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C H A P T E R. 12. Investments in Debt and Equity Securities. Learning Objective 1. Understand why companies invest in other companies. Insufficient cash (relieved by short-term borrowing). 1/1. 6/30. 12/31. Average Cash Needs. Excess cash (used for short- term investments).

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Investments in Debt and Equity Securities

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Investments in debt and equity securities

C H A P T E R

12

Investments in

Debt and Equity

Securities


Learning objective 1

Learning Objective 1

Understand why companies invest in other companies.


A cash flow pattern

Insufficient cash

(relieved by

short-term

borrowing)

1/1

6/30

12/31

Average

Cash

Needs

Excess cash

(used for short-

term investments)

Actual Cash on Hand

A Cash Flow Pattern

Companies often need cash flow from sources other than their own operations because the company’s own cash flow might vary greatly over the course of a year.


What are some other reasons companies invest their excess cash

What Are Some Other Reasons Companies Invest Their Excess Cash?

  • To earn a return.

    • Banks give a fixed return.

    • Investing in stocks or bonds of other companies may earn a higher rate of return (and demand a higher degree of risk).

  • The ability to ensure a supply of raw materials.

  • To influence a board of directors.

  • To diversify their product offerings.

  • Less expensive than R&D.


Investments in debt and equity securities

Learning Objective 2

Understand the different classifications for securities.


Define the two classifications for securities

Define the Two Classifications for Securities.

Debt Securities

Financial instruments issued by a company that carry with them a promise of interest payments and the repayment of principal.

Equity Securities (Stock)

Shares of ownership in a corporation that can change significantly in value and that provide for a return to investors in the form of dividends.


Classifying securities

Classifying Securities

Investments

Debt

Equity


Classifying securities matching

Held-to-Maturity Securities

Equity Method Securities

Classifying Securities—Matching

Equity Method Securities

Held-to-Maturity Securities

Method used to account for an investment in the stock of another company when significant influence can be imposed (presumed when 20 to 50 percent of the outstanding voting stock is owned).

Debt securities purchased by an investor with the intent of holding the securities until they mature.


Classifying securities matching1

Trading Securities

Available-for-Sale Securities

Classifying Securities—Matching

Trading Securities

Available-for-Sale Securities

Debt and equity securities not classified as trading, held-to-maturity, or equity method securities.

Debt and equity securities purchased with the intent of selling them should the need for cash arise or to realize short-term gains.


Investments in debt and equity securities

Investments

Held-to-

Maturity

Trading

Classifying Securities

Debt

Equity

Available-

for-Sale

Equity

Method


Investments in debt and equity securities

Classifying Securities

Investments

Debt

Equity

Held-to-

Maturity

Available-

for-Sale

Equity

Method

Trading


Investments in debt and equity securities

Reporting of

Changes in FMV

Classification

Disclosed at

Trading

Available-

for-Sale

Held-to-

Maturity

Equity

Method

Classifying Securities—

Fill in the Chart

Fair value

Fair value

Amortized cost

Cost adjusted for changes in net assets of investee

Income statement

Stockholders’ equity

Not recognized

Not recognized


Investments in debt and equity securities

Learning Objective 3

Account for the purchase, recognition of revenue, and sale of trading and available-for-sale securities.


Purchase of securities

Cost

(including

broker’s fees)

Type

Classification

1DebtTrading$ 3,000

2EquityTrading15,500

3DebtAvailable-for-sale10,000

4EquityAvailable-for-sale7,300

Purchase of Securities

Caribou Corp. purchased the following securities on January 1, 2003. Record the appropriate entry.


Purchase of securities1

Cost

(including

broker’s fees)

Type

Classification

1DebtTrading$ 3,000

2EquityTrading15,500

3DebtAvailable-for-sale10,000

4EquityAvailable-for-sale7,300

Investment in Trading Securities . . . . . . . . . .18,500

Investment in Available-for-Sale Securities. .17,300Cash . . . . . . . . . . . . . . . . . . . . . . 35,800

Purchased debt and equity securities.

Purchase of Securities


Accounting for return earned on an investment

Security

Interest

Dividends

1Debt$270

2Equity$895

3Debt920

4Equity560

Cash. . . . . . . . . . . . . . . . . . . . . . . . .2,645Interest Revenue. . . . . . . . . . . . .1,190Dividend Revenue. . . . . . . . . . . . 1,455

Received interest and dividend revenues.

Accounting for Return Earned on an Investment

Buffalo Corp. earned the following return on their owned securities. Record the journal entry.


Accounting for the sale of securities

Cost

(including

broker’s fees)

Type

Classification

1DebtTrading$ 3,000

2EquityTrading15,500

3DebtAvailable-for-sale10,000

4EquityAvailable-for-sale7,300

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . .17,000Investment in Trading Securities. . .15,500Realized Gain on Sale of Securities 1,500

Sold Security 2 for $17,000.

Accounting for the Sale of Securities

Buffalo Corp. sold Security 2 for $17,000. The historical cost was $15,500.Record the entry.


What are realized gains and losses

What Are Realized Gains and Losses?

Gains and losses resulting from the sale of securities in an arm’s-length transaction.

At the end of the accounting period, any gain or loss on the sale of securities must be included on the income statement.


Investments in debt and equity securities

Learning Objective 4

Account for changes in the value of securities.


Investments in debt and equity securities

What Are Unrealized Gains

and Losses?

Gains and losses resulting from changes in the value of securities that are still being held.


Accounting for changes in value trading securities

Unrealized Loss on Trading Securities . . .200

Market Adjustment, Trading Securities 200

Recorded market adjustment for trading securities.

Accounting for Changes in Value — Trading Securities

The following market values were recorded for Buffalo Corp.’s portfolio on December 31, 2003.Record the changes in the values of the securities.

Historical

Cost

MarketValue12/31/03

Type

1Trading$ 3,000$ 2,800

3Available-for-sale 10,00010,500

4Available-for-sale 7,3009,250


Accounting for changes in value available for sale

Market Adjustment, Available-for-Sale Securities. 2,450

Unrealized Increase in Value of

Available-for-Sale Securities . . . .2,450

Recorded market adjustment for available-for-sale securities.

Accounting for Changes in Value — Available-for-Sale

Historical

Cost

Market Value 12/31/03

Type

1Trading$ 3,000$ 2,800

3Available-for-sale10,00010,500

4Available-for-sale7,3009,250


Subsequent changes in value

Historical

Cost

Market Value 12/31/04

Type

Market Adjustment, Trading Securities. . . .300Unrealized Gain on Trading Securities .300

Recorded market adjustment for trading security.

Subsequent Changesin Value

The following market values were recorded for Buffalo Corp.'s portfolio on December 31, 2004. Record the subsequent change in the trading security.

1Trading$ 3,000$ 3,100

3Available-for-sale10,00010,300

4Available-for-sale7,3009,500


Investments in debt and equity securities

Expanded Material

Learning Objective 5

Account for held-to-maturity securities.


Investments in debt and equity securities

Example: Initial Purchase of Held-to-Maturity Securities

The Moose Company purchased a 5-year, $500,000 bond and received interest payments of 10 percent, payable semiannually. Assume the effective rate is 12 percent.Record the investment.

1.Semiannual interest payments$ 25,000

Present value of interest annuity$184,002

2.Principal of bonds$500,000

Present value of bonds 279,197

3.Present value of investment$463,199


Investments in debt and equity securities

Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . . . . .463,199

Cash. . . . . . . . . . . . . . . . . . . . . 463,199

Purchased a $500,000 bond as an investment.

Example: Initial Purchase of Held-to-Maturity Securities

1.Semiannual interest payments$ 25,000

Present value of interest annuity$184,002

2.Principal of bonds$500,000

Present value of bonds 279,197

3.Present value of investment$463,199


Bonds purchased between interest dates

Investment in Held-to-Maturity Security. . . . . . . . . . . . . . . . . . . . .463,199Bond Interest Receivable . . . . . . . .16,667Cash. . . . . . . . . . . . . . . . . . . . . .479,866

Purchased a $500,000 bond as an investment and paid four months’ accrued interest.

Bonds PurchasedBetween Interest Dates

Assume the bond purchased by the Moose Company paid interest on July 1 and January 1 of each year. If the Moose Company purchased the bond on April 31, 2003, how will the purchase be recorded?


Accounting for amortization of premiums and discounts define

Accounting for Amortization of Premiums and Discounts. Define.

Straight-Line Amortization

A method of systematically writing off a bond discount or premium in equal amounts each period until maturity.

Effective-Interest Amortization

A method of systematically writing off a bond premium or discount that takes into consideration the time value of money and results in an equal rate of amortization for each period.


Straight line amortization

Cash. . . . . . . . . . . . . . . . . . . . . . . .600.00Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . . . .134.20Bond Interest Revenue . . . . . . 734.20

Received bond interest and amortized discount.

Straight-Line Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually.Using the straight-line method, record the first interest payment received.


Effective interest amortization

Hint:

Won’t you need an amortization table?

Effective-Interest Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent.Using the effective-interest method, record the first interest payment received.


Investments in debt and equity securities

Effective-Interest Amortization

CashInterest Amortized Investment

PaymentReceived EarnedAmount Balance

(0.16 x 0.5 x Balance) $ 8,658

1 $600 $693 $ 93 8,751

2 600 700 100 8,851

3 600 708 108 8,959

4 600 717 117 9,076

5 600 726 126 9,202

6 600 736 136 9,338

7 600 747 147 9,485

8 600 759 159 9,644

9 600 772 172 9,816

10 600 784 184 10,000


Effective interest amortization1

Cash. . . . . . . . . . . . . . . . . . . . . . . .600 Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . . . .93Bond Interest Revenue . . . . . . .693

Received bond interest and amortized discount.

Effective-Interest Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent.Using the effective-interest method, record the first interest payment received.


Sale or maturity of bonds

Cash. . . . . . . . . . . . . . . . . . . . . . . .10,000Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . 10,000

Received the principal of bond at maturity.

Sale or Maturity of Bonds

The Rhinoceros Company holds the bond until maturity.Record the entry for the receipt of the bond principal.


Sale or maturity of bonds1

Cash. . . . . . . . . . . . . . . . . . . . . . . .9,900Gain on Sale of Bond. . . . . . . . 100Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . . 9,800

Sold bond for $9,900.

Sale or Maturity of Bonds

What journal entry is required if the Rhinoceros Company sells the bond for $9,900 before maturity when the balance in the bond account is $9,800?


Investments in debt and equity securities

Expanded Material

Learning Objective 6

Account for securities using the equity method.


Illustrating the equity method

Available-for-Sale Method

Investment in Available-for-Sale Securities . . . . . . . . . . . . . . . . . . . . . . .200Cash. . . . . . . . . . . . . . . . . . . . . . . .200

Equity Method

Investment in Equity Method Securities200Cash. . . . . . . . . . . . . . . . . . . . . . . .200

Illustrating the Equity Method

Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record Brown Tree’s transactions using both the available-for-sale method and the equity method.


Illustrating the equity method1

Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record the $0.80 per share dividend.

Available-for-Sale Method

Cash . . . . . . . . . . . . . . . . . . . . . . . . . .80Dividend Revenue . . . . . . . . . . . . .80

Equity Method

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . .80Investment in Equity Method

Securities. . . . . . . . . . . . . . . . . . . 80

Illustrating the Equity Method


Illustrating the equity method2

Available-for-Sale Method

No entry.

Equity Method

Investment in Equity Method Securities. 2,000Revenue from Investments. . . . . . . .2,000

Illustrating the Equity Method

Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Koala Corp. announces a $10,000 earnings for the year. Record the appropriate entries.


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