Chapter 3: Investments

Why Companies Invest

A company may temporarily have excess cash that is not needed for use in its current operations. companies may invest their idle or excess funds in securities such as:

1. Debt securities , which are notes and bonds that pay interest and have a fixed maturity date.
2. Equity securities , which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

A “security” represents the issuer’s share, participation or other interest in an entity or issuer’s obligation that:

(a) either is represented by an instrument issued in bearer or registered from; or (b) dealt in on securities exchanges or used as a medium for investment; or (c) divisible into a class of shares, participations or obligations.

The purpose of investment (temporary or long term) might be different, but the same debt or equity securities will be used in both temporary and long term investments. The primary objective of temporary investments is to:

• earn interest revenue.
• receive dividends.
• realize gains from increases in the market price of the securities.

For purposes of valuation and reporting at a financial statement date, short-term and long-term investments must be further classified as trading securities, available-forsale securities, or held-tomaturity securities.

• Trading securities are debt or equity securities bought and held principally for the purpose of being sold in the near term to generate income on short-term price differences.
• Available-for-sale securities are debt or equity securities that do not meet the criteria for either trading or held-tomaturity securities.
• Held-to-maturity securities are debt securities that the investor has an intend and ability to hold until their maturity date.

Investments in Debt Securities

The security that represents a credit relationship with another entity upon issuance is called debt security. By investing in a debt security issued by another enterprise, a company plays the creditor role in the market.

Debt securities are classified in three groups based on the intention of a company on investing:

1. Held-to-maturity Securities
2. Available for sale Securities
3. Trading Securities

Held-to-Maturity (HTM) Securities

Held-to-maturity securities include only debt securities because equity securities do not have a maturity (consistent with going concern assumption).

When a debt security is issued, an investor purchases it for a price and receives two types of cash flows in exchange; (i) interest, and (ii) face (nominal or par) value to be received at the maturity.

Face value is the amount written on a debt security to be paid by issuer upon delivery at maturity date.

If the price paid for security is equal to the face value, then the security is told to be sold at par . However, the purchase price generally differs from face value. If the security is sold at a price below the face value, it is sold at a discount . On the other hand, if the price exceeds the face value, security is sold at a premium.

The amounts of premium or discount represent the difference between the face value and the purchase price. These amounts are amortized during the life of security (until maturity), so that the total initial profit or loss (difference between purchase price paid and face value to be received at the end) is allocated to each period. Therefore, these securities are reported with their amortized costs i n the financial statements instead of their fair (market) values.

Held-to-maturity securities are recorded using the amortized cost instead of fair values. Therefore, there is no holding gain or loss to recognize in financial statements.

Fair Value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

An investor should use effective interest rate in order to calculate the amount of amortization for the period.

The effective interest rate is the interest rate that makes the present value of all future cash receipts equal to the purchase price of security.

Discount on bond is a contra-asset account, which is represented to disclose asset at amortized value.

Example (Bond purchased at discount): On 1 January 2018, Investor Company has purchased the bonds of Debtor Company by paying 187,580 TL. The bonds have 200,000 TL face value with 4 years maturity and 10% interest rate declared on it. The interest will be paid semiannually. On January 1, market interest rate is 12%. ( See p.63).

Available for Sale Securities

Companies may invest in debt securities, which are held to be terminated in case of a cash need in the future. These securities are initially designated as available for sale securities, depending on the intention of the management to keep them.

Available for sale securities are usually recognized as noncurrent asset in balance sheet with their fair values (market prices). When the fair value of the security changes, the value of investment changes, too. Therefore, company records “unrealized holding gain” account for an increase in value and “unrealized holding loss” account in case of a decrease in value.

Available for sale securities are measured with their fair values. Any change in value is reflected in balance sheets with the help of unrealized holding gain or loss accounts.

Example:On January 1, 2018,InvestorCompany has purchased the bonds of Debtor Company by paying 116,042 TL with the intention to get interest income as well as protecting the company from a possible illiquidity problem in following years. The bonds have 120,000 TL face value with 4 years maturity and 8% interest rate declared on it. The interest will be paid semiannually. On January 1, market interest rate is 9%. ( See p. 66 ) .

Trading Securities

Trading refers to the purchase and resale of an item. Therefore, when a company purchases a debt security with an aim of reselling for a higher price, this security is classified as trading security.

Capital (holding) gain is the profit generated from an investment arising from the change in value.

When a company purchases a debt security with the aim of reselling for a higher price, this security is classified as trading security.

Trading securities are reported in current assets at fair value, with any change in value being considered in the calculation of net income. No discount or premium is amortized.

Example: On 5 May, 2018 Investor Company have purchased a Treasury bill for 130,000 TL. The Treasury bill has 180 days maturity and a face value of 150,000 TL ( See p. 68 ).

Investments in Equaty Securites

Another option for companies to invest their excess funds in is equity securities. Equity securities are the instruments representing the ownership interest in an entity, such as common stocks, preferred stocks, etc. The initial value of security to record in balance sheet includes purchase price and other incidental expenditures such as brokerage commission and taxes.

In an investment process, the investing party is called “investor” while invested company is called as “investee”.

Holdings of less than 20 Percent (Minority, Passive Investments)

When a company invests in another corporation up to 20% of total outstanding shares, it is assumed that the investor company does not possess an important role in determination of company policies. In other words, this investment does not represent a managerial role in invested company. In this case, depending on the intention of management, the security can be reported either as tradingsecurity or available for sale security.

Trading Securities

If the aim of management is to generate profit from price changes in short term, the security is recorded as trading security (same as in debt securities). Trading securities are initially recorded with their acquisition costs (purchase price plus other costs related to purchase).

Example: On 12 November, 2018 Investor Company purchased 1,200 shares of Equitor Corporation by paying 1.50 TL/share. Investor also paid an additional 120 TL as brokerage commission for this transaction. On the balance sheet date, market price for each Equitor share is 2.00 TL.

(See pages 70,71,72)

Available for Sale Securities

When an investor company purchases less than 20% of another company without an initial intention to generate profit from price changes in short-term, the security is classified as Available for Sale Security.

Example: On December 12, Investor Company has purchased 2,000 shares of Equitor Corp. by paying 3.00 TL for each share. Additionally, the company paid 600 TL for brokerage fees, taxes and other fees, as well. (See pages 72,73).

Mark-to-market rule states that marketable securities should be represented in financial statements with their market values as of the reporting date.

Holdings between 20 Percent and 50 Percent (Minority, Active Investments)

Companies may invest in other in the shares of the other companies’ shares at such a percentage that is enough to join policy determination process but not to control the entity. Generally, it is assumed that having at least 20% of the shares of a company gives an investor the right and power to participate in policy determination process.

Significant influence can be defined as the power to participate and have affect on policy determination process of investee.

When an investor owns more than 20% but less than 50% of invested company providing a significant influence, the investee is reported as “affiliate” in the balance sheet. In this case, investors should initially recognize the affiliate with acquisition cost and use “equity method” 13 for subsequent valuation for this investment, instead of fair value method used for the equity investments representing lower than 20% ownership.

Example: On 23 February, 2018 Investor Company paid 135,000 TL including brokerage commissions, taxes and other fees and bought 35% of Equitor Corporation. (See p. 75)

Holdings of more than 50 Percent (Majority, Active Investments)

When the rate of ownership in invested company exceeds 50 percent, the investor is assumed to have control over the investee because in any case the decision is taken by the investor as more than half of the shares belongs to him. The investor company is called parent and the investee is subsidiary .

Consolidation means that parent company adds all financial statement items of the subsidiary to his own financial statements (after some eliminations and adjustments) and prepares a joint financial statement set combining the financial values of the both of the companies.

Claims of other owners are represented in the consolidated financial statement as “ minority interest ”.

Derivatives as Contractual Investments

Derivatives are the contracts that provide payoffs to investors depending on the values of other assets that they are derived from.

The two most common types of derivative instruments are options and forwards or futures contracts.

While a call option gives right to buy instruments, a put option provides the selling right.

Derivatives are recognized in balance sheet with their fair values. Profit/Loss from derivatives is reported in the income statement.

Transfers Between Categories

Independent from which investment alternative is initially chosen, companies may change their intentions to keep the securities. This change in intention may result in change in classification, too.

When securities are reclassified between the available for sale and trading categories, the unrealized holding gains or losses that incur at the transfer date are recognized in income statement and the securities are valued at fair value as the new cost basis.

In Turkey, it is forbidden to reclassify a security from trading securities to any other form.