1. business and industrial
2. company
3. merger and acquisition

11-1
Chapter 11 -- Marketable
Securities and Investments
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
10th Edition
Clyde P. Stickney and Roman L. Weil
11-2
Learning Objectives
1. Understand why firms acquire securities and other financial
instruments.
2. Develop skills to apply the market value method to minority,
passive investments.
3. Develop skills to apply the equity method to minority, active
investments, contrasting its financial statement effects with
those of the market value method.
4. Understand the concepts underlying consolidated financial
statements for majority active investments, contrasting the
financial statement effects with those of the equity method.
5. Develop the necessary skills to prepare consolidated financial
statements. (Appendix 11.1)
6. Develop an understanding of the financial effects of using the
purchase method to account for a corporate acquisition.
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Chapter Outline
1. Types of investments
2. Marketable securities:
Current assets
a. Classification
b. Valuation at acquisition
c. Valuation after
acquisition
d. Disclosures about
securities
e. Controversy
3. Minority, passive investments
4. Minority, active investments
5. Majority, active investments
a. Legally separate corps.
b. Purpose of consolidated
statements
c. Disclosure of consolidation
policy
d. Limitations of consolidated
statements
6. An international perspective
Chapter Summary
Appendixes 11.1-11.3
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1. Types of Investments (Figure 11.1)
The accounting for investments depends on the
purpose of the investment and the percentage
of voting stock held.
Investor
Corporation
Minority, Passive
Investments (less than
20% ownership)
Minority, Active
Investments (typically
between 20% and
50% ownership)
Majority, Active
Investments
(greater than
50% ownership)
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

1. Types of Investments (Cont.)
Minority, passive investments
 Less than 20% of voting stock.
 Assumed to be held for short term returns
including dividends and growth.
Minority, active investments
 Between 20% and 50% of voting stock.
 Assumed to be held to exert influence over the
other company.
Majority, active investments
 Greater than 50% of voting stock.
 Assumed to be held so for full control over the
other company.
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2. Marketable Securities
Marketable securities are bonds or stocks for
which there is an active market and hence a
reliable market value.
 They are liquid assets in that they can easily
and quickly be converted into cash.
 Marketable securities held as a temporary
investment are classified as current assets.

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2.a. Classification
Securities are properly classified as marketable
securities when
1. The firm can readily convert them into
cash, and
2. Intends to do so when it needs cash.
 If either of the two tests for marketable
securities do not apply, then the securities are
properly classified as investment in securities.
 Investment in securities are securities held for
long-term goals and are classified as long-term
assets.

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2.b. Valuation at Acquisition
Marketable securities are initially recorded at
acquisition cost.
 Which includes purchase price plus any
commissions, taxes or other costs related to
the acquisition.
 This is the same rule as the general rule for
valuing assets at acquisition.

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2.c. Valuation after Acquisition
Because there exists a market value, marketable
securities can be reliably written up or down to the
market value giving a more current estimate of
economic worth.
This also results in a holding gain or loss which is not
due to the normal operations of a firm.
For the purposes of valuation after acquisition, there
are three classes of marketable securities:
1. Debt held to maturity
2. Trading securities
3. Securities available for sale
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

2.c.1. Debt Held to Maturity
Debt securities for which a firm has both the positive
intent and ability to hold to maturity.
Shown on the balance sheet at the amortized
acquisition cost.
Amortized acquisition cost means that the securities
are amortized like a mortgage or bond.
 The acquisition cost is assumed to be the present
value.
 The maturity value and maturity date are known
from the bond certificate.
 An internal rate of return can be calculated using
PV techniques.
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2.c.2. Trading Securities
Trading securities are assumed held for short-term
profit.
Characterized by frequent and active buying and
selling with the object of generating profit.
Typically only financial institutions hold trading
securities.
Since trading securities are acquired for short-term
profit, unrealized gains or losses that result from
adjustments to market value pass through the
income statement and increase or reduce net income
before there is a sale of the securities.
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2.c.2. Trading Securities
Example 6 from text, page 602

Record acquisition of trading securities
Dec 28 Marketable securities
Year 3
Cash

400,000
To revalue the securities to market value and
recognize an unrealized holding gain.
Dec 31 Marketable securities
Year 3
Unrealized holding gain

400,000
35,000
35,000
The unrealized holding gain is closed to income,
appears on the income statement and increases
retained earnings.
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2.c.2. Trading Securities
Example 6 from Text (Cont.)


Record the sale for $480,000 in the next year after
the unrealized gain has been closed to income.
Recall at the new value of the securities is $435,000.
Jan 3
Year 4

cash
marketable securities
realized gain on sale
480,000
435,000
45,000
This realized gain (because it is supported by a sale)
is closed to income also.
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2.c.3. Securities Available for Sale
Securities available for sale are neither trading
securities or securities held to maturity. They are an
intermediate class and are typically tied to a specific
cash need.
They are held by non-financial companies.
For example, a manufacturing firm may build a large
fund of securities to pay for a renovation to its plant or
to retire bonds that will come due.
Since they are acquired for longer-term return,
unrealized gains or losses that result from adjustments
to market value do not pass through the income
statement but stay on the balance sheet as an equity
account.
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2.c.3. Securities Available for Sale
Example 7 from text, page 603


Reconsider example 6, but assume that the securities
are properly classified as securities available for sale.
Record acquisition of trading securities at acquisition
cost just as before
Dec 31
Year 3


Marketable securities
Unrealized holding gain
35,000
35,000
To revalue the securities to market value and recognize
an unrealized holding gain (also like before).
This unrealized holding gain is not closed to income,
but appears in the equity section of the balance sheet
having bypassed the income statement.
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2.c.3. Securities Available for Sale
Example 7 from Text (Cont.)


Record the sale for $480,000 in the next year after
the unrealized gain has been closed to income.
Recall at the new value of the securities is $435,000.
Jan 3
Year 4

Cash
Unrealized holding gain
Marketable securities
Realized gain on sale
480,000
35,000
435,000
80,000
This realized gain (because it is supported by a sale)
is closed to income also.
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Comparing Trading Securities with Securities
Available for Sale
Both are recorded at acquisition cost. Both are written
up or down to market with adjusting entries.
Both give rise to an unrealized holding gain or loss
account upon adjustment.
However, the unrealized holding gain or loss for trading
securities is considered income; it is close to income and
increases or decreases net income.
While the unrealized holding gain or loss for available for
sale securities is not closed but remains on the balance
sheet. When these securities are sold, this account must
then be closed and the realized gain or loss is the same as
historical cost accounting.
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2.d. Disclosure about Securities
FASB 115 requires the following disclosures for each period
for marketable securities:
1. The aggregate market value, gross unrealized holding
gains, gross unrealized holding losses, and amortized costs
for debt securities held to maturity and equity securities
available for sale.
2. The proceeds from sales of securities available for sale and
the gross realized gains and losses on those sales.
3. The change during the period in the net unrealized holding
gains or loss on trading securities included in a separate
shareholders’ equity account.
4. The change during the period in the net unrealized holding
gain or loss on trading securities included in earnings.
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
2.e. Controversy
The accounting for marketable securities has been
controversial. The accounting issues are:
 Whether to report these instruments at historical
cost (or some method based on historical cost) or
at market value, and
 If at market value, whether to report the changes
from period to period as part of that period’s
income or to await the period when the firm sells
or otherwise disposes of the instrument to record
the gain or loss in income.
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 Minority
3. Minority, Passive
refers to less than 50% ownership.
 Greater than 50% of the voting stock means absolute
control over the corporation.
 When the investing firm cannot or does not influence
the decisions of the owned firm, the investment is
passive.
 The owner of a passive minority investment must
account for the investment using the
 Initial investment is recorded at acquisition cost
 Dividends are recorded as revenue
 At the end of accounting periods, the asset is
adjusted to the market value
 A sale of the asset results in a realized gain or loss
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 Between
4. Minority, Active
20% and 50% gives rise to the presumption of
active because an investor can often exert influence over
the decisions of the firm with less than 50% of the
voting stock provided the remainder of the votes are
split.
 Require the equity method of accounting
 Initial purchase is recorded as an asset at the
acquisition cost.
 Each period, the investing firm recognized revenue
equal to its proportionate share of the firm.
 Dividends reduce the asset and are not revenue but
rather a return of capital.
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4. Rationale for Equity Method
Since the purchaser is assumed to be able to
influence the decision of the purchased firm
including its dividend policy,
 There is a risk that the purchaser might use this
influence to manipulate its own income…
 by having the purchased firm declare or fail to
declare a dividend.
 Recognizing a proportionate share of the
purchased firm’s income removes this risk.
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5. Majority, Active
A
parent firm holds more than 50% of the voting stock
of another firm, called the subsidiary firm.
 This gives the parent complete control over the
subsidiary.
 The portion of the subsidiary not owned by the parent
is called the minority interest.
 A corporation is a legal entity and not necessarily an
economic entity. Laws might require or allow separate
legal entities that are controlled by one entity, thus
being one economic entity.
 Certain legal risks can be reduced by having legally
separate corporations.
Copyright  2000 by Harcourt Inc. All rights reserved.
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 Because
5. Majority, Active (Cont.)
one economic entity can control several legal
entities and because there is a risk that income might
be manipulated by economic transactions between the
legal entities,
 U.S. GAAP requires that the financial statements of
legally separate entities be combined under one
controlling economic entity and that one set of
financial statements called the consolidated financial
statements be produced.
 Consolidated financial statements combine the
individual financial statements but reverse out all
transactions that occur between the related firms (for
example, sales from one to another).
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6. An International Perspective
Most countries account for minority, passive
investments using the lower-of-cost-or-market rule.
Accounting for minority and majority active
investments is similar to U.S. GAAP.
The IASC requires the equity method for
investments where the holder exerts significant
influence and has no plans to sell in the near future.
The IASC expresses a preference for consolidations
of controlled entities.
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Chapter Summary
Investments are held either for profit (resold at a
higher price) or for control purposes.
If held for profit, the current market value provides
useful information on that profit potential. Because of
this, GAAP provides for certain securities to be valued
at market value.
If held for control, then the profit of the subsidiary
firm provides useful information. Both the equity
method and consolidations require the parent firm to
recognize accrued income of the subordinate.
Copyright  2000 by Harcourt Inc. All rights reserved.
11-27
Appendix 11.1:
Preparing Consolidated Financial Statements
Preparing consolidated statements requires:
1. Eliminating the parent’s investment account,
2. Eliminating intercompany receivables and
payables, and
3. Eliminating intercompany sales and purchases.
These accounts or transactions are identified and
the journal entries made to eliminate the account
or reverse the transaction.
Balances are taken to equity accounts.
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Appendix. 11.2:
Accounting for Corporate Acquisitions
In a corporate acquisition, one corporation acquires all,
or substantially all of another’s common shares.
Two methods of accounting for acquisitions:
1. Purchase method – like the purchase of a single
asset, records stock at the value of what was given.
Assets and liabilities are recorded and any
difference is goodwill.
2. Pooling-of-interest method – not a purchase but the
two firms continue to operate separately, records
stock at book value and no excess of value over the
purchase price is recorded.
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Appendix 11.3:Effects on the Statement of
Cash Flows of Investments in Securities
Market Value Method:
Calculating cash flow from operations
normally requires no adjustments to net
income.
Unrealized gains or losses require an
adjustment for trading securities but do not
for available-for-sale securities.
 Equity Method:
Does require an adjustment to net income.
