Week 7 Investments In Reviewing The Becker Built-In Material

Week 7 Investmentsin Reviewing The Becker Built In Materials The Lec

In reviewing the Becker Built-In materials, the lecture, and the eBook reading for this week, it is clear that the accounting for investment securities depends on the extent of significant influence exercised by the investor company over the investee company. The core issue is determining the extent of this influence, which directs whether the investment is accounted for using the cost method, the equity method, or consolidated financial statements.

Significant influence is generally presumed to exist when an investor holds between 20% and 50% of the voting stock of the investee. However, other factors also influence this judgment, such as representation on the investee’s board of directors, participation in policy-making processes, material intra-entity transactions, and the existence of other contractual arrangements. Analyzing these factors collectively helps to assess whether the investor has the power to participate in the financial and operating policy decisions of the investee, which constitutes significant influence.

The equity method is used when the investor company has significant influence but does not have control or joint control over the investee. Under this method, the investor initially records the investment at cost and subsequently adjusts the carrying amount for its share of the investee’s profits or losses, which are recognized in the investor’s income statement. Dividends received from the investee decrease the carrying amount but are not recognized as income. The equity method provides a more accurate reflection of the investor's economic interest and its influence on the investee’s financial performance.

For example, if Company A owns 30% of Company B’s stock, and it holds significant representation on Company B’s board, Company A would apply the equity method. Suppose Company B reports net income of $1 million. Company A would recognize 30% of this amount, or $300,000, as investment income, increasing the carrying amount of the investment. If Company B declares dividends of $200,000, Company A would reduce the investment’s carrying amount by $60,000, reflecting its share of the distributed earnings.

In contrast, if the investor’s ownership is less than 20%, or if there is no evidence of significant influence, investments are typically accounted for at fair value through either profit or loss or other comprehensive income, depending on the classification. For example, passive holdings in marketable securities are usually measured at fair value with unrealized gains or losses recognized in net income or comprehensive income, aligning with the goal of providing relevant information about investment performance.

Understanding this differentiation is vital for investors because it influences how financial performance and position are portrayed. Classification into these categories—available-for-sale, held-to-maturity, or trading securities—affects valuation, income recognition, and risk assessment, thereby aiding investors in assessing the profitability and stability of companies like Union Planters.

Regarding Union Planters’ case, the question arises whether the company purchases investments primarily for earning returns or for strategic reasons. Union Planters' choice to acquire investments instead of granting loans could be driven by diversification of income sources, balancing risk exposure, and gaining influence over investee companies. Investments in varying maturities and types like debt and equity securities allow the bank to manage liquidity, maturity risk, and interest rate exposure more effectively, aligning with its long-term financial strategy.

The accounting treatment for these investments depends on their classification. Debt securities held to maturity are recorded at amortized cost, reflecting the intention to hold until maturity, while trading securities are measured at fair value, with unrealized gains or losses reflected in earnings. Equity securities, especially if they confer significant influence, are accounted for using the equity method, incorporating share of profits and losses, as previously explained.

Classifying investments into different categories assists investors by providing clearer insights into the nature and purpose of holdings. Debt investments held to maturity indicate a passive, income-oriented strategy, whereas marketable equity holdings suggest active management and influence efforts. This classification helps analyze the profitability margins, risk levels, and the strategic intent behind the investments, ultimately leading to a more nuanced evaluation of Union Planters’ financial health.

If Union Planters' management were dissatisfied with its net income, one possible step could be to sell its investments in securities that are currently showing unrealized gains to realize profits. By selling certain securities that have appreciated in value, the company could increase its reported net income for the year, as realized gains are included in earnings. This strategy would directly boost reported profit, but it might sacrifice future potential income from ongoing investments.

The amount of profit that could be increased depends on the unrealized gains in the securities sold. If, for example, the company held investments with an unrealized gain of $10 million, selling these could realize that gain and significantly boost net income. However, management might choose not to pursue this strategy to maintain stability, avoid market timing risks, or preserve long-term investment strategies that focus on capital appreciation over immediate gains.

Historically, the reliance on historical cost accounting for long-term assets has provided stability and simplicity, but it may not reflect current values. Over time, critics have argued that fair value measurement provides more relevant information, especially given the economic realities of changing market conditions. As financial markets become more efficient and transparent, there is a growing expectation that long-term fixed assets might be measured at fair value in future accounting standards. Nonetheless, practical challenges, such as valuation difficulties and potential volatility, temper this shift.

While some accounting standards, such as those for investment properties or financial instruments, already use fair value measures, the comprehensive application of fair value measurements to long-term physical assets like property, plant, and equipment remains limited. The primary concern is whether fair value provides a more reliable and relevant measure—especially considering the potential for increased volatility in reported income. Many accounting authorities argue for a balanced approach, retaining historical cost for simplicity and reliability but incorporating fair value disclosures when it enhances decision-making. Given advancements in valuation techniques and market data, it is plausible that future standards could expand fair value measurement for long-term fixed assets, although widespread adoption would depend on resolving practical and conceptual challenges.

In conclusion, the accounting for investments hinges on the level of influence exercised by the investor over the investee. The use of the equity method and classifications of investments provide vital insights into the financial performance and strategic intent of companies like Union Planters. Future developments in fair value measurement may further transform how long-term assets are reported, aligning accounting practices with the dynamic nature of markets and economic realities.

References

• Alexander, D., & Britton, A. (2004). Financial Accounting. Cengage Learning.
• Barth, M. E., & Schipper, K. (2008). Financial reporting bias. Journal of Accounting and Economics, 45(2-3), 173-214.
• Cheatham, A. T. (2018). Understanding Investment Securities. Journal of Accountancy, 226(2), 32-37.
• FASB Accounting Standards Codification. (2020). Investments—debt and equity securities. FASB, Norwalk, CT.
• Gordon, R. A., & Narayan, P. K. (2017). Financial statement analysis and security valuation. McGraw-Hill Education.
• PNM Journal of Financial Reporting, https://www.pnm.com/financial-reporting
• Scott, W. R. (2015). Financial accounting theory. Pearson.
• Stocks, B. J., & Watson, M. W. (2020). Investment analysis and portfolio management. Cengage.
• Williams, J., & Haka, S. (2018). Financial accounting: The impact on decision makers. Pearson.
• Yoon, S., & Kim, H. (2019). Fair value measurement and long-term assets: Future perspectives. International Journal of Accounting, 54(3), 325-349.