Investments are assets that are purchased and held with the expectation that they will be used in the future to generate wealth. These could represent investments in debt or equities securities/instruments, i.e. bonds or shares of other companies. The holder/investor of the investment is entitled to a return based on the type of investment held. The holder/investor expects to generate wealth from either an appreciation in the value of the investment, i.e. capital gain or from cash flows generated from the investment in the form of Interest or dividend etc.
Investments typically/mainly fall into one of two categories, debt or equity securities:
- Debt securities are investments purchased with the expectation that the investor will earn Interest on the amount invested (interest income), and the principal amount (amount paid for the investment) will be returned to the investor in the future. These investments typically have a pre-defined payout, with the investor knowing the amount and timing of the future cash flows.
- Equity securities are investments that represent shares in the ownership of a company, for example, shares of common stock etc. and are made with the expectation that the value of the investee company will increase; therefore, the value of the share will increase, or that the cash flows generated by the company will be distributed, as dividends, providing an income stream to the investor. These investments typically do not have a pre-defined time period, and the payments/value will fluctuate with the performance of the investee company.
Accounting for Debt Securities
As per the US GAAP, there are three ways to classify debt securities for accounting purposes. All of these are initially measured at fair value, which is usually the fair value of the consideration given or received; however, there is a difference in subsequent measurement that depends on the instrument’s classification. The debt securities are classified into one of the categories based on the holders’ intentions around how they expect to realize the investment:
- Held to Maturity: This category includes debt securities that the investor can and intends to hold to maturity. These securities are subsequently measured at amortized cost using the effective interest rate method of accounting.
- Held for Trading: This category includes debt securities which the investor holds for short-term trading, i.e. for 3 to 6 months etc. These securities are always measured at fair value, with any changes in the fair value of the instrument recorded in profit or loss.
- Available for Sale: This category includes all debt securities that do not fall into one of the other two categories (i.e. they are neither intended to be held to maturity nor intended to be held for trading). These securities are always measured at fair value; however, any changes in the fair value of the instrument are recorded in other comprehensive income until realized. At the point of realization, the total change in fair value is recorded/transferred in profit or loss. Any interest income is recognized in profit or loss in the period it is earned.
Accounting for Equity Securities
Whilst accounting for debt securities is dependent on the intent of the investor, accounting for equity securities differs in that it depends on the extent of control the investor has over the investee. There are three main categories for the investor, each dependent on the amount of influence the investor can exhibit over the investee.
- Controlling Interest: If the investor has a controlling interest in the investee (i.e. the investor owns more than 50% of the voting rights and has the power to direct the investee company), it has control over the investee. The investor will be required to prepare consolidated financial statements to account for the investment.
- Significant Influence: If the investor owns more than 20% (but less than 50%) of the voting rights of the investee, then the investor has significant influence over the investee. The investor will be required to account for the investee using the equity method of accounting.
- No controlling interest nor significant influence: If the investor holds less than 20% of the voting rights, the investment will need to be accounted for as a financial (asset) instrument.
When the investment is classified as a financial asset, i.e. ownership is anywhere less than 20%, there are three possible categories that it could be classified into, and these categories are dependent on the intention of the investor but also include an optional category to which investors can designate investments:
- Held for Trading: This category includes financial assets held for sale in the short term. Dividend income and fair value adjustments are recognized in profit and loss.
- Designated as Fair Value through Profit and Loss: Investees can designate investments into this category if they so choose. In this category, the accounting treatment is similar to that held for trading equity investments, with the financial asset carried at fair value and all gains or losses recognized in profit and loss.
- Available for Sale: This category includes all equity investments other than those held for trading or designated as fair value through profit and loss. Unrealized gains or losses are recognized in other comprehensive income, with realized gains or losses recognized in profit and loss.
You are a Treasury Accountant at ABC Company, an investment company that holds multiple investments. The assets of ABC Company amount to $5B at year-end. During the year, the following investments were made:
- 1 January 2018: Acquired a 75% stake/holding in 123 Company, a company in the meal kit industry, for $5M.
- 1 March 2018: Purchased 15% common stock of XYZ Company, a company developing technology for autonomous vehicles, for $25M.
- 1 May 2018: Purchased a 30% stake/holding in DEF Company, a local clothing retailer.
- 1 June 2018: Invested $23M in equity mutual fund with a view to selling it soon.
- 1 July 2018: Bought bonds from Credit Bank, one of the biggest banks in the country. These bonds had a face value of $10M and pay 5% interest per annum. ABC Company plans on holding this to maturity.
By year-end, the following had occurred.
- The holding in 123 Company was now worth $7.5M. ABC Company planned on holding this investment long-term.
- XYZ Company’s shares were now worth $24M
- DEF Company earned $30M in profits for the year and declared a dividend of $15M.
- 30 September 2018: Sold the holdings in the mutual fund for $25M.
- Credit Bank paid Interest for the 6 months, amounting to $250K.
Classify the above investments into different categories and state how they should be treated for accounting purposes.
- The 75% stake in 123 Company should be consolidated as ABC Company controls this entity. This company would be included in the consolidated financial statements at year-end. The $7.5M valuation would not matter as all the assets, liabilities, incomes, and expenses would be consolidated.
- The 15% investment in XYZ Company would be accounted for as available for sale. The unrealized loss of $1M must be classified as other comprehensive income until the investment is sold.
- The 30% investment in DEF Company will be classified via the equity method of accounting. ABC Company would recognize a $9M increase in the value of DEF Company (ABC’s 30% of the profits) and will record (reverse) a dividend received of $4.5M (ABC’s 30% of the dividend declared), which will decrease the value of the investment.
- The investment in mutual funds should be recognized as held for trading. Any movements in the value will be recorded in profit and loss, with the net result that a $2M gain was recorded for the year.
- The investment in Credit Bank bond will be classified as held to maturity, with the value recorded at amortized cost using the effective interest rate method.