Financial Accounting: Tools for Business Decision Making, 2nd Ed.

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Financial AccountingTools for Business Decision
Making, 2nd Ed.
Kimmel, Weygandt, Kieso
Prepared by
Ellen L. Sweatt
Georgia Perimeter College
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Chapter 12
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Chapter 12Reporting and Analyzing Investments

• After studying Chapter 12, you should be able
  to
• Identify the reasons corporations invest in
  stocks and debt securities.
• Explain the accounting for debt investments.
• Explain the accounting for stock investments.
• Describe the purpose and usefulness of
  consolidated financial statements.

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Chapter 12Reporting and Analyzing Investments

• After studying chapter 12, you should be able
  to
• Indicate how debt and stock investments are
  valued and reported in the financial statements.
• Distinguish between short-term and long-term
  investments.

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Illustration 12-1
Temporary Investments and the Operating Cycle
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Reasons Companies Invest...
Illustration 12-2
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Vertical and Horizontal Acquisition

• Vertical acquisition would occur if Nike
  purchased a chain of athletic shoe stores.
• Horizontal acquisition would occur if Nike
  purchased Reebok.

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Debt Investments...

• Are investments in government and corporation
  bonds.
• In accounting for debt investments, entries are
  required to record
• the acquisition
• the interest revenue
• the sale
• Are recorded at cost including brokerage fees.
  

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Debt Investments
Kuhl Corporation acquires 50 Doan, Inc. 12,
10-year, 1,000 on Jan. 1 for 54,000.
Jan 1 Debt investments 54,000 Cash 54,000
To record purchase of 50 Doan, Inc. bonds
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Bond Interest

• The bonds pay interest of 3,000 semiannually on
  July 1 and January 1.
• The entry to record the receipt of interest on
  July 1 is
• July 1 Cash 3,000
• Interest Revenue 3,000
• (To record receipt of interest on Doan Inc. bonds)

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Accrued Bond Interest

• If the buyers (Kuhl) fiscal year ends on
  December 31, the following adjusting entry is
  needed to accrue interest of 3,000 earned since
  July 1
• Dec. 31 Interest Receivable 3,000
• Interest Revenue 3,000
• (To accrue interest on Doan Inc. bonds)

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Bond Interest

• Interest Receivable is reported as a current
  asset in the balance sheet.
• Interest Revenue is reported under Other Revenues
  and Gains in the income statement.
• When the interest is received on January 1, the
  entry is
• Jan. 1 Cash 3,000
• Interest Receivable 3,000
• (To record receipt of accrued interest)

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Sale of Bonds

• Kuhl sells the bonds for 58,000 on January 1,
  2002, after receiving the interest due. The
  bonds were purchased for 54,000.
• Kuhl must record a gain of 4,000. The entry to
  record the sale of the bonds is as follows
• 1/1 Cash 58,000
• Debt Investments 54,000
• Gain on sale of Debt Investments 4,000
• (To record sale of Doan Inc. bonds)

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Stock Investments...

• Are investments in the capital stock of
  corporations.
• When a company holds stock and/or debt of several
  different corporations, the group of securities
  is identified as an investment portfolio.
• The accounting for investments in common stock is
  based on the extent of the investor's influence
  over the operating and financial affairs of the
  issuing corporation (the investee).

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Stock Investments

• Factors to consider in determining an
  investor's influence are whether
• (1) the investor has representation on the
  investee's board of directors.
• (2) the investor participates in the investee's
  policy-making process.
• (3) there are material transactions between the
  investor and the investee.
• (4) the common stock held by other stockholders
  is concentrated or dispersed.

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Accounting Guidelines - Stock Investments
Illustration 12-3
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Cost Method

• Under the cost method, the investment is recorded
  at cost, and revenue is recognized only when cash
  dividends are received.
• Cost includes all expenditures necessary to
  acquire these investments, such as the price paid
  plus brokerage fees (commissions), if any.

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Acquisition of Stock

• On July 1, 2001, Sanchez Corporation acquires
  1,000 shares (10 ownership) of Beal Corporation
  common stock at 40 per share plus brokerage fees
  of 500.
• July 1 Stock Investments 40,500 Cash 40,5
  00
• (To record purchase of 1,000 shares of Beal
  common stock)

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Recording Dividends

• A 2.00 per share dividend is received by
  Sanchez Corporation on December 31
• Dec. 31 Cash (1,000 x 2) 2,000
• Dividend Revenue 2,000
• (To record receipt of cash dividend)

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Sale of Stock

• When stock is sold, the difference between the
  net proceeds from the sale (sales price less
  brokerage fees) and the cost of the stock is
  recognized as a gain or a loss.

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Sale of Stock

• Sanchez Corporation receives net proceeds of
  39,500 on the sale of its Beal Corporation stock
  on February 10, 2002.
• Since the stock cost 40,500, a loss of 1,000
  has been incurred.
• 1/1 Cash 39,500
• Loss on Sale of Stock
  Investments
  1,000
• Stock Investments 40,500
• (To record sale of Beal common stock)

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Sale of Stock

• A loss would be reported under Other Expenses and
  Losses in the income statement.
• A gain on a sale would be shown under Other
  Revenues and Gains.

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Equity Method...

• Is an accounting method in which the investment
  in common stock is initially recorded at cost,
  and the investment account is adjusted annually
  to show the investors equity in the investee.

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Equity Method

• Failure to recognize the investors share of net
  income until a cash dividend is declared ignores
  the fact that the investor and investee are, in
  some sense, one company.

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Acquisition of Stock

• Milar Corporation acquires 30 of the common
  stock of Beck Company of 120,000 on January
  1,2001.
• Jan. 1 Stock Investments 120,000
• Cash 120,000
• (To record purchase of Beck common stock)

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Revenue and Dividends

• For 2001 Beck reports net income of 100,000 and
  declares and pays a 40,000 cash dividend.
• Milar is required to record
• (1) its share of Beck's income, 30,000 (100,000
  x 30), and
• (2) the reduction in the investment account for
  the dividends received, 12,000 (40,000 x 30).

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Revenue and Dividends

• 12/31 Stock Investments 30,000 Revenue from
  Investment in Beck Company 30,000
• To record 30 equity in Beck's 1998 net income
• 12/31 Cash 12,000 Stock Investments 12,000
• (To record dividends received)
• During the year the investment account has
  increased by 18,000 (30,000 - 12,000).

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Holdings of More than 50

• A company that owns more than 50 of the common
  stock of another entity is known as the parent
  company.
• The entity whose stock is owned by the parent
  company is called the subsidiary (affiliated)
  company.

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Consolidated Financial Statements...

• Are usually prepared when a company owns more
  than 50 of the common stock of another.
• Present the assets and liabilities controlled by
  the parent company and the aggregate
  profitability of the subsidiary companies.
• Are prepared in addition to the financial
  statements for each of the individual parent and
  subsidiary companies.
• Are useful to the stockholders, board of
  directors, and management of the parent company.
• Inform creditors, prospective investors, and
  regulatory agencies as to the magnitude and scope
  of operations of the companies under common
  control.

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Valuation And Reporting Of Investments

• Many argue that fair value - the amount for which
  a security could be sold in a normal market -
  offers the best approach because it represents
  the expected cash realizable value of securities.
  
• Others contend that unless a security is going to
  be sold soon, the fair value is not relevant
  because the price of the security will likely
  change again.

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Valuation And Reporting Of Investments

• Debt and stock investments are classified into
  the following three categories
• Trading securities
• Available-for-sale securities
• Held-to-maturity securities

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Trading Securities...
Illustration 12-5

• Are securities bought and held primarily for sale
  in the near term to generate income on short-term
  price differences.
• Are reported at fair value referred to as
  mark-to-market accounting.
• Changes from cost are reported in net income.

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Available-for-Sale Securities...
Illustration 12-5

• Are securities that may be sold in the future.
• Are reported at fair value.
• Changes from cost are reported in the
  stockholders equity section.

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Held-to-Maturity Securities...
Illustration 12-5

• Are debt securities that the investor has the
  intent and the ability to hold to maturity.
• More will be covered in advanced courses.

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Investment Portfolio

• Under the accounting standards for reporting
  investments in debt securities and equity
  investments of less than 20 that were introduced
  in 1993, companies can choose which of the three
  categories of securities to use for an
  investment.
• Unfortunately, under these new standards,
  companies can "window-dress" their reported
  earnings results--that is make net income look
  better than it really was.

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Investment Portfolio

• Gains and losses on investments classified as
  available-for-sale are not included in income,
  but rather are recorded an adjustment to equity.
• A company wanting to manage its reported income
  can sell those available-for-sale investments
  that have unrealized losses, and not sell those
  available-for-sale investments that have
  unrealized losses, deferring the losses until a
  later period.

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Temporary And Long-term Investments

• For balance sheet presentation, investments must
  be classified as either temporary or long-term.

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Temporary Investments

• Short-term investments are securities held by a
  company that are
• readily marketable - (can be sold easily whenever
  the need for cash arises) and
• intended to be converted into cash within the
  next year or operating cycle, whichever is
  longer.

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Temporary Investments

• Because of their high liquidity, short-term
  investments (at fair value) are listed
  immediately below Cash in the current asset
  section of the balance sheet.

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Long-Term Investments

• Long-term investments-are generally reported in a
  separate section of the balance sheet immediately
  below Current Assets.
• Long-term investments in available-for-sale
  securities are reported at fair value, and
  investments in common stock accounted for under
  the equity method are report at equity.

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Gains and Losses on Investments

• Gains and losses on investments, whether realized
  or unrealized, must be presented in the financial
  statements.
• In the income statement, gains and losses, as
  well as interest and dividend revenue, are
  reported in the nonoperating section under the
  following categories
  Illustration 12-9
• Other Revenue and Gains Other Expenses and
  Losses
• Interest Revenue Loss on Sales of Investments
• Dividend Revenue Unrealized Loss--Income
• Gain on Sale of Investments
• Unrealized Gain--Income

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Gains and Losses on Investments

• Earlier, it was noted that an unrealized gain or
  loss on available-for-sale securities is reported
  as a separate component of stockholders' equity.
• Dawson Inc. has common stock of 3,000,000,
  retained earnings of 1,500,000, and an
  unrealized loss on available-for-sale securities
  of 100,000.

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Gains and Losses on Investments
Illustration 12-10

• DAWSON INC.
• Balance Sheet (partial)
• Stockholders' equity
• Common stock 3,000,000
• Retained earnings 1,500,000
• Total paid-in capital 4,500,000
• and retained earnings
• Less Unrealized loss on (100,000)
• available-for-sale securities
• Total stockholders' equity 4,400,000

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Gains and Losses on Investments

• Note that the presentation of the loss is similar
  to the presentation of the cost of treasury stock
  in the stockholders' equity section.
• Reporting the unrealized gain or loss in the
  stockholders' equity section serves two important
  purposes
• It reduces the volatility of net income due to
  fluctuations in fair value, and
• It informs the financial statement user of the
  gain or loss that would occur if the securities
  were sold at fair value.

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