Hello, I'm Professor Brian Bushee, welcome back. In this video, we're going to kick off our look at marketable securities, which are a company's investments in the stock or debt of other companies. We've got a lot of methods to get to, so let's get started. So let me do a big overview of the different accounting methods for inter-corporate investments and then we'll, of course, dive in and look at some of these in more detail. So, we're talking about investments in equity or debt of another company. So, equity is you're buying shares of stock of another company, debt would mean that you're buying the bonds issued by another company. The accounting treatment for these investments is going to depend on your influence and your intent for doing the investment. So, for small investments in equity, so you buy less than 20% of another company's shares, and that's considered a situation where wouldn't have a lot of influence over the other company. Or for all investments in debt securities, obviously there's no percent ownership with debt, you're just buying amounts of bonds on the market. We're going to call these assets marketable securities, and there's going to be three methods that we're going to look at. Trading securities available for sale, and how the maturity with the latter only being used for ead investments whereas the first two could be used for equity or debt. Then you can have a strategic investment in the equity of another company. So here you own 20 to 50% of the shares of stock, of another company or you have what's called significant influence even if you don't own 20%. This asset is going to be called Investment in affiliates, and here there's going to be two methods. Either the Equity method or Fair value accounting. And then the last kind of investment is you could actually control the other company. You could own more than 50%of another company, which means that you could outvote all the other shareholders and basically decide what the other company does. Here there's just one method for consolidation where you add up all the assets, liabilities of the other company and then recognize this thing called non-controlling interest for the part that you don't own. Six methods? Really? Are you serious? How can we possibly learn six methods? >> Yeah, you're right six methods is a lot to learn and we are not going to learn all six methods, we are just going to focus on the trading securities, available for sales securities and how the maturity. We are not going to talk about the significant investments. Or the control investments in this course. Just the fact of the matter is they're both way too complicated and in fact, we have an entire semester long elective here, which talks about those methods in detail. So, I can't do them justice without spending, say, a week or maybe even two weeks on them. So you're not going to be held responsible for this equity method, or for this consolidation method. Instead, we're just going to focus on the marketable securities. >> And why don't all equity investments go into stockholders' equity? And why don't all the debt investments go in to notes payable? >> Yeah, thanks for the, the questions, this is a good chance to clarify the following. So when we issue equity, raise money with equity, that's common stock. When we buy another company's stock, so we're on the other side of the transaction, it's an investment asset. Similarly, if we borrow money by issuing a bond, it's not payable, but if we're in the other side of the transaction buying another company's bond, then it's an investment asset. So focusing on the marketable securities, first we're going to look at equity investments so this is where we're buying the stock of another company, and we're holding less than 20% of the ownership, we don't have any significant influence. So the accounting is going to be based on the intent for making the investment, so the first method is called Trading Securities. Here your intent is to profit from short-term fluctuations in market prices. In other words, you're actively managing these investments, trying to beat the market. Trying to buy low, sell high, earn profits in the short term. This method is common in financial services firms, so banks or investments banks, and financial services divisions like General Electric has GE Capital as a division. These financial services firms and divisions part of their business is to profit based on their information and try to beat the market in the short term. So they would use this trading securities method. The next method is available for sale securities, or what we'll probably call AFS through most of the video. Here the intent is to just earn returns over medium to long term, it's a way to invest excess cash until you need it for a new project, so you have some excess cash, you're holding on to it, waiting for an acquisition or some capital expenditures to come, you could put it in a savings account and earn 7/10% of interest, or you could invest in stocks to try to get a higher return. But you're not trying to actively manage the portfolio to get gains in the short term. This method is very common among non-financial firms. So, firms other than banks or investment banks. >> Really, intent, this whole accounting choice is based on intent? How does the manager know his intent? What if he changes his mind? >> Yes, I agree this is sort of weird that we have managers' intentions dictating how this is accounted for. But little history will show that this really came about as a compromise. So when the FASB first proposed putting marketable securities at fair value on the balance sheet. Your idea was that the unrealized gains and losses would just go on the income statement. That was fine for financial services firms, which viewed trading and marketable securities as a core part of their business and so it made sense to have it on the income statement. You had a number of non financial firms, some regular companies. They were holding these securities, they did not want their income to now show the volatility of these unrealized gains and losses over time. So there was a compromise where basically if you wanted to show these unrealized gains or losses in income. You could, we call that method trading securities. If you don't want to show these unrealized gains and losses in your income, you want to keep that volatility out of your income statement, we've got a method for you, as well, called available for sale securities. So that's really where the two methods came from, and it really breaks down to almost a financial versus non-financial categorization. Although many financial firms still have some AFS and some non, non financial firms have trading. As far as changing method, you are allowed to change the classification of the securities if you change your intent. And we'll talk about all of these issues as the video goes along. So, now let's talk about the differences in accounting treatment between trading securities and available for sale securities. On this slide we'll just lay out the conceptual differences and then obviously we'll go through examples to make these more concrete. On the balance sheet, it turns out there's going to be no difference between the two methods. Under both methods, the investment's going to be carried at fair value on the balance sheet date, or as people say, mark to market. So if you held shares of stock in another company like, let's say, Microsoft. At the balance sheet date you'd have to look at the stock price of Microsoft use that to figure out the market value of your investment. That's what would show up on the balance sheet date. Now what that's going to create is unrealized gains or losses. Unrealized gains or losses are where you get a gain or loss on holding the security. But it's a paper gain, or I guess now a days an electronic gain. You still hold the stock, it's still holding the gain or loss, you haven't realized it. What, later we'll talk about realized gains or losses, that's where you actually sell the stock, and then get a gain or loss based on selling the stock. Unrealized is a gain or loss that you've experienced from holding the stock, but that could go away as you continue to hold the stock. Now these unrealized gains or losses are important because this is where the two methods are going to differ. So when we go to the income statement, for trading securities, unrealized gains and losses are going to go directly on the income statement. So if you're holding shares of Microsoft stock over the quarter it goes up in value, you get an unrealized gain. That unrealized gain goes on the income statement as part of your net income. For available for sales securities or AFS securities, that unrealized gain or loss is going to go into something called Accumulated Other Comprehensive Income or as we're going to call it AOCI. So we're going to talk more about AOCI. LAter on in the course, but we have to introduce the concept here because it is a central part of this accounting treatment. So AOCI is like a retained earnings account, in fact look, the words are sort of similar so instead of retained, we say accumulated, instead of earnings we say comprehensive income, which sort us downs like earnings,. But the difference is that transactions go directly in an AOCI without appearing on the income statement. So think back to, how we do things that go on the income statement, like a trading security gain would go on the income statement. Into net income, and then net income would go into retained earnings. For available for sale, this unrealized gain or loss is going to go directly into AOCI without showing up on the income statement. So either way it goes into stockholders' equity. Stock holders equity would go up with an unrealized gain. The difference is with ALCI, it doesn't have to go through the income statement, like it does with retained earnings. ALCI is going to store up this unrealized gains and losses until the security is sold, and then when it's sold, when we realize the gain or loss. Then it's going to be reversed out into the income statement. And, and obviously this is very abstract at this point. We're going to go through examples to show you exactly how this works. But one more key disclaimer, transactions actually go into AOCI net of taxes. But we're going to ignore taxes for now, but we're going to ignore taxes for now. Cause to do taxes, we'd have to talk about deferred taxes and we're not scheduled to talk about that for another couple of weeks. So just keep in the back of your mind we're finessing this a little bit. We're having these gains or losses go into AOCI before tax, but in reality we would take out a tax effect before they would go into AOCI. >> Accumulated other comprehensive income. That has to be the dumbest account name I have ever heard! What were those FASB guys thinking when they came up with this one? What is this Comprehensive income stuff? Why isn't this just income? >> I like to think of AOCI as the FASB's attic. You know how a house will have an attic, like a storage room up near the roof, where you have something that you don't know what to do with now. You store it in the attic until you need it later. Well, that's essentially how AOCI functions, is you have this unrealized gain or loss. It has to go into stockholder's equity, because otherwise your balance sheet equation won't balance. But you don't want it to go through the normal income statement retrained earnings channel, so instead, we take this unrealized gain or loss and stored in AOCI. Stored in the attic until we need it, and then when we need it, we take it out of AOCI and run it through the income statement into retained earnings. This will all be clear as we do some examples, but for now, just think of this notion of comprehensive income and ALCI as needing to balance the balance sheet equation. So I'd have to put things in stockholders' equity. But we don't want to run through the income statement yet. So we just store it up in ALCI, till we're ready to run it through the income statement. Then when that happens, we'll pull it out of ALCI, running through the income statement and into it's permanent home in retainer X. Okay, so let's start looking at some examples to get a better insight into how these two methods work. So Bott Bank goes out and buys $100 of TK stock which is less than 20% ownership in, in TK. Bott decides to classify the investment as trading security because their intent is to try to profit on this investment in the short term. Their journal entry is they debit marketable securities to create the asset for the investment. And, of course, credit cash because they're paying cash. Meyer Company, a non-financial firm, goes out and also buys $100 of TK stock, also less than 20% ownership. They decide to classify the investment as an available for sale security. Because they're making this investment as like a medium term use of cash. They're not trying to profit in the short term. They just want to have a decent return on their cash until they need to use it to make some kind of strategic investment. Their journal entry is the same. They debit the investment asset, Marketable Securities, credit cash and so when you buy the securities there's no difference between AFS and Trading. Now we receive dividends from TK stock, so Bott Bank gets a $5 dividend payment from TK stock, their journal entry is debit cash, so they receive cash $5 credit, dividend revenue. You get to record this as a source of revenue on the income statement, $5. Meyer gets the same dividend, because they own the same percent of stock. And they make the same journal entry. They get cash, they get to record it as dividend revenue and there's no difference, again, between the two methods any time we receive a dividend on our investment. Really? There are two methods, but all of the entries are the same? This sounds like Accumulated Other Comprehensive Nonsense. >> [LAUGH] Accumulated Other Comprehensive Nonsense. I love it, can I steal that one from you? So now we're going to get to the part of the example where the two methods will have different outcomes. Now let's look at what happens when we get to the balance sheet date. So, it's the end of quarter and we have to mark our investments to market value. So quarter end Bott Bank's investment in TK stock is now worth $103. So we bought it at 100, now it's 103,so it's gone up in value by $3. So we do is first of all in the journal entry, we debit Marketable Securities by three to increase the balance in that account from 100 to 103 which is the current market value. And since it's a trading securities method, that gain goes onto our income statement. So it's going to be treated as a, like a revenue account, show up in the income statement and then eventually works way into stock holders equity through retained earnings. Meyer Company has the same investment in TK stock and so at quarter end it's also gone up to 103. Their journal entry is debit marketable securities by three. So, the balance sheet is the same under both methods where we market to the current market value or fair value. So we need to increase the investment account by three to get it from 100 to 103. But what differs is under the AFS method, we credit accumulated other comprehensive income. Notice there's no plus R here it doesn't go onto the income statement. It goes directly into stockholders equity. And what I'm going to do is carrying around thee AOCI T-account so that we can see how it works through the example. So what this does is basically put an entry on the credit side of AOCI, which is going to increase stockholder's equity. [SOUND] So the unrealized gain that we got is part of net income, under the trading securities method for Bott. Which means it goes into net Income, and eventually into retained earnings but it bypasses net income for available for sale. AFS, for Meyer. So, it doesn't show up in the income statement, goes in to AOCI, the net effect is stockholder's equity goes up under both cases, but the difference is, it doesn't show up on the income statement under AFS, where it does under trading. What do you mean by an unrealized gain? A gain is a gain. >> Yeah I would always want to book gains on my income statement. I don't care whether they are unrealized or not. >> Yeah, good time for a reminder that an unrealized gain is called unrealized because you still hold the stock. It's essentially a holding gain or a paper gain. It could go away tomorrow if the stock price drops. This is different from a realized gain, which would happen when you actually sell the stock and it locks in the total gain that you're going to get on the investment. And of course, it'd be nice to always book unrealized gains in income, but how about unrealized losses? It's one of these things where you have to choose the method. You can't choose it after you see the gains and losses, you have to choose it before. Maybe you could choose that after. We'll talk about that a little bit later. Finally, we, both companies decide to sell their investments. So after the quarter end, Bott Bank decides to sell its TK stock. And at that point, the price is 101. So the journal entry is, Bott is receiving $101 of cash. Makes sense, right, they sell their stock for 101, that's how much they get in cash, they get rid of the asset account, so remember we just wrote the asset account to 103 at the quarter end. So to get rid of the balance we need to credit marketable securities for 103. And then we plug, a gain or loss in this case it's a loss, because we need a debit. So it's a loss on investment of two. That will show up as, as an expense on the income statement, and then eventually reduce stockholder's equity when we run it through retained earnings. Meyer also decides to sell its TK stock for $101. Now, this seems sort of strange, because they did available for sale, which meant their intent was to hold it for the medium or long term. But even if that's your intent, you're always allowed to change your mind. So if Meyer eventually decides they need to sell the stock now to get the cash, it's okay to do that even though they chose AFS. It's based on your orignal intent, but you can change your mind if you need the cash to fund some kind of project. So anyway, Meyer also gets 101 cash. And they also remove the markable securities balance of 103. So these two parts are not different between the two methods. You get the same cash, debit cash, you get rid of your balance and marketable securities, which is 103 under both methods. But what's different under AFS is, we're restoring up this gain under AOCI. So let me bring up the T-account. So we had this credit balance where we were storing up this gain of 3 until we sold the stock. So it's like we put it up in the attic until we need it. Well, now that we've sold the stock, we need to pull that gain out of the attic. We need to remove it from AOCI, and the way you remove it from AOCI is a debit. By debiting AOCI, it cancels out that credit and gets the gain out of there completely and leaves a zero balance in AOCI. Then we plug, and it turns out, [LAUGH] that Meyer gets to record a gain on the investment, because this is a realized gain. We actually realized this by selling the stock. It goes on the income statement. We'll go through retained earnings and the stockholders' equity. So notice that the realized gain or loss for Trading securities, for Bott is based on the last based on the last balance sheet value. So relative to the value of 103 at the last quarter end you lost 2 on your investment. But for Myer the gain or loss is based on the original cost. You bought it at 100, you sold it at 101, you actually got a gain of one. So, this is a fundamental difference between the two methods. Trading securities you're realized gain and loss is always based on what it was last valued at the balance sheet date. Whereas for available for sale, your gain or loss is based on what you originally bought at. You bought it at 100, sold it at 101, that's a gain of 1. Versus AFS, it was 103 the last time you put it on the balance sheet, you sold it for 101, you actually lost 2 relative to that most recent valuation. Really? Bott and Meyer bought the stock at the same price, and sold the stock at the same price. But, their gains are different? LOL, this is just silly. Yeah, I, I would agree it seems silly on first glance. But really the method is set up to accomplish two different objectives. So if you want to show you gain or loss based on what's happened recently what's happens since the last balance sheet date,. Then the trading securities method does that. But if you want to show gain and loss over the entire history of the investments, then available for sales securities does that. So, it really gets back to, what's your intent for holding the securities. Do you want to show recent market performance or long term market performance. Whatever your choice is, we've got a method for you. When we get to the summary slide at the end of the example, I hope you'll see that it's not quite as silly as it, as it may seem. But you're going to have to wait to see that great summary slide and the rest of the example until the next video. It's not the most ideal place to cut off the example but I got a lot of stuff to get through yet, so I figured I'd better stop here. And, cut it into two more manageable size videos. I'll see you next time. See you next video.
