Chapter 12: Investments

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Why does one company invest in another company? Investments can be equity securities (common stock, preferred stock) or debt securities (bonds) Investments can be short-term (current asset) or long-term

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Accounting for Investments in Securities
  Passive

– No Significant Influence   Significant Influence, but not Control
–  ability of an investing company to have an important impact on operating and financing policies of another company
»  Note: Only an investment in common stock implies influence . Neither preferred stock (no voting rights) nor bond investments convey any influence.

  Control –  ability of an investing company to determine operating and financing policies of another company

Accounting for Investments in Securities
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The degree of influence and control an investing company has over the policies of the investee company determines how we account for the investment. Main Accounting Treatments
Control (Common stock ownership > 50%) => Consolidate Significant influence but not control (Common stock ownership between 20% and 50%) => Equity method No significant influence – passive investment (Common stock < 20%, or preferred stock, or bonds) – accounting treatment depends on how investment is classified

Investments with no significant influence – Passive investments
  Used

when less than 20% of the outstanding voting stock is held by the investor.   Securities are classified as either:
–  Trading Securities (stock or bonds) –  Available-for-sale Securities (stock or bonds) –  Held-to-maturity Securities (bonds only)

Trading Securities   Held primarily for the purpose of selling them in the near future   Intent is to profit on short-term price differences   Classified as Current Assets   Accounted for using Market Value method (investment is "marked to market") .

Available-for-Sale Securities   Securities that are NOT held primarily for the purpose of selling them in the near future   Intent is to earn a return on the funds invested   Classified as Current or Noncurrent Assets depending on intent of management   Accounted for using Market Value method (investment is "marked to market ) .

Held-to-maturity securities (bonds)   Securities that company intends to hold until maturity   Generally classified as Noncurrent Assets until year bond matures   Typically accounted for using Historical Cost method (effectiveinterest method of recognizing interest revenue) but may use Market Value method .

»  the gains or losses are unrealized because the stock has not yet been sold .   In periods after acquisition.Market Value Method (Trading and Available-for-sale securities)   Initial acquisition of investment is recorded at cost. –  Unrealized (holding) gains and losses related to changes in the market value of securities are recognized. the securities are reported at market value.

000 .000 Allowance to adjust investments to market 1.Market Value Method   At the end of each accounting period.000): Unrealized holding losses 1. a journal entry is recorded to adjust the book value of the investment to equal the current market value   The adjustment is recorded in an Allowance to adjust to market account Example (investment declines in value by $1.

not retained earnings).Market Value Method The treatment of Unrealized Losses depends on the classification of the investment: –  For trading securities. but corporations have the option to including these unrealized gains and losses on the income statement (as part of net income and closed to retained earnings) . the an unrealized holding gain/ loss and is typically reported as other comprehensive income and is closed to the stockholders equity section of the balance sheet as accumulated other comprehensive income (i. an unrealized holding gain/loss must be reported on the income statement ( thus.. a part of net income) and closed to Retained Earnings –  For available-for-sale securities.e.

Netflix Investment disclosures .

Market Value Method (trading) Unrealized holding gains and losses from trading securities are reported on the income statement. .

Market Value Method (AFS) Company A Comprehensive Income 12/31/X6 Net lncome (loss) Stockholders' Equity Common stock Paid-in-capital Unrealized holding loss (AOCI) 3. .000) 27.000 (8.000 125.000 $ Retained Earnings Total Stockholders' Equity 50.000 $ 194.000 Unrealized holding gains and losses from Available-For-Sale securities are typically part of comprehensive income and are reported in the equity section of the balance sheet (as part of Accumulated Other Comprehensive Income .

000 and a net book value of $9.500 is sold for $9.200 300 500 10.Market Value Method .000 . to market Investment 9.200.Trading When a trading security is sold –  record a gain or loss based on the difference between the sales price and the current book value of the investment (cost adjusted by the Allowance to adjust to market) »  the gain or loss is an income statement account Example: An investment (trading) with a cost of $10.   Cash Loss on sale Allowance to adj.

accumulated other comprehensive income ).]   .AFS When an available-for-sale security is sold –  record a (realized) gain or loss based on the sales price and the original cost of the investment » the gain or loss is an income statement account   At period end. record an adjusting entry to zero out the Allowance to adjust to market account related to the investment. [This is also called a "Reclassification Adjustment" – from unrealized to realized gain or loss. The other side of the entry is to the Unrealized Holding Gain/Loss account (in stockholders equity – that is.Market Value Method .

500 is sold for $9.AFS Example: An investment (available-for-sale) with a cost of $10.000 and a net book value of $9.200 Loss on sale (to income statement) 800 Investment 10.200.Market Value Method . Cash 9.000 Allowance to adjust to market Unrealized holding loss (OCIèAOCI) 500 500 .

Market Value Method: Example Assume that Motorola purchases shares of Dell stock. Dell shares are trading at $90 per share 5  On 7/6/20C. Motorola purchases 10. Motorola sells its shares of Dell for $95 per share Give required journal entries assuming Motorola accounts for the investment in Dell as a Trading Security. the shares of Dell are trading at $100 per share 3  On 4/15/20B. . Dell pays a dividend of .25 a share 4  On 12/31/20B.000 shares of Dell on the open market at a cost of $80 per share 2  On 12/31/20A. The following transactions and events occur: 1  On 11/27/20A.

000 10.000 shares × $80 per share .000 800.Trading – Purchase of Stock 11/27/20A Record the investment at COST Investment Cash 800.

adjustment needed at the end of the reporting period to increase or (decrease) the investment account for any UNREALIZED gain or (loss) during the year .Trading – Change in Value at Year End 12/31/20A Market value is $100 per share ($1.000.000 total) Investments should be reported on the balance sheet at their Market Value -.

000 total) Allowance to adjust to market 200.000 Unrealized gain (income stmt) 200.000* *Market value (1.000.000.Trading – Change in Value at Year End 12/31/20A Market value is $100 per share ($1.000) – book value (800.000) .

500 2.Trading – Income Earned on Stock 4/15/20B Dividends received from stock (classified as passive investments) are considered income Cash Investment revenue 2.000 shares × $0.500 10.500 .25 per share dividend = $2.

000 Balance required in Allowance account = $100.000 in previous year) Unrealized loss (income stmt) 100.000 Allowance to adjust to market 100.000.Trading – Change in Value at Year End 12/31/20B Market value is $900.000 debit Therefore.000 (down from $1.000 debit Balance in Allowance account as of 12/31/03 = $200.000 . credit the Allowance account by $100.

000 Investment 800.000) – Book value (900.000 Gain = Selling price (950.000) .000 Allowance to adjust to market 100.000 Gain on sale (income statement) 50.Trading – Sale of Stock 7/6/20C Sell shares of Dell for $95 per share Record gain on loss on sale of stock on date of sale Cash 950.

Available-for-Sale   Assume Motorola classifies its Dell stock as Available-for-Sale.   How would the journal entries differ?   Would the difference affect the Balance Sheet or Income Statement? .

Purchase of Stock 11/27/20A Record the investment at COST Investment Cash 800.000 10.000 800.Available-for-Sale .000 shares × $80 per share .

000 200.AFS – Change in Value at Year End 12/31/20A Market value is $100 per share ($1.000* *Market value (1.000) .000 total) Investments should be reported on the balance sheet at their Market Value -.000) – book value (800.000.000.adjustment needed at the end of the reporting period to increase or (decrease) the investment account for any UNREALIZED gain or (loss) during the year Allowance to adjust to market Unrealized gain (OCI) 200.

000 shares × $0. Cash Investment revenue 2.500 .500 10.500 2.25 per share dividend = $2.AFS – Income Earned on Stock 4/15/20B Dividends received from a passive investment in stock are considered income.

000 (down from $1.000 in previous year) Unrealized loss (OCI) 100.000 .AFS – Change in Value at Year End 12/31/20B Market value is $900.000 Allowance to adjust to market 100.000.

000) – Cost (800.000 .000 Allowance to adjust to market 100.000* *Gain = Selling price (950.000) Unrealized holding gain (OCI) 100.000 150.AFS – Sale of Stock 7/6/20C Sell shares of Dell for $95 per share Record gain on loss on sale of stock on date of sale Cash Investment Gain on sale (Income St) 950.000 800.

the market rate of interest is 11%. The market rate of interest when Alpha acquires the bonds is 10%.000. At 12/31/Year 1.000. Alpha plans to hold the bonds until they mature. Give Alpha s entries at acquisition and to recognize interest revenue on 12/31/Year 1 and 12/31/Year 2. . Alpha Company acquires bonds with a par value of $1. The bonds mature in 14 years and pay interest annually on 12/31 at 8%.Held-to-maturity securities (bonds) On 1/1/Year 1.

END èPV = $852.666 Entry on 1/1/Year 1: Bond investment 852. PMT = $80. n = 14. i = 10%.000.666 .Held-to-maturity securities (bonds) Acquisition price: FV = $1.666 Cash 852.000.000.

267* Bond book value on 12/31/Year 1? = $852.933 Entry on 12/31/Year 2: Cash Bond investment Interest revenue *$857.793* .Held-to-maturity securities (bonds) Entry on 12/31/Year 1? Cash Bond investment Interest revenue *$852.666 + $5.933 × 10% 80.666 × 10% 80.000 5.267 85.793 85.267 = $857.000 5.

assumed when the investment is between 20% 50% of the total common stock outstanding Original acquisition of ownership interest is recorded at cost value The investment is not adjusted for changes in market The investment is adjusted for dividends and earnings of the investee. .Equity Method – Significant Influence           It is presumed that the investment is made as a long-term investment Used when an investor can exert significant influence over an investee-.

Investee Increase (decrease) Net Income investment by our (Loss) proportionate share.Equity Method Effect on Investment Account Reduce investment for dividends received. Adjusting Item Dividends .

Give the journal entry to record TSN s investment.000.000.Equity Method Example On 1/1/20A.000. at a cost of $2.000 2. Inc.000. Record investment at cost: Investment Cash 2.000 . The Super Network (TSN) acquires a 30% interest in Sports Films.

Considered a return OF investment. 30% of which goes to TSN. Record TSN s receipt of the dividend.000 in dividends.000* 60.000 .000 × 30% 60. Cash Investment *$200.Equity Method Example On 3/31/20A. Sports Films pays $200.

  Investment 480.Equity Method Example Sports Films net income for the year ending 12/31/20A is $1.600. Revenue recorded for % of Co.000 × 30% 480.000* . Record the appropriate journal entry on TSN s books at 12/31/20A.600. owned.000   Investment revenue   *$1.000.

000.$60. How would you determine the gain or loss on sale? Investment book value = $2.Equity Method Example What if in January 20B TSN sells its interest in Sports Films.000 .000 .000 = $2.420.000 + $480.

Equity Method Example Proceeds from sale = $3.000 Proceeds from sale = $2.000 Cash 3.000 Investment 2.000 2.000.100.420.420.000 320.000 Cash Loss on Sale Investment 2.000.000 .100.000 Gain on sale 580.

  Consolidated financial statements must be prepared.Investing to Achieve a Controlling Interest = Consolidation Ownership of more than 50% of the outstanding voting stock of another company results in control of the company.   The acquiring company is the parent.   –  report the financial information from two or more different companies as if they were one company .   The acquired company is the subsidiary.

Economic Return from Investing Dividend Income + Interest Income + Gains* !Losses* Fair Value of Investments at Beginning of Year** * Include both Realized and Unrealized Gains and Losses ** The ratio represents an annual rate of return if proceeds from sales remain are reinvested .

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