of money as the face value. So let’s take a look at these three scenarios. If for some strange reason, the contract rate
and the market rate are exactly the same, which is very rare, then we issue the bonds –
or actually, the bonds are issued at face value. So if you have a $10 million bond,
the investor would pay $10 million. If the contract rate is higher than the
market rate, then the market says a bond for this investment or credit
risk rating, like triple A or double A, should be paying this amount. We happen to have locked
in a rate that’s higher. Perhaps when we initially locked in the rate
– or I should say, when the issuer locked in the rate, interest rates then
started to drop a little bit. So then the contract rate is
now higher than the market rate. And if you think about it, if the
issuer is paying, let’s just say, 8%, and now the market rate is 7%, well, they don’t want to pay any higher
interest than they absolutely have to. But it’s difficult to change the
interest rates so that they exactly match. It’s a timing issue that’s never going to work. So instead, what we do is, we adjust the price. Or the issuer adjusts the price tag. And when the contract rate is
higher than the market rate, and the issuer is paying us a rate that’s
better than what the market says they should, they’re going to charge a higher
price than the face value. And we call that a premium. The bonds will be issued at a premium, and the investor will have to
pay more than the face value. If on the other hand, the contract rate
is less than the market rate, okay, the issuer is paying 8%, but now
the market rate has gone up to 9%, well the investors would rather have 9%. So no one is going to invest in our bonds,
unless we discount the bonds, we drop the price, so that the face value, okay, which is
the amount that has to be repaid, okay, the investor will end up investing less money than the face value, since
the bonds were discounted. And what’s going to happen, in both the
case of the premium and the discount, is that the price tag on the bonds is adjusted so that they are effectively
paying the market rate of interest. This is kind of a compensation mechanism for
determining the price of bonds and the date of issuance, when the market rate and
the contract rate are different, okay? It’s much more common for bonds
to be issued at a discount, so let’s take a look at that example. First we’re going to look at
held-to-maturity securities. We have both the intent and the ability
to hold the bonds until they mature. On January 1, 2015, ABC company issued
bonds with a face value of $5 million, a stated or contract rate of 8%,
that are mature in January of ’19. So it’s a four-year bond, and they pay
interest semiannually or twice a year. So interest will typically be paid
on say, June 30, and December 31. That’s what we mean by semiannual interest. Now at the time of issuance,
the market rate for bonds with a similar risk rating,
paid a market rate of 10%. So we’re paying less than the market rate,
which means we have to discount the bonds, okay? Assume that XYZ company invested
in the entire bond issuance, and they planned to hold the
investment until it matures. So let’s see how we’re going to calculate the
value with these bonds on the date of issuance. Okay, as we said earlier, the bonds will have
to be discounted in order to attract investors. So what the investors pay for these
bonds will be less than the face value. Now here’s where you need to review your
time value and present value calculations. Assuming you’ve done that, let’s take a look. First, the interest payment that the
investors will receive every six months, will be the face value, $5 million
times the contract rate of 8%. Annual interest is 400,000. Since it’s a semiannual interest
payment, we divide that by 2, and every six months the investor will
receive $200,000 of semiannual interest. Now to calculate the fair value of the bonds, we discount back to their present
value, all future payments. So look at the little timeline here. Okay, notice we have a total of
8 interest payments at 200,000. And remember, bonds pay interest
at the end of a time period. And when you pay interest
at the end of a time period, then you’re going to use what’s
called the ordinary annuity tables. So we have two different cashflows
that we’re going to have to look at. First, we have the $200,00 interest payments. And notice it’s the same amount of money,
over equal time intervals of six months. That’s an annuity. And since the interest is
paid at the end of the period, we use the present value
ordinary annuity table, okay? Now at the end of the four years, the
issuer has to pay back $5 million. That’s a onetime payment. That’s not an annuity, so we would
use the present value of 1 table to calculate the present
value of that future cashflow. Now when the interest payments are made
semiannually, you have to do two things. If the number of years is 4, but
its interest is paid twice a year, then we have eight time periods. So N will equal 8; 8 periods. And the interest rate, which is little i,
the market rate, we always discount back to present value, using the market
rate, not the contract rate, okay? The market rate was 10%. We divide that in half, and
we’re going to use 5%, okay? So when we’re going to the tables, the
present value ordinary annuity table, and the present value of 1 table, we’re going
to go, n equals 8 periods; that’ll be the row. And then we go across until we find
the 5% column, and that’s what’s going to help us find the factors, okay? So I’ve pulled those numbers from the tables,
but you would go to the tables and review those. And what we would find is that for the
present value of 1 table, when n equals 8 and i equals 5, the factor is .67684. We multiply 5 million times
.67, and we get 3,384,200. Now we have to discount back to their
present value, all those interest payments. So we go to the present value
ordinary annuity table, and the factor – again, n equals 8, i equals 5. The factor is 6.46, and we multiply that
times 200,000, and we get 1,292,642. We add those two amounts together,
and then total present value of all future cashflows is
4,676,842, which is the market value of these bonds on the date of issuance. That’s what the investor is
willing to pay for these bonds, given that the market rate was
higher than the contract rate. Let me reiterate, since this
is a point of confusion. When you calculate the interest payment,
it’s face value times contract rate. But when we’re calculating the present value
of a bond, we always use the market rate. Please make sure to make that note. Here are the journal entries for the investor. And I just happened to put the journal
entry for the issuer, just so you could see that it’s kind of the mirror image. The investor is going to record an
investment at face value, 5 million. They paid 4 million, 676. And so they’re going to have
a discount of 323,158. Now I’m going to abbreviate, but
here is the investment account. Now I’m just going to put 5 million. And here is the discount. Okay, and notice it’s a credit
balance of 323,158. So we would say that this discount account
is a contra asset to the investment account. And this book value of this
bond, this investment, is going to be face value
minus the unamortized discount. Okay, so because we issued the bonds at
a discount, our book value is 4,676,842. We record the investment at face
value in the investment account, and then here’s our discount
account, which is a contra asset. Now when the first interest payment is
received, I’m going to receive $200,000. To determine interest revenue, we
multiply the book value, 4,676,842, times half of the market rate, which is 5%. And my interest revenue is 233,842. The difference between the interest revenue
and the interest payment or receipt, is the amortization of the
discount, which is 33,842. And that leaves an unamortized
balance of 289,316. So now the unamortized discount is 289,316. That’s as of July 1, 2015. And if we took 5 million minus 289, the
amortized cost would be 4 million, 710. Now let’s go ahead, and let’s take
a look at the next six-month period. On December 30th — or 31st, I’m going to receive another 200,000,
okay, debit cash for 200,000. I’m going to amortize the discount again. And the way we do it is first,
we calculate interest revenue. 4 million 710 times half
the market rate; that’s 5%. 4 million, 710 times 5% gives
us interest revenue of 235,534. That’s going to be a credit to interest revenue. And then the difference between the cash
payment of 200,000 and the interest revenue of 235 is the amortization of
the discount, which is 35,534. And that’s going to give us a year-end
unamortized discount of 253,782, okay? On December 31, end of the first year, the
market value of these bonds had increased to 5 million, 250, which means interest
rates must have started to drop, because that pushes bond values up. Since these are classified as held-to-maturity
securities, we ignore the market value. And we’re going to report the bonds at
their amortized cost, which is 5 million, minus the unamortized discount;
and you’d have to look at the amortization schedule
to see that – what that was. And on the Income Statement,
interest revenue for the first year, will be the interest revenue, the –
for the first two six-month periods. 233 plus 235 gives us 469,376,and
that goes on the Income Statement. And then notice on the Statement of Cashflows,
any difference between the cash receipts and the interest revenue will be
a reconciling item to net income in the Operating Activities section. Four days later, January 4th of ’16, we
sell the investment for 5 million, 300. Notice, we’re going to ignore
four days’ worth of amortization. We shouldn’t, but we will for simplicity’s sake. Look at the journal entry. Debit cash for what we sold
it for, 5 million, 300,000. When you sell an investment, we
would credit the investment, right? A credit to the investment
zeros out the account. We’re going to debit the discount, right? We’ve got a credit balance of 253,782. So I debit the discount for 253,782. That zeros out the discount, because
we no longer have these bonds. We shouldn’t see either account
in our general ledger. And then notice, we have a gain of 553,782. Not only do we know the gains 553, just
because it makes the journal entry balance. If we were to compare the cash received, 5
million 300, to the amortized cost at the end of the first year, we would
see the difference was 553,782. So again, review the amortization schedule,
so that you’re comfortable with these numbers. Okay, those are the accounting journal
entries for held-to-maturity securities. Now we’re going to look at trading securities. By definition, trading securities mean we
plan on trading or selling these investments within a one-year period, so it’s going
to be classified as a current asset, whereas the held-to-maturity is
typically a noncurrent asset. Data is the same. Everything stayed the same. I left up the investment account, the discount,
unamortized discount, and notice, same thing, market value at the end of
the year is 5 million, 250. The unrealized holding gain or loss –
remember, we haven’t sold this investment yet. So we’re sitting on a gain or a loss, the difference between the amortized
cost and the market value, okay? So the amortized cost at the end of the year
is face, minus the unamortized discount, okay? And the fair value is now 5 million, 250. We have an unrealized holding gain of 503,782. So look at the journal entry that
we have to record at year-end. We’re going to debit an account
called Fair Value Adjustment. This is an asset account that
relates to the investment. Fair Value Adjustment. I’m going to have to abbreviate. And I’m going to debit 503, 782. Okay, and then we credit unrealized
holding gain or loss – net income. And that tells us that that
unrealized holding gain or loss gets reported on
the income statement, okay? Trading securities. Even though we have not yet sold the investment,
any unrealized holding gains or losses go onto the income statement, because of the
short term nature of this investment, okay? So what I suggest you do is paus, make
sense of the numbers before we continue. When we sell the investment four days later
for the 5,300,000, here’s our journal entry. And we’re going to – we have a
choice of a couple of things. Debit cash for the amount that we receive,
credit the investment for 5 million, debit the discount, right, 253, credit
the Fair Value Adjustment account, 503, to get rid of these three accounts, and then
notice that we have a $50,000 gain on sale, because at year end, four days ago,
the market value was 5 million, 250. Four days later, it went up to 5,300,000. We already recognize the gain from last
year on last year’s income statement. This year we have an additional $50,000 gain,
which will go on this year’s income statement with these trading securities, okay? Now what we could also have done if we wanted
to, is we could’ve recorded the gain first, and then we would have a slightly
different journal entry on the date of sale. Either way would work. We’ll stick with what we have here. The last classification is available-for-sale. We don’t plan on selling it in the
short term, so it’s not trading. We’re not committed to hanging on for however
many years this bond may be outstanding, so it’s not held-to-maturity. It’s in-between; we call
that available-for-sale. The journal entries are going to be very similar to a trading security, with
one notable difference. And that is, the unrealized holding gain or
loss does not go on the Income Statement. It becomes part of Comprehensive Income. You may need to review comprehensive
income, okay, to feel comfortable with it. But notice, the year-end adjustment to
fair value is the same number, 503, 782; but the credit goes to unrealized
holding gain, Other Comprehensive Income. Let’s just briefly review. Here’s the Income Statement;
sales down to Net Income. Comprehensive Income is below that income;
it’s not part of the income statement. And these unrealized holding gains and
losses for available for securities — available-for-sale securities, is one of four
primary comprehensive income adjustments. So we have the Comprehensive Income Statement,
and that’s where this gain or loss will go. It’s a gain in this case. And then on the Balance Sheet, in
the stockholders’ equity section, we have accumulated Other
Comprehensive Income, okay? So there you have it. That’s where this is going to end
up; not on the Income Statement. But since it’s part of comprehensive income, it’s going to end up in the Stockholders’
Equity section of the Balance Sheet, as part of Other Comprehensive Income. Here’s where things get a little
bit unusual, so let’s take a look. Again, four days later, four days into
the new year, we sell for 5,300,000. So we had another 50,000
gain in that four-day period. So I debit the Fair Value
Adjustment account, okay. That would be 50,000. So this is what? 5503,782. And I credit the unrealized
holding gain, Other Comprehensive Income, which I know the T account
is not on the board here. So now, here’s where you
have to listen carefully. When you sell an investment,
it becomes realized. When you are sitting on a gain or a loss, and you haven’t sold the
investment, it’s unrealized. When you sell it, that gain or loss
becomes realized, and all realized gains or losses go on the Income Statement. So now, we have $553,000 in the Fair Value
Adjusted account on the Balance Sheet, and we have 553,000 in the unrealized holding
gain, Other Comprehensive Income account, which is on the Balance Sheet, okay? Since we’re selling the investment, and
we’re going to have a realized gain, we don’t want to double-count the increase
to equity that this gain generated, okay? So we have to reclassify the journal entry,
to get rid of the other comprehensive income. This is weird; I know it. So we have to get rid of the unrealized
holding gain, Other Comprehensive Income, which is sitting on the Balance Sheet, okay? It’s a credit balance. I’m going to have to debit
that account, to zero it out, and I’m going to credit the
Fair Value Adjustment account, to get rid of this account, as well. Then when I record the sale of the investment,
as we see below, I’m going to credit the gain on sale net income for the same amount. And that’ll go on this year’s Income Statement. Since this is the year that
we sold the investment; this is the year that we realized the gain. So you may want to hit pause, and review this. This is a tricky area here, okay? So again, the unrealized holding gain is sitting in Other Comprehensive Income,
which is on the Balance Sheet. We have to get rid of that, first. That’s that reclassification entry
to debit unrealized holding gain, Other Comprehensive Income, and Credit
Fair Value Adjustment for the 553. Now that that’s gone, we sell the
investment, and we recognize the gain of 553 on the Income Statement; and that will
ultimately end up in Retained Earnings. So the gain is now, sitting in Retained
Earnings, and it’s not being double-counted as Other Comprehensive Income,
which is the reason we got rid of the Other Comprehensive
Income in the first place. Okay, so I threw a lot at you. Review that; try to get comfortable with it.

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