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Chapter 12. Investments . Objectives of The Chapter. To learn the accounting for investments in stock (with ownership less than 20%) and bonds.

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chapter 12

Chapter 12

Investments

objectives of the chapter
Objectives of The Chapter
  • To learn the accounting for investments in stock (with ownership less than 20%) and bonds.
  • To learn the accounting for investments in stock with significant influence on investee’s operating and dividend policy (i.e., ownership is between 20% ~ 50%).
  • To learn the accounting for consolidated financial statements (i.e., ownership is more than 50%).
types of investments
Types of Investments

Equity Investments: invest in corporate Stock (i.e., common stock, preferred stock, and stock options).

Debt Investments: invest in U.S. treasury bills, municipal securities, corporate bonds, commercial papers.

Investment in equity or debt securities provides an opportunity to park cash in a financial instrument with an earning power

reasons of investments
Reasons of Investments
  • Invest excess cash for short period of time (i.e., invest in highly liquid securities such as treasury bills).
  • Invest cash in securities to generate earnings (i.e., banks invest in debt securities; mutual funds invest in equity securities).
  • Invest in equity securities of a supplier or a customer to gain influence.
acquisition of bonds
Acquisition of Bonds
    • Initial Recording: at cost.
    • Interest revenue and realized gains (or losses) from sales of investments are reported in the income statement.
  • Example: CGS Corp. Acquires 80 Creative Corp. 6%, 5-year, $1,000 bonds on 12/1/20x7 for the face value plus the brokerage fees of $1,000. Interests are paid semiannually. The related entries for this transaction are:
acquisition of bonds contd
Acquisition of Bonds (contd.)
  • 12/1/x7 Investment in bonds 81,000
  • Cash 81,000
  • Purchase of 80 Creative bonds
  • 12/31/07 Interest Receivable 400
  • Interest Revenue 400
  • Record the one-month accrued interest
  • $80,000x 6% x 1/12

Short-Term Investments & Receivables

acquisition of bonds contd1
Acquisition of Bonds (contd.)
  • 6/1/x8 CGS collects the 6-month interest:
  • Cash 2,400
  • Interest Receivable 400
  • Interest Revenue 2,000

Short-Term Investments & Receivables

sale of bonds
Sale of Bonds
  • CGS sells the investment in Creative bonds on 6/1/20x8 after receiving the interest due for net proceeds of $90,000 (i.e., sales price minus the brokerage fees). The entry to record this transaction is:
  • Cash 90,000
  • Investment in bonds 81,000
  • Gain on sale of investment in bonds 9,000

L-T Investments and International Operations

acquisition of stock holdings of less than 20
Acquisition of Stock (Holdings of Less than 20%)
  • Valuation:
    • Initial Recording: at cost.
    • Dividends and realized gains (or losses) from sales of investments are reported in the income statement.

L-T Investments and International Operations

acquisition of stock holdings of less than 20 an example
Acquisition of Stock (Holdings of Less than 20%) – An Example
  • On11/18/08, EDS acquires 2,000 shares (5% ownership) of Freddy Corp. common stock for $30 per share plus brokerage fees of $1,000.
  • Freddy pays cash dividend $1 per share on 12/2/08. At year end, the market value of Ford stock is $65,000.
  • On 12/27/08, EDS sells Freddy stock for $35 per shares and pays brokerage fees of $1,000.
acquisition of stock an example contd
Acquisition of Stock- An Example (contd.)
  • 11/18/08 Investments in stock 61,000
  • Cash 61,000
  • 12/2/08 Cash 2,000
  • Dividend revenue 2,000
  • 12/27/08 Cash 69,000*
  • Investment in stock 61,000
  • Gain on sale of inv. In stock 8,000
  • *$35x 2,000-$1,000

L-T Investments and International Operations

categories of securities and end of period reporting for investments
Categories of Securities and End of Period Reporting for Investments

Investments in stock (holdings less than 20%) and bonds can be classified into the following three categories:

  • 1. Trading securities: held for sale in the near future (debt or equity securities).
  • 2. Available-for-sale securities: held for sale sometime in the future (debt or equity securities.
  • 3. Held-to-maturity securities: debt securities that the investor has the intent and ability to hold to maturity.
reporting of investments in securities
Reporting of Investments in Securities
  • Reporting of Trading Securities (TS):
    • (1) At purchase: Cost.
    • (2) End of Period: Market value.
    • the unrealized gains/ losses reported in the income statement.

L-T Investments and International Operations

reporting of investments contd
Reporting of Investments (contd.)
  • Reporting of available-for-sale securities (ASS):
  • (1) At purchase: Cost.
  • (2) End of period: Market value.
  • The unrealized gains/ losses reported in the balance sheet statement as a separate component of stockholders’ equity.

L-T Investments and International Operations

reporting of investments contd1
Reporting of Investments (contd.)
  • Reporting of Held-to-maturity securities (HTM):
    • (1) At purchase: Cost.
    • (2) End of Period: Amortized cost.

L-T Investments and International Operations

example a assume that camp corp acquired the following securities on 1 1 x9
Example A: Assume that Camp Corp. acquired the following securities on 1/1/x9
  • Shares$ per share
  • A. Company’s common stock 100 $50
  • B. Company’s common stock 300 $80
  • C. Company’s preferred stock 200 $120
  • D. Company’s 10% bonds with a face value of $15,000 at par.
  • Interests are paid on 6/30 and 12/31.
  • These securities are reported as trading securities by Camp Corp.
example a contd
Example A (contd.)
  • 1/1/x9 Initial recording
    • Investment in stock -Trading 68,000 *
    • Cash 68,000
    • * Cost = 100 x 50 + 300 x 80 + 200 x 120 + 15,000 = 68,000
  • 6/30/x9
    • Cash 750
    • Interest Revenue 750
  • 12/31/x9
    • Cash 750
    • Interest Revenue 750
  • Assuming Kent received $1,000 of dividends in 20x9:
    • Cash 1,000
    • Dividends Revenue 1,000

L-T Investments and International Operations

example a contd1
Example A (contd.)
  • At the end of 20x9, the market value for these securities is $71,000. The following entry is needed to adjust the value of investment in trading securities:

12/31/x9

Fair Value Adjustment – Trading Sec. 3,000

Unrealized Gain*

on Investment -Income 3,000

To record unrealized gain on trading securities

*reported in the income statement of 20x9

balance sheet presentation balance sheet 12 31 x9
Assets

Investments -

Trading Securities

(at market value) $71,000

Liabilities

.

.

.

.

Stockholders’ Equity

Balance Sheet PresentationBalance Sheet 12/31/x9

L-T Investments and International Operations

example b assume that camp corp acquired the following securities on 1 1 x9
Example B: Assume that Camp Corp. acquired the following securities on 1/1/x9
  • Shares$ per share
  • A. Company’s common stock 100 $50
  • B. Company’s common stock 300 $80
  • C. Company’s preferred stock 200 $120
  • D. Company’s 10% bonds with a face value of $15,000 at par.
  • Interests are paid on 6/30 and 12/31.
  • These securities are reported as available-for-sale securitiesby Camp Corp.
example b contd
Example B (contd.)

1/1/x9 Initial recording

Investment in stock –Available-for-Sale 68,000

Cash 68,000

6/30/x9

Cash 750

Interest Revenue 750

12/31/x9

Cash 750

Interest Revenue 750

Assuming Kent received $1,000 of dividends in 20x9:

Cash 1,000

Dividends Revenue 1,000

L-T Investments and International Operations

example b contd1
Example B (contd.)
  • At the end of 20x9, the market value for these securities is $71,000. The following entry is needed to adjust the value of available-for-sale securities market:

12/31/x9

Fair Value Adjustment – Avail.-for-Sale 3,000

Unrealized Gain*

on Investment –Equity 3,000

To record unrealized gain on avail.-for-sale securities

*reported in the balance sheet of 20x9

balance sheet presentation balance sheet 12 31 x91
Assets

Investments -

Available-for-Sale $71,000

Liabilities

.

.

.

.

Stockholders’ Equity

Unrealized gain on

investments 3,000

Balance Sheet PresentationBalance Sheet 12/31/x9

L-T Investments and International Operations

income statement skip for the period ended 12 31 x9
Income Statement (skip)for the period ended 12/31/x9
  • Revenues $XXX
  • Expenses (including income tax) (XXX)
  • Net Income $XXX
  • Other Comprehensive Income:
  • Unrealized Gain on
  • Investment 3,000
  • Less income tax (40%) (1,200)$1,800
  • Comprehensive Income ........….. $XXX

L-T Investments and International Operations

presentation of realized and unrealized gain and loss
Presentation of Realized and Unrealized Gain and Loss
  • The revenue and gains/losses related to the investments are presented in the income statement as follows (source: Financial Accounting by Weygandt, Kimmel and Kieso)
presentation contd
Presentation – contd.
  • The unrealized gain/loss – equity(from the valuation of available-for-sale securities) is presented in the stockholders’ equity section of the balance sheet, NOT the income statement.
  • See Illustration 13-12 of WKK textbook for an example of balance sheet presentation on investments and the unrealized gain/loss on available-for-sale securities.

L-T Investments and International Operations

investments in debt securities held to maturity
Investments in Debt Securities Held to Maturity
  • The GAAP for Investment in Debt securities held to maturity (FASB 115):
    • (a) Initial recording at cost.
    • (i.e., the present value of the investment in debt security).
    • (b) End of period reporting at amortized cost.
    • (c) Unrealized holding gains (or losses): not recognized.
    • (d) Interests and realized gains (Losses) from sale (if any) are included in income.

L-T Investments and International Operations

example c held to maturity
Example C : Held-to-Maturity
  • Assume that Emey Corp. purchases $100,000 of GNC 9% bonds on 7/1/20x1 at 99. Interests on the bond are paid on 7/1 and 12/31. Emey Corp intends to hold the bonds till their maturity date on 7/1/20x6.
  • 7/1/x1 (Initial recording at cost) = 99,000
    • (Face amount - Discount) = 100,000 - 1000
    • Investments in Bonds 100,000
    • Cash 99,000
    • Discount on Investment in Bonds 1,000

L-T Investments and International Operations

example e contd
Example E (contd.)
  • The discount ($1,000) will be amortized to increase the interest revenue using the effective interest method, unless the use of straight-line method does not result in a material difference on the amount of interest revenue recognized each year.

L-T Investments and International Operations

example e contd1
Example E (contd.)
  • The followings are subsequent entries for this investment (assuming the amortization method is straight-line method):
  • 12/31/x1
    • Cash 4,500
    • Interest Revenue 4,500
    • To recognize interest revenue for 6 months.
    • Discount on Investment in Bonds 100
    • Interest Revenue 100
    • To amortize discount on bond investment for 6 months.

L-T Investments and International Operations

example e contd2
Example E (contd.)
  • 7/1/x2
    • Cash 4,500
    • Int. Revenue 4,500
    • To receive semiannual interest.
    • Discount on Investment in Bonds 100
    • Interest Revenue 100
    • To amortize discount for six months.
    • .

L-T Investments and International Operations

acquisition of stock holding of 20 to 50
Acquisition of Stock (Holding of 20% to 50%)
  • GAAP requires the use of equity method by an investor who is able to exercise significant influence over the operating and financial policies of an investee.
  • In the absence to the contrary, an investment of 20% to 50% in the outstanding common stock of the investee leads to the presumption of significant influence.
  • The investee companies are referred to as affiliates.

L-T Investments and International Operations

equity method
Equity Method
  • In some cases, the investors hold more than 20% of the outstanding common stock of an investee and do not have significant influence. The equity method should not be used to account for the investment in those cases.

L-T Investments and International Operations

equity method1
Equity Method
  • A survey of 600 companies conducted by Accounting Trends & Techniques indicated 252 (42%) of the corporations surveyed used the equity method to account for their investments.

L-T Investments and International Operations

the accounting procedures of the equity method
The Accounting Procedures of the Equity Method
  • The investment is recorded at cost of the shares acquired.
  • The investment is subsequently adjusted each period for the changes in the equity of the investee.

L-T Investments and International Operations

the accounting procedures of the equity method1
The Accounting Procedures of the Equity Method
  • For example, the investment account will be increased (decreased) by the investors’ proportionate shares of investees’ earnings (losses) and decreased by the dividends received.*
    • * This is due to investee’s net income will increase investee’s equity while dividends will decrease investee’s equity.

L-T Investments and International Operations

the accounting procedures of the equity method contd
The Accounting Procedures of the Equity Method (contd.)
  • Therefore, the investor’s investment account = Acquisition Cost + Investor’s Share of Investee’s Income - Dividends Received

L-T Investments and International Operations

equity method an example
Equity Method: An Example
  • On 1/1/x9, Clibron Company purchases 4,200 shares of common stock of the Sam Corporation which has 16,800 shares of common stock outstanding on 1/1/x9. Thus, Cliborn has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000 (including $2,000 brokerage fees).
  • Also, Sam Corp. paid $20,000 dividends on 8/28/x9, and reported net income of 81,000 for 20x9. These events are recorded on Cliborn Company’s book as follows:

L-T Investments and International Operations

equity method example contd
Equity Method Example (contd.)
  • To record the investment on 1/1/x9:

Investment in stock 125,000

Cash 125,000

2. To record the receipt of dividends on 3/28/x9:

Cash (20,000 x 25%) 5,000

Investment in stock 5,000

L-T Investments and International Operations

equity method example contd1
Equity Method Example (contd.)
  • 3. To record Cliborn Company’s 25% share in the year’s net income:
    • 12/31/x9
    • Investment in stock
    • ($81,000 x 25%) 20,250
    • Investment Revenue 20,250

L-T Investments and International Operations

presentation on the b s and i s
Presentation on the B/S and I/S:
  • Balance Sheet
    • 12/31/x9
    • Assets
    • Investment in Sam’s stock, at equity 140,250
  • Income Statement
    • for the year ended 12/31/x9
    • Other Revenue:
    • Investment Revenue 20,250

L-T Investments and International Operations

gain or loss on sales of an equity method investment skip p22 p23
Gain or Loss on Sales of an Equity-Method Investment (Skip p22, p23)
  • Gain or loss on sales of an equity-method investment is measured as the difference between the sale proceeds and the carrying amount of the investment.

L-T Investments and International Operations

sale of equity investment an example skip
Sale of Equity Investment: An Example (skip)
  • On 1/3/10, Clibor Sells 20% of its holding of Sam Corp. for net proceeds of $30,000.
    • Cash 30,000
    • Investment in stock 28,050 *
    • Gain on Sale of Investment 1,950
    • * 140,250 x 20% = 28,050

L-T Investments and International Operations

joint venture
Joint Venture
  • A joint venture is a separate entity or business project owned by a small group of investors.
  • A Joint venturer usually accounts for its investments using the equity method even if their shares are less than 20%.
  • This is because a joint venturer usually has significant influence on the investee company.

L-T Investments and International Operations

accounting for consolidated subsidiaries
Accounting for Consolidated Subsidiaries
  • When a parent company purchased more than 50% of the outstanding common stock of subsidiary corporations, consolidated financial statements (F/S) should be prepared.
  • The consolidated F/S will combine the F/S of the parent company with those of majority-owned subsidiaries as if the parent and its subsidiaries were a single entity.

L-T Investments and International Operations

income of a consolidated entity
Income of A Consolidated Entity
  • The income of a consolidated entity is the net income of the parent plus the parent’s share (proportion) of the subsidiary’s net income.

L-T Investments and International Operations

accounting for consolidated subsidiaries contd
Accounting for Consolidated Subsidiaries (contd.)
  • A work sheet is used to facilitate the combining of the financial statements of the parent company and the subsidiaries.
    • A. Parent corporation owns all of subsidiary’s stock.
    • B. Parent company owns less than 100% of subsidiary’s stock.

L-T Investments and International Operations

a parent corporation owns all of subsidiary s stock
A. Parent Corporation Owns All of Subsidiary’s Stock
  • Some accounts are eliminated:
  • a. the parent company’s investment in subsidiary account and the subsidiary’s equity accounts because these two accounts represent the same thing – subsidiary’s equity which is also represented by assets and liabilities of the subsidiary in the combined financial statements).

L-T Investments and International Operations

parent corporation owns all of subsidiary s stock contd
Parent Corporation Owns All of Subsidiary’s Stock (contd.)
  • b. The reciprocal of note receivable/payable accounts of the parent and subsidiary.
  • For an example of the consolidated balance sheet, see illustration 13-A2 on p616 of the textbook

L-T Investments and International Operations

b parent company owns less than 100 of subsidiary s stock
B. Parent Company Owns Less Than 100% of Subsidiary’s Stock
  • A minority interest account (on the credit side as a liability) is used to account for the subsidiary’s equity which is held by stockholders other than the parent company.

L-T Investments and International Operations