Chapter 2. Short term investments

Chapter 2. Short term investments WHAT YOU WILL LEARN IN THIS CHAPTER: Purpose and classification of short term investments Types of short term investments Debt investments Bond purchases Equity investments Controls for short-term investments Ethics related to short-term investments

Debt investments Investments It is common for a business to have excess cash on hand: 1. Healthy profits 2. Seasonal sales 3. Customers advance payments • Example: Dell Computers: • Customers pay in advance before the computer is built. • They pay their suppliers in a month or two • The advance payments are not needed for a while and can therefore be invested to earn interest

Why would a business invest outside a company? PICTURE OF A BANK PICTURE OF A FACTORY Low interest earned from a bank. Higher returned when invested with other businesses who need the cash Debt investments Investments What can businesses do to manage temporary surplus cash? Reinvest back into the business (new hires, upgrade equipment, etc) • Distribute to shareholders (owners) • Keep it in the bank • Invest outside company

Cash is listed first because it’s the most liquid asset Short term investments are less liquid than cash but more liquid then Accounts Receivable or Inventory Debt investments Investments Classifying Short Term Investments

Debt: where the loan (principle) is expected to be paid back with interest. Picture of a bank Equity: buying ownership in an organization with expectation of sharing in profits and making a profit on the investment. Picture of a factory Debt investments Investments Investments can be Debt or Equity based

Animate after answer Correct. There is no change to equity because one asset has been exchanged for another. No change to equity Debt investments Investments Invest cash in the form of a savings account with a bank. What happens to the equity of the business? - 10,000 + 10,000 Increase Decrease No change

Debt investments Investments - 10,000 Dr. Cash, Cr. Investment – no change to equity Cr. Cash, Dr. Investment – no change to equity + 10,000 Dr. Cash, Cr. Investment –equity decreases Cr. Cash, Dr. Investment –equity increases IT: animate after the answer No change to equity: One asset is exchanged for another. 7

High risk = higher interest rate Picture of a factory Investing in the form of debt Investments Cash is invested with the expectation of interest in return for the loan (principle). The higher the risk the higher the expected return. Low risk = low interest rate Picture of a bank

Investing in the form of debt Investments IT: Flash revenue and “equity increases” with animation +5,000 (Cr) +5,000 (Dr) Interest received is not regarded as a regular form of revenue (income). Equity increases 9

illustration #2 105,000 60,000 45,000 Adding interest revenue results in a $45,000 gross profit. Investing in the form of debt Investments Interest is not considered as regular day to day revenue illustration #1 100,000 60,000 40,000 Revenues less COGS = $40,000 Gross Profit. 10

Investing in the form of debt Investments 100,000 IT: flash No Change with arrow 100,000 60,000 60,000 No change 40,000 40,000 IT: flash $5,000 5,000 Large font and bold “If you cannot measure it, you cannot manage it” 11

Investing in the form of debt Investments When interest is received in the same month in which it is earned, cash increases together with equity ( revenue earned). +1,000 (Dr) +1,000 (Cr) Equity increases 12

+1,000 (Dr) Since interest owing is not a regular Accounts Receivable which should be used for trade receivables only. +1,000 (Dr) +1,000 (Cr) Investing in the form of debt Investments Interest is not always received at the end of every month but must still be recognized. If the interest amounts are material then a special subsidiary ledger can be set up to carefully control amounts owing. IT: Move this down slowly with Animation 2 IT: fade out the $1,000 on cash when presenting the accounts receivable $1,000 with animation #2 13

Test your knowledge Investments Exercise: Invest $10,000 on January 1st. $100 interest is earned but will not be received until February 3rd. Which of the following is correct? Dr. Accounts receivable, Cr. Revenue –equity increases Cr. Accounts receivable, Dr. Revenue – equity increases Dr. Other Assets, Cr. Other Revenue – no change to equity Dr. Other Assets, Cr. Other Revenue – equity increases Since the interest due is not a trade receivable, it is recorded as Other Assets and since the revenue is not regarded as day to day trading revenue, it is regarded as Interest Revenue. Equity increases because the value of the assets increased. 14

When collecting amounts owing, there is no change to equity because one asset is exchanged for another asset. (Other assets exchanged with cash). No change to equity Test your knowledge Investments In February, $100 of interest that was accrued in January is actually paid in February. Which of the following is correct? Dr. Cash, Cr. Interest Revenue –equity increases Cr. Accounts receivable, Dr. Cash – equity increases Dr. Cash, Cr. Other Assets – no change to equity Dr. Cash, Cr. Other Revenue – equity increases Animate after answer 15

A traditional loan involves the lending of money to another person or business. Bonds are loans made to institutions like businesses or municipalities. Bonds are bought on sold on the open market. Traditional loans are negotiated directly between the parties on an individual bases. Debt investments Investments A common way of investing cash is in the form of bonds. The primary difference between traditional loans and bonds. 16

Debt investments Investments Bonds are bought and sold through brokers in exchange for a fee (brokerage fee) - 10,500 (Cr) There are two ways to record the brokerage fee. + 10,500 (Dr) 1. Capitalize the brokerage fees by adding the fee to the cost of the bond One asset is exchanged for another asset therefore no change to equity: 17

If the business buys and sells bonds on a regular bases it is better to expense the fees so they can be tracked on the income statement. + 500 (Dr) Investing in the form of debt Investments 2. Expense the brokerage fee - 10,500 (Cr) + 10,000 (Dr) The GAAP Rule of Consistency requires that one method or the other should be used. IT: Flash the $500 with A1 Equity decreases by $500 18

Test your knowledge Investments Invest $100,000 in the form of bonds and pay $4,000 for brokerage fees which are to be capitalized. Which of the following is correct? Dr. Cash $104,000, Cr. Investment $104,000 Equity decreases by $4,000 Cr. Cash $104,000, Dr. Investment $104,000 Equity increases by $4,000 Cr. Cash $104,000, Dr. Investment $104,000 No change to equity Dr. Cash $104,000, Cr. Investment $100,000 & Dr Brokerage fee expense $4,000 Equity decreases by $4,000 Since the brokerage fee is capitalized, the cost of the bond and the brokerage fee is recorded as an asset with no change to equity 19

Test your knowledge Investments Invest $10,000 in the form of bonds and pay $300 for brokerage fees which are to be expensed. Which of the following is correct? Dr. Cash $10,000, Cr. Investment $10,000 Equity decreases by $300 Cr. Cash $10,300, Dr. Investment $10,300 Equity increases by $300 Cr. Cash $ 10,300, Dr. Investment $ 10,300 No change to equity Dr. Cash $ 10,300, Cr. Investment $ 10,000 & Dr Other Expense $300 Equity decreases by $300 Animate after answer The brokerage fee is expensed under Other Expenses because brokerage fees are not part of day to day operations. Only the expense of $300 decreases equity. 20

Not earned The bond holder will still receive all 6 months worth of interest but one months worth of interest has not been earned. IT: highlight arrow and not earned Investing in the form of bonds Investments Companies normally pay interest twice a year on bonds. What if bonds are purchased between interest payment dates? When a bond is purchased, it is “linked” to interest receivable until the bond matures. (IT: highlight all months) Value of Bond$100,000 Bearing interest of 12% per annum ($1,000 per month) If the bond is purchased on the first day of January and interest is paid every 6 months, then the bond holder will have earned $6,000 interest. (IT: highlight all months) If the bond is purchased on the last day of January and interest is paid every 6 months, then the bond holder will earn $5,000 interest. (IT: highlight Feb – June) First payment Second payment 21

Investing in the form of bonds Investments Buy $100,000 in bonds on January 31st. The bonds yield interest payments of 12% paid semi annually on June 30 and December 31st. 1. Pay $100,000 for the bonds. (IT: flash the $100,000 entries on the left) -100,000 (Cr) +100,000 (Dr) 22

On June 30th you will receive the first interest payment of $6,000 but only $5,000 of the interest has been earned. (February to June). + 6,000 (Dr) If the full amount of $6,000 is not adjusted, it will overstate the profit. $6,000 profit Investing in the form of bonds Investments 23

 $100,000 was paid for the bond $1,000 was paid for interest attached to the bond (Interest for January)  -100,000 (Cr)  -1,000 (Cr) “overpayment”   To offset the “overpayment”, and to balance the balance sheet, a temporary account is debited which will be cleared when the payment is actually received on June 30th.  $100,000 (Dr)  +1,000 (Dr) No change to equity Investments Investing in the form of bonds Reminder: The seller had already earned the $1,000 interest relating to January, which was included in the selling price of the bond. 24

Investing in the form of bonds Investments Combining the two transactions into a compound journal entry. +101,000 (Cr) +100,000 (Dr) +1,000 (Dr) 25

 1. Receive a payment of $6,000 relating to 6 months of interest attached to the bond. + 6,000 (Dr) 2. Only $5,000 should be recognized (interest revenue) 3. Offset Other Assets to clear the account with no impact to equity.  -1,000 (Cr) +5,000 (Cr)  Other assets is now zero Profit increased $5,000 Investing in the form of bonds Investments When $6,000 interest is received in June only $5,000 will have been earned (February to June). IT: flash with A1 “Overpayment” which needs to be cleared +1,000 (Dr) IT: flash with A2 Reminder: Other assets was only used as a temporary account to offset the $1,000 interest paid. This was necessary to keep the balance sheet in balance. IT: flash with A3 26

+ 6,000 (Dr) Summary of journal entry +100,000 (Dr) -1,000 (Cr) + 5,000 (Cr) 27

Summary of debt investment (Maybe better to create this in PDF format) 1. Excess cash is invested outside the business to attract a higher rate of return than lying unused in the business. 2. The cash can be invested in the form of debt or equity. Debt investments expect the loan to be repaid with interest. Equity is in the form of ownership with the expectation of sharing in the profits and/or making a profit on the principle amount invested. 3. Interest on loans and bonds do not always correspond to the date in which they are earned but must still be recognized as earned revenue. 4. Brokerage fees can be capitalized or expensed depending on the material value of the fees. 5. When a bond is purchased between the interest payment dates, the interest that is not earned is paid to the seller when buying the bond. The amount is adjusted when the interest payment is made.

Investments Moodle exercises 29

Investing in the form of equity Investments WHAT YOU WILL LEARN IN THIS CHAPTER: Purpose and classification of short term investments Types of short term investments Debt investments Bond purchases Equity investments Controls for short-term investments Ethics related to short-term investments

Toronto Stock Exchange Tokyo Stock Exchange New York Stock Exchange Investing in the form of equity Investments • Equity investment involves buying ownership in the form of shares usually in publicly traded companies. The buyer of the shares expects to receive their share of the profits called a dividend and also hope to make a profit when selling the shares.

Investing in the form of equity Investments We are now going to change the manner in which the exercises are done.Chad, we need to demonstrate this. Let’s discuss.

When buying shares in a company, the investment is recorded in the same manner as a bond. Brokerage fee Brokerage fees can be capitalized Brokerage fees can also be expensed Brokerage fee Investing in the form of equity Investments IT: Fade out this arrow before animation 2

Investing in the form of equity Investments Invest $100,000 worth of shares in Trimore Manufacturers and add $3,000 relating to brokers fees which are to be capitalized. IT: click on cash and investment

Investing in the form of equity Investments Dividends earned but not received. Trimore Manufacturing informs you that you are to receive a dividend of $5,000 relating to this period but will only receive the cash next period. Record the journal entry. IT: click other assets and other revenue

Equity increases as the value of the shares increase, (Unrealized Gain) Conversely equity decreases as the value of the shares decrease (Unrealized Loss) Investing in the form of equity Investments Change to the value of the share. Shares will often increase and decrease in value on a daily basis. 100,000 The GAAP Rule of Conservatism requires that the value of a share not be recorded at a higher price than paid before being sold. IT: fade out the “up” arrows before presenting the “down” arrows

Investing in the form of equity Investments Decreasing the value of the shares. The value of the investment decreased from $103,000 to $102,000. Adjust your records with the correct journal entry The loss is called “unrealized” because the shares have not yet been sold. IT: click other expenses and and investment

Investing in the form of equity Investments Increasing the value of the shares. The value of the investment ended last month with a value of $102,000. The market has improved increasing the value of the shares by $500. Make the appropriate adjustment. The gain is called “unrealized” because the shares have not actually been sold. IT: click other assets and other revenue

Investing in the form of equity Investments Increasing the value of the shares. This month the value of the shares increased by another $1,500. The value of the investment at the end of last month was $102,500. keeping in mind that the original cost was $103,000 make the correct adjustment. The GAAP Rule of Conservatism requires that until the shares are sold the value cannot be recorded at a higher value than the original cost IT: click other assets and other revenue

Investing in the form of equity Investments Increasing the value of the shares. The next month the shares that are valued on the books for $103,000 are finally sold for $105,000 less a $3,000 brokerage fee which is to be capitalized. Make the appropriate entry. The brokerage fees created a loss on the sale of the investment which is recorded as Other Expenses IT: click cash, other assets and other expenses

Investing in the form of equity Investments Summary PDF followed by Boodle quiz

Chapter 2. Short term investments