Question

Watson Company has several investments in the securities of other companies. The following information regarding these investments is available at December 31, 2019.

1. Watson holds bonds issued by Fowler Corp. The bonds have an amortized cost of $600,000, and their fair value at December 31, 2019, is $700,000. Watson intends to hold the bonds until they mature on December 31, 2022.

2. Watson has invested idle cash in the equity securities of several publicly traded companies. Watson intends to sell these securities during the first quarter of 2020, when it will need the cash to acquire seasonal inventory. These equity securities have a cost basis of $500,000 and a fair value of $620,000 at December 31, 2019.

3. Watson has a significant ownership stake in one of the companies that supplies Watson with various components Watson uses in its products. Watson owns 5% of the common stock of the supplier, does not have any representation on the supplier’s board of directors, does not exchange any personnel with the supplier, and does not consult with the supplier on any of the supplier’s operating, financial, or strategic decisions. The cost basis of the investment in the supplier is $1,400,000, and the fair value of the investment at December 31, 2019, is $1,800,000. Watson does not intend to sell the investment in the foreseeable future. The supplier reported net income of $200,000 for 2019 and paid no dividends.

4. Watson owns some common stock of Stein Corp. The cost basis of the investment in Stein is $300,000, and the fair value at December 31, 2019, is $250,000. Watson believes the decline in the value of its investment in Stein is other than temporary, but Watson does not intend to sell its investment in Stein in the foreseeable future.

5. Watson purchased 25% of the stock of Love Co. for $500,000. Watson has significant influence over the operating activities of Love Co. During 2019, Love Co. reported net income of $200,000 and paid a dividend of $50,000.

Required: Determine whether each of the investments described should be classified as fair value securities, held-to-maturity securities, or equity method securities. Determine the reason of your classification.

Answer 1

Held to maturity securities are debt securities which the enterprise has the intent and ability to hold the maturity. These are reported at amortized cost and which have fixed or determinable payments. Common stock, preferred stock cannot be classified as held to maturity as they do not have fixed payments.

Fair value securities are debt and equity securities held principally for selling them in the near future. They are reported at fair value with unrealized gains and losses included in earnings.

Equity method securities are those where investment is more than 20% i.e, investment in the associate enterprise. The ownership of less than 20% creates an investment position.

1) Held to maturity securities.

Reason: Given that, Watson intends to hold the bonds until they mature and using the amortized cost for recognition of bonds. Here bonds will be having fixed payments.

2)Fair value securities.

Reason: Given that, Watson intends to sell the securities during the first quarter when it will need the cash for purchasing seasonal inventory. It intends to sell these securities in the near future.

3) Equity method securities

Reason: Given that, Watson does not intend to sell the investment in the foreseeable future and owns 5% of common stock of the supplier, therefore it is not a case of fair value security or held to maturity security. Therefore classified as Equity method securities.

4) Equity method securities

Reason: Given that, Watson does not intend to sell the investment in the foreseeable future and owns some of common stock of the supplier, therefore it is not a case of fair value security or held to maturity security. Therefore classified as Equity method securities.

5) Equity method securities

Reason: Given that, Watson purchased 25% of the stock of Love Co and it has significant influence over Love co. Therefore this is an investment in associate enterprise.