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Investments Judith Paquette . Chapter 12. Financial Accounting, Seventh Edition. Discuss why corporations invest in debt and stock securities. Explain the accounting for debt investments. Explain the accounting for stock investments.

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Investments

Judith Paquette

Chapter12

Financial Accounting, Seventh Edition


Study objectives

Discuss why corporations invest in debt and stock securities.

Explain the accounting for debt investments.

Explain the accounting for stock investments.

Indicate how debt and stock investments are reported in financial statements—valuing investments

Distinguish between short-term and long-term investments.

Study Objectives

Note: Learning objective #4 is not included.


Why corporations invest
Why Corporations Invest

Corporations generally invest in debt or stock securities for one of three reasons.

  • Corporation may have excess cash.

  • To generate earnings from investment income.

  • For strategic reasons.

Illustration 12-1

Temporary investments and the operating cycle


They have excess cash
They have Excess Cash $$$$$$$$$$

  • If you have excess cash, it should be working for you! (working = earning interest $$$$$$$$)

  • But, it needs to be readily available when you need it (a “rainy day” fund)

  • Hence: invest in low risk funds that can be liquidated quickly


They want to generate earnings from investment income
They want to generate earnings from investment income

Maybe liquidity isn’t an issue….they want to benefit from dividends and stockappreciation. So they invest in mutual funds and stocks.


For strategic reasons buying a related company
For Strategic Reasons—buying a related company

Buying a large amount of stock in a company gives the company a certain amount of stock votes…even without a controlling interest, it gives the company an influence.

Which company?

-a related industry – e.g., Taco Bell buys stock in Chipotle, its competitor… WHY invest in your competitor?


For strategic reasons to influence
For Strategic Reasons –to influence

Which company? -a related industry – e.g., Taco Bell buys stock in Chipotle, its competitor… WHY invest in your competitor?

To expand its influence in its own industry.


For strategic reasons buying an unrelated company
For Strategic Reasons—buying an unrelated company

It still gives you some influence, but also something else.

An Unrelatedindustry– e.g., Taco Bell buys stock in….Pfizer (pharmaceutical)…tacos and drugs….hmmmm….WHY would they do that?


For strategic reasons to diversify
For Strategic Reasons- to DIVERSIFY

An Unrelated industry– e.g., Taco Bell buys stock in…Pfizer (pharmaceutical)…tacos and drugs…. ….WHY would they do that?

Diversifying its investment in different industries allows the company to (possibly) face less market risk by not putting all its investment in the same industry… If fast food sales go down, drug sales may not be affected as much.


Investing in another company
INVESTING IN ANOTHER COMPANY

You have TWO choices:

DEBT – LOAN $$ TO A COMPANY - BUY BONDS

EQUITY – BECOME AN OWNER - BUY STOCK

How do you make money with your investments?


Investing earning money
INVESTING – earning money

  • You have TWO choices:

  • DEBT – Interest Revenue (new account)

  • EQUITY 2 ways:

    • Dividends paid

    • Stock Appreciation (buy at a lower price, sell at a higher price)

How does a company report its investments?


Investing reporting
INVESTING – Reporting

INVESTMENTS are ASSETS (could be long term on short term) with a NORMAL BALANCE of DEBIT.

You must clearly understand the difference between:

  • The Company’sownstock or bonds sold =

    • Common Stock, Equity, normal balance = credit or

    • Bonds Payable, LT Liabilties, normal balance = credit

AND

TheCompany’s investment in another company’s stock or debt purchased = Investments, Assets, normal balance = debit


Investments in government and corporation bonds.

In accounting for debt investments, the required entries to record:

the acquisition

the interest revenue

the sale

Accounting for Debt Investments


Accounting for debt investments acquisition
Accounting for Debt Investments – Acquisition

Recording Acquisition of Bonds

Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

Note: Bonds are recorded at acquisition cost, NOT face value.

SO 2 Explain the accounting for debt investments.


Accounting for debt investments bond interest
Accounting for Debt Investments– Bond Interest

Recording Bond Interest

Calculate and record interest revenue based upon the FACE value of the bond times the interest rate times the portion of the year the bond is outstanding.

Face Value: $1,000 for each bond

Contract Interest Rate: 7% (for example)

Annual interest revenue = 1,000 * .07 = $70


Accounting for debt investments
Accounting for Debt Investments

Sale of Bonds

Credit the investment account for the cost of the bonds and record as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds.

Note: if you only sell some of the bonds, you need to prorate the cost.

If you go back to the chapter on Long Term Assets, this is the same as how we retire an asset…


Accounting for debt instruments example acquisition
Accounting for Debt Instruments – example - Acquisition

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:


Accounting for debt instruments example acquisition1
Accounting for Debt Instruments – example - Acquisition

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000.

The entry to record the investment is:

Debt Investments 54,000

Jan. 1

Cash 54,000

An asset account, normal balance = debit

Question: What type of account is Debt Investments?

Hint: watch the wording, if it said “plus a brokerage fee of $1,000” the entry would be for $55,000.


Accounting for debt instruments interest
Accounting for Debt Instruments - interest

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1.

The entry for the receipt of interest on July 1 is:

*


Accounting for debt instruments interest1
Accounting for Debt Instruments - interest

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is:

July 1

Cash 2,000

*

Interest revenue 2,000

Question: What type of account is Interest Revenue?

A revenue account, normal balance = credit

*($50,000 x 8% x ½ = $2,000)


Accounting for debt instruments year end interest accrual and payment
Accounting for Debt Instruments-year end interest accrual and payment

Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1.

Kuhl reports receipt of the interest on January 1 as follows.


Accounting for debt instruments year end interest accrual and payment1
Accounting for Debt Instruments-year end interest accrual and payment

Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1.

Dec. 31

Interest receivable 2,000

Interest revenue 2,000

Kuhl reports receipt of the interest on January 1 as follows.

Jan. 1

Cash 2,000

Interest receivable 2,000


Accounting for debt instruments sale of investment
Accounting for Debt Instruments – sale of investment and payment

Illustration: Assume that Kuhl corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2011, after receiving the interest due. Prepare the entry to record the sale of the bonds.

Cash 58,000

Jan. 1

Debt investments 54,000

Gain on sale of investments 4,000


Accounting for debt instruments practice
Accounting for Debt Instruments – practice and payment

  • Let’s Practice: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees). Record:

  • Jan 1 - The acquisition

  • Jul 1 - The first semiannual interest revenue

  • Dec 31 The accrual of the second interest revenue.

  • Record these transactions for 2011


Accounting for debt instruments practice continued
Accounting for Debt Instruments – practice - continued and payment

  • Let’s Practice: Assume that Jubilee Farms has only these bonds and three years have passed. It is now 2014

  • Jan 1 – Received the semiannual interest

  • Jan 1 – Sold $70,000 of Whole Food bonds at 112. The broker charged $1,500 in fees.

  • Jul 1 - Received semiannual interest revenue

  • Dec 31 The accrued semiannual interest revenue.

  • Record these transactions for 2014

See End of Power Points for Solution



Accounting for stock investments1
Accounting for Stock Investments and payment

For this class, you are ONLY responsible for learning about holdings of Less than 20%

When do you get to learn about:

Holdings between 20-50%?

Holdings of OVER 50%?

In greater detail:

--Intermediate Accounting

--Advanced Accounting

--or….you can read about it in the textbook as a more general topic…


Accounting for stock investments2
Accounting for Stock Investments and payment

Holdings of Less than 20%

Companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received. --This is similar to debt investments

Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions).


Investments in a corporation’s common stock. and payment

In accounting for common stock investments, the required entries to record:

the acquisition

the dividend revenue

the sale

Accounting for Stock Investments


Holdings of less than 20 acquisition
Holdings of Less than 20% - acquisition and payment

Illustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 per

share plus brokerage fees of $500. The entry for the purchase is:


Holdings of less than 20 acquisition1
Holdings of Less than 20% - acquisition and payment

Illustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 per

share plus brokerage fees of $500. The entry for the purchase is:

July 1

Stock investments 40,500

Cash 40,500


Holdings of less than 20 dividends earned
Holdings of Less than 20% - dividends earned and payment

Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:

SO 3 Explain the accounting for stock investments.


Holdings of less than 20 dividends earned1
Holdings of Less than 20% - dividends earned and payment

Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:

Dec. 31

Cash 2,000

Dividend revenue 2,000


Holdings of less than 20 sale of stock
Holdings of Less than 20% - sale of stock and payment

Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:


Holdings of less than 20 sale of stock1
Holdings of Less than 20% - sale of stock and payment

Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:

Feb. 10

Cash 39,500

Loss on sale of stock 1,000

Stock investments 40,500


Accounting for stock instruments practice continued
Accounting for Stock Instruments – practice - continued and payment

Let’s Practice: Frank’s Produce Conglomerate Company had the following transactions pertaining to stock investments.

Feb. 1 - Purchased 500 shares of Jordan Company common stock (2% ownership position) for $5,000 cash, plus brokerage fees of $250.

July 1 - Received cash dividends of $1 per share on Jordan common stock.

Sept. 1 - Sold 250 shares of Jordan common stock for $3,000, less brokerage fees of $75.

Dec. 1 - Received cash dividends of $1 per share on Jordan common stock.

Record these transactions

See End of Power Points for Solution


Valuing and Reporting Investments and payment

Categories of Securities

  • Companies classify debt and stock investments into three categories:

    • Trading securities

    • Available-for-sale securities

    • Held-to-maturity securities

These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%.


Valuing and Reporting Investments and payment

Trading Securities

  • Companies hold trading securities with the intention of selling them in a short period.

  • Trading means frequent buying and selling, e.g., “day trading.”

  • Companies report trading securities at fair value, and report changes from cost as part of net income. This is called “mark to market” because it adjusts the value of the trading security to the market price.


TRADING SECURITIES – and paymentALERT!

Trading Securities

  • Because they are valued at FAIR VALUE….

  • This is a departure from the Cost Principle (see Chapter 1 where assets are recorded at their historic cost)

  • The change in trading securities’ “fair value” affects net income,even though they haven’t been sold!

  • This is called an “unrealized gain or loss”, but it still affects net income.


Valuing and Reporting Investments and payment

Available-for-Sale Securities

  • Companies hold available-for-sale securities with the intent of selling these investments sometime in the future.

  • These securities can be classified as current assets or as long-term assets, depending on the intent of management.

  • Companies report securities at fair value, and report changes from cost as a component of the stockholders’ equity section—does NOT impact net income


Trading Securities - example and payment

Illustration: Pace Company invests in two stocks classified as trading securities. On December 31, 2011 (when its fiscal year ends, it classified these securities at their current fair value:.

The adjusting entry for Pace Corporation is:

Dec. 31

Market adjustment—trading 7,000

Unrealized gain—income 7,000


Available-for-Sale Securities and payment

Problem:How would the entries change if the securities were classified as available-for-sale?

The entries would be the same except that the

  • Unrealized Gain or Loss—Equity account is used instead of Unrealized Gain or Loss—Income.

  • The unrealized loss would be deducted from the stockholders’ equity section rather than charged to the income statement.


Available-for-Sale Securities - Example and payment

Illustration: Assume that Ingrao Corporation has two securities that it classifies as available-for-sale.

Illustration 12-8

The adjusting entry for Ingrao Corporation is:

Unrealized gain or loss—equity 9,537

Dec. 31

Market adjustment—available-for-sale 9,537


Too many accounts
Too many accounts? and payment

Remember:

If it is a GAIN, it will be a credit balance (like revenue)

If it is a LOSS, it will be a debit balance (like expense)

If it is a GAIN or LOSS account, its balance will vary (debit for Loss, credit for Gain.


Accounting for debt instruments jubilee farms continued
Accounting for Debt Instruments – JUBILEE FARMS - continued

Remember the earlier practice problem: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees).

Now, let’s add the Year-end adjustment.


Accounting for debt instruments practice continued1
Accounting for Debt Instruments – practice - continued continued

Let’s Practice: On December 31, 2011: Assume that the FAIR VALUE of the bonds on Dec 31, 2011 WAS $192,000. These bonds are categorized as “available-for-sale securities.

Prepare the adjusting journal entry for 2011.

See End of Power Points for Solution


Valuing and Reporting Investments continued

Balance Sheet Presentation

Short-Term Investments

Also called marketable securities, are securities held by a company that are

  • readily marketable and

  • intended to be converted into cash within the next year or operating cycle, whichever is longer.

Long-Term Investments

Investments that do not meet both criteria are classified as long-term investments.


Income statement presentation gains losses
Income Statement Presentation – Gains/Losses continued

Presentation of Realized and Unrealized Gain or Loss

Nonoperating items related to investments


Balance sheet presentation avail for sale
Balance Sheet Presentation – Avail. For Sale continued

Realized and Unrealized Gain or Loss

Unrealized gain or loss on available-for-sale securities are reported as a separate component of stockholders’ equity.

Illustration 12-11


Classified Balance Sheet (partial) continued

Illustration 12-12


End of Chapter 12 continued

Good Bye and Good Luck.

Solutions to Coursepack problems to follow


SOLUTION TO JUBILEE FARMS: continued

a) 2011

Jan.  1 Debt Investments 200,000

Cash 200,000

To record purchase

July  1 Cash ($200,000 X .07 X 1/2)    7,000

Interest Revenue    7,000

To record dividends

Dec. 31 Interest Receivable    7,000

Interest Revenue    7,000

To record dividends accrual

2014

Jan.  1 Cash    7,000

Interest Receivable    7,000

To record dividends payment

 1 Cash [($70,000 X 1.12) – $1,500]   76,900

Debt Investments   70,000

Gain on Sale of Debt

  Investments    6,900

To record sales of bonds.

July  1 Cash ($130,000 X .07 X 1/2)    4,550

Interest Revenue    4,550

To record dividends

Dec. 31 Interest Receivable    4,550

Interest Revenue    4,550

To record dividends accrual

(b) 2011

Dec. 31 Unrealized Gain or Loss—Equity    8,000

Market Adjustment—

  Available-for-Sale    8,000

To record market adjustment of bonds


SOLUTION TO FRANK continued’S PRODUCE CONGLOMERATE:

(a) Feb. 1 Stock Investments  5,250

Cash ($5,000 + $250)  5,250

To record purchase

July 1 Cash (500 X $1)    500

Dividend Revenue    500

To record dividend payment

Sept. 1 Cash ($3,000 – $75)  2,925

Stock Investments

  ($5,250 X 1/2) 2,625

Gain on Sale of Stock Investments

  ($2,925-2,625)  300

To record sale of stock

Dec. 1 Cash (250 X $1)    250

Dividend Revenue    250

To record dividend payment


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