Difficulty: Advanced | Prerequisites: Chapter 6 (TVM), Chapter 14 (Bonds, especially amortisation and effective interest method)
Chapter 14 covered bonds from the issuer's perspective. This chapter flips to the investor's side: how to account for investments in debt and equity securities. The classification you assign to an investment (Held to Maturity, Trading Securities, Available for Sale, Equity Method or Consolidation) determines everything about how it appears on the financial statements, from balance sheet valuation to where gains and losses are reported. This is one of the most detail-heavy chapters in intermediate accounting, and it draws heavily on the bond mechanics you have already studied.
Debt investments are classified as HTM, Trading or AFS, each with different rules for balance sheet valuation and income recognition. Equity investments below 20% ownership generally use fair value through net income. Ownership of 20-50% triggers the equity method, and over 50% requires consolidation. The classification drives whether unrealised gains and losses hit Net Income, OCI, or are not recognised at all.
Held to Maturity (HTM)
A classification for debt securities the investor intends and is able to hold until maturity. Reported at amortised cost on the balance sheet. Think of it as: "We are not selling this, so market fluctuations do not matter for reporting."
Trading Securities (TS)
Debt or equity securities held for short-term resale. Reported at fair value, with all unrealised gains and losses flowing through Net Income. In simple terms, these are the investments the company is actively buying and selling.
Available for Sale (AFS)
Debt securities that do not qualify as HTM or TS. Reported at fair value on the balance sheet, but unrealised gains and losses go to Other Comprehensive Income (OCI), not Net Income.
Fair Value Adjustment (FVA)
A valuation account that captures the difference between an investment's amortised cost and its fair value. FVA-TS flows through Net Income; FVA-AFS flows through OCI.
Unrealised Holding Gain or Loss (UHG / UHL)
The change in fair value of an investment that has not yet been sold. Where it is reported depends on the investment classification.
Other Comprehensive Income (OCI)
A component of equity that captures certain gains and losses not included in Net Income. AFS unrealised gains and losses are the classic example in this chapter.
Reclassification adjustment
When an AFS security is sold, any cumulative unrealised gain or loss previously reported in OCI must be reclassified into Net Income so it is not counted twice.
Equity method
Used when the investor owns 20-50% of the investee and has significant influence. The investment account is adjusted for the investor's share of the investee's earnings and dividends.
Consolidation method
Used when the investor owns more than 50% and controls the investee. The financial statements of both entities are combined.
Goodwill
The excess of the purchase price over the investor's share of the fair value of the investee's net assets. Arises under the equity method and consolidation.
Other-Than-Temporary (OTT) impairment
A decline in fair value that is judged unlikely to recover. Triggers a write-down, with the reporting location depending on the type of investment and the nature of the loss.
HTM | Trading Securities | AFS | |
|---|---|---|---|
Balance sheet | Amortised cost | Fair value | Fair value |
Unrealised gains/losses | Not recognised | Net Income | OCI |
Income statement | Interest revenue only | Interest revenue + UHG/UHL | Interest revenue only |
Debt securities only. The investor must have both the intent and the ability to hold to maturity.
Reported at amortised cost. No fair value adjustments are recorded.
Journal entries follow a three-step pattern:
Acquisition: Debit Investment in Bonds, Credit Cash (purchase price).
Interest receipt: Debit Cash (coupon rate x face / 2 if semiannual), Debit or Credit Investment in Bonds (plug for discount amortisation or premium amortisation), Credit Interest Revenue (purchase price x yield / 2 if semiannual).
Fair value adjustment: None for HTM.
If sold before maturity: Debit Cash (proceeds), Debit or Credit Gain/Loss on Sale (plug), Credit Investment in Bonds (amortised cost at sale date).
Held for current resale. Short-term profit motive.
Balance sheet shows fair value. Income statement includes interest revenue and unrealised holding gains or losses.
Journal entries:
Acquisition: Same as HTM.
Interest: Same as HTM.
Fair value adjustment: Debit FVA-TS (FMV minus amortised cost), Credit UHG-Net Income. If fair value has fallen, the entry reverses.
If sold before maturity: Debit Cash, Debit or Credit Gain/Loss on Sale (plug), Credit FVA-TS, Credit Investment in Bonds. No reclassification adjustment is needed because UHG/UHL already went through Net Income.
The default for debt securities that are neither HTM nor TS.
Balance sheet shows fair value. Unrealised gains and losses go to OCI, not Net Income.
Journal entries:
Acquisition: Same as HTM.
Interest: Same as HTM.
Fair value adjustment: Debit FVA-AFS (FMV minus amortised cost), Credit UHG-OCI.
If sold before maturity: Debit Cash, Debit Reclassification Adjustment (cumulative OCI amount x % sold), Debit or Credit Gain/Loss on Sale (plug), Credit FVA-AFS, Credit Investment in Bonds. The reclassification adjustment moves the cumulative unrealised gain or loss from OCI into Net Income so it is not double-counted.
Default method for equity investments where the investor owns less than 20% and does not have significant influence.
Recording purchases: Debit Investment at acquisition cost. Maintain a separate sub-account for each security.
Dividends: Record revenue when declared. Debit Cash or Dividend Receivable, Credit Dividend Revenue.
Year-end revaluation: Calculate the unrealised gain or loss for each security. Adjust the FVA account so the balance sheet reflects fair value. UHG and UHL go through Net Income.
Sale: Record the difference between proceeds and current book value as a realised gain or loss. Debit or credit FVA to zero it out for the sold security.
Used when the investor has significant influence over the investee.
The investment account is a living balance that changes with the investee's performance:
Record investment: Debit Investment in [Investee] (equity x % owned), Credit Cash.
Recognise share of earnings: Debit Investment in [Investee] (net income x % owned), Credit Investment Revenue.
Recognise dividends declared: Debit Dividend Receivable (dividend x % owned), Credit Investment in [Investee]. Note: dividends decrease the investment account, they are not revenue under the equity method.
Excess cost depreciation: If the purchase price exceeded the investor's share of book value, the excess attributable to depreciable assets is amortised. Debit Investment Revenue, Credit Investment in [Investee].
Goodwill = Purchase price minus [(FV of assets minus Liabilities) x % owned]. Goodwill is not amortised but is tested for impairment.
When the investor controls the investee, the financial statements of both entities are combined into a single set of consolidated statements.
Intercompany transactions are eliminated.
Available for HTM, AFS and equity method investments.
If elected, the investment is carried at fair value with all unrealised gains and losses in Net Income.
The election is made for each individual investment and is irrevocable.
Equity investments:
Step 1: Is fair value below cost? If yes, the investment is impaired.
Step 2: Can the investor assert intent and ability to hold until recovery? If not, the impairment is other-than-temporary.
Step 3: The OTT impairment is reported in Net Income.
Debt investments:
Step 1: Is fair value below amortised cost? If yes, impaired.
Step 2: Does the investor intend to sell, believe it is "more likely than not" they will be required to sell before recovery, or have incurred credit losses? If any of these, the impairment is OTT.
Step 3: If the investor intends to sell or is more likely than not to be required to sell, the entire impairment goes to Net Income. Otherwise, the credit loss portion (amortised cost minus PV of expected cash flows) goes to Net Income, and the non-credit loss portion (total impairment minus credit loss) goes to OCI.
Banks and insurance companies hold enormous portfolios of debt securities classified as HTM or AFS. The classification choice directly affects the volatility of their reported earnings: HTM shields the income statement from market-rate swings, while AFS keeps unrealised movements in OCI. This is why, during periods of rising interest rates, you see headlines about banks' "unrealised losses" in AFS portfolios. The equity method is how companies like Berkshire Hathaway account for their large minority stakes in other businesses.
Students frequently mix up where unrealised gains and losses are reported. Remember: Trading goes to Net Income, AFS goes to OCI, HTM recognises nothing.
Students sometimes forget that under the equity method, dividends reduce the investment account. They are not recorded as revenue (unlike the fair value through NI method for equity investments below 20%).
Some students think the reclassification adjustment for AFS only applies when there is a gain. It applies to losses too. Any cumulative OCI amount must move to Net Income upon sale.
Students often confuse the FVA account directions. FVA is debited when fair value exceeds amortised cost and credited when it falls below. The offsetting entry depends on the classification.
⚠️ Be able to prepare all four journal entries (acquisition, interest, fair value adjustment, sale) for HTM, TS and AFS. The exam will almost certainly include at least one full walk-through.
⚠️ Know the classification summary table cold: where each type sits on the balance sheet and where unrealised gains/losses are reported.
⚠️ The reclassification adjustment for AFS is a common exam question. Understand why it exists (to avoid double-counting) and how to compute it.
⚠️ Under the equity method, be ready to compute goodwill, excess cost depreciation and the impact of dividends on the investment account.
⚠️ OTT impairment: know the three-step process for both equity and debt investments. For debt, be able to split the impairment into credit loss (Net Income) and non-credit loss (OCI) portions.
True or False: HTM securities are reported at fair value on the balance sheet.
False. HTM is reported at amortised cost.
Fill in the blank: Under the equity method, dividends received from the investee ______ the investment account.
Decrease (reduce).
True or False: Unrealised gains on Trading Securities are reported in OCI.
False. They go through Net Income.
Fill in the blank: The reclassification adjustment for AFS ensures that gains or losses are not ______.
Double-counted (counted in both OCI and Net Income).
True or False: The fair value option, once elected for an individual investment, can be reversed in a later period.
False. The election is irrevocable.
Q: A company purchases bonds for $980,000 (face value $1,000,000, yield 6%, coupon 5%, semiannual). It classifies the investment as HTM. What is the interest revenue for the first period?
A: Interest revenue = Purchase price x (Yield / 2) = $980,000 x 3% = $29,400.
Q: An AFS bond investment has an amortised cost of $500,000 and a fair market value of $520,000 at year-end. What journal entry is required?
A: Debit FVA-AFS $20,000, Credit UHG-OCI $20,000.
Q: A company holds 30% of another firm. The investee reports net income of $200,000 and declares dividends of $50,000. What entries does the investor make?
A: To recognise earnings: Debit Investment in [Investee] $60,000 (200,000 x 30%), Credit Investment Revenue $60,000. To recognise dividends: Debit Dividend Receivable $15,000 (50,000 x 30%), Credit Investment in [Investee] $15,000.
Q: A company sells 40% of its AFS bond portfolio. The cumulative UHG in OCI for the entire portfolio is $100,000. What is the reclassification adjustment?
A: $100,000 x 40% = $40,000. Debit Reclassification Adjustment (OCI) $40,000, which moves that portion into Net Income as part of the gain or loss on sale.
Q: How does the OTT impairment analysis differ between equity and debt investments?
A: For equity: the entire OTT impairment is recorded in Net Income. For debt: if the investor intends to sell, the full impairment hits Net Income. Otherwise, the credit loss portion goes to Net Income and the non-credit loss portion goes to OCI.
This chapter is the mirror image of Chapter 14. Where Chapter 14 covers the issuer's Bonds Payable, this chapter covers the investor's Investment in Bonds. The amortisation mechanics (effective interest method, discount and premium) are identical; only the account names and debit/credit directions change.
The equity method connects to consolidation topics that appear later in advanced accounting courses. Understanding how goodwill arises and how the investment account moves with earnings and dividends is essential groundwork.
OCI, introduced here through AFS and the reclassification adjustment, will reappear in topics such as foreign currency translation and pension accounting.
Investments, debt securities, equity securities, held to maturity, HTM, trading securities, available for sale, AFS, fair value adjustment, FVA, unrealised holding gain, unrealised holding loss, UHG, UHL, other comprehensive income, OCI, reclassification adjustment, equity method, significant influence, consolidation, goodwill, fair value option, other-than-temporary impairment, OTT impairment, credit loss, non-credit loss, amortised cost, fair value through net income, dividend revenue, investment revenue, ACC 472, intermediate accounting, Chapter 12