1 chapter 23 investments in stocks and bonds of other companies

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CHAPTER 23

INVESTMENTS IN STOCKS AND BONDS

OF OTHER COMPANIES

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Chapter Overview

How does a company classify its

investments on its financial statements?

How does a company record and report its

investments that are available for sale?


investments in companies over which it has

significant influence?

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Chapter Overview

When and why does a company prepare

consolidated financial statements?


investments in bonds that it expects to hold

until maturity?

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Classification of Investments Common stock is the ownership unit of a corporation; common stockholders are the owners.

Owners have the right to vote on company policies and the right to share in the corporation’s net income by receiving dividends.

Bonds are a type of note in which a company agrees to pay the holders the face value on maturity and interest periodically at a specified rate.

Bondholders are creditors and cannot vote; they only share in the company’s income by receiving a fixed amount of interest each period.

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Classification of Investments

A company (called an investor) may choose to invest in the common stock of another company (called an investee).

How the investor accounts for its investment under GAAP depends on its “influence” over the investee.

Influence is defined by the percentage ownership the investor company has in the investee; percentage ownership being the number of votes the investor has.

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Classification of Investments If an investor company has no significant influence (less than 20% ownership), the

investor has “available-for-sale stock “ and must use the market value method of reporting.

If an investor company has significant influence (20% to 50% ownership), the investor has an equity investment and uses the equity method of reporting.

If an investor company owns more than 50%, the investor has control and uses the consolidated method of reporting.

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Classification of Investments A company may choose to invest in another company’s bonds. How the investor

accounts for this investment under GAAP depends on how long it expects to hold the bond.

If the company expects to sell the bond before maturity date, it calls them “available for sale bonds” and reports this investment using the market value method.

If the company expects to hold the bonds to maturity, it calls them “held-to-maturity bonds” and reports this investment using the amortized cost method.

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Accounting for Investments

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Market Prices of Stocks and Bonds

A company (just like an individual) usually makes an investment in stocks or bonds of publicly traded companies through a stockbroker.

Stocks and bonds of large corporations are traded on organized securities exchanges such as the New York Stock Exchange, the Tokyo Stock Exchange, or the Oslo Stock Exchange.

The stocks of other companies are traded in the over-the-counter markets, such as NASDAQ, in which brokers deal directly with each other rather than through stock exchange.

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The market prices of stocks are quoted daily and are reported on many Internet sites and in many newspapers. For example, the stock of IBM was recently listed as follows – what does all of this mean?

Market Prices of Stocks

52 weeks YTD % change

High Low Symbol Dividend Yield %

Price Earnings

Volume 100s

Close Net Change

-39.2

126.39

66.10

IBM

.60

.8

18

52,044

73.50

2.99

The stock sold at a high of $126.39 and a low of $66.10 per share in the last 52 weeks.

The stock ticker symbol

The stock price decreased 39.2% in the last year.

The closing price is 18 times EPS for last 4Qs

5,204,400 shares tradedDividend as % of

market price

Closing price per

share

Change in price from

previous day

The annual dividend per share

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Bonds Current

Yield

Volume

Close Net

Change

7 25

6.8

10

102.63

1.38

The market prices of bonds are quoted daily and are reported on many Internet sites and in many newspapers. For example, IBM bonds were recently listed as follows – what does all of this mean?

This is the contract rate of interest paid (7%) –

bonds due 2025

10 bonds were traded

Based on current market price, yield is 6.8%.

Change in price from previous day

The bond is trading at 102.63% of face, or $1,026.30

Market Prices of Bonds

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A company uses the market value method for investments in the available-for-sale securities category.

Stock is this category means the investor does not have significant influence (less than 20% ownership). For bonds, it means the investor does not expect to hold them to maturity.

Available-for-sale securities are sometimes called marketable securities.

Market Value Method

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Under the market value method, a company must report investments at their fair market value on the balance sheet at the end of the year. This is based primarily on management’s intention – the intention not to hold the securities.

Lets look at a comprehensive example of how to record the investment, report investment income, report the value on the balance sheet, and calculate gain or loss on sale when this method is used.

Market Value Method

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Suppose Unlimited Decadence purchases 200 shares of Fox Company common stock for $4,000 and 8 bonds of Crow Company for $8,000. These investments qualify as available-for-sale securities.

The bonds have a contract interest rate of 10% and pay interest semiannually on June 30 and December 31. How are the investments initially recorded.

Market Value Method

-$12,000 (Cash)

Assets = Liabilities + Stockholders’ Equity+$12,000

(Investments in Available-for-

Sale Securities)

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+$400 (Cash)

+$200 (Cash)

Assets = Liabilities + Stockholders’ Equity

During 2004, Unlimited Decadence receives $200 in dividends from the Fox Company common stock.

Also during 2004, Unlimited Decadence receives interest payments on the Crow Bonds. On each payment date, $400 would be received ($8,000 X 10%/2). Only one interest payment is illustrated below.

Market Value Method

+$400 (Interest Revenue)

Crow interest payment

+$200 (Dividend Revenue)

Fox cash dividend

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Under the market value method, Unlimited Decadence must adjust the value of its available-for-sale securities to fair market value at year-end even though they are still on hand.

Based on a review of market value, the available-for-sale investments are worth $12,500, up $500 from when they were purchased on January 1. How is this recorded?

Market Value Method

Assets = Liabilities + Stockholders’ Equity+$500

(Available-for-sale Securities)

+$500 (Unrealized Increase in Market

Value of Investments)

The value of the securities on the

balance sheet is now $12,500, the current

market value

The unrealized gain is not reported as

income on the income

statement but is part of

comprehensive income in

stockholders’ equity

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Schedule to Compute Market Value of Investments in

Available-for-Sale Securities

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When Unlimited Decadence sells an investment, it must record the cash received, reduce the investment account, and record a gain or loss that is reported on the income statement.

When the gain or loss is reported on the income statement, any related unrealized gain or loss already recognized under the market value method must be reversed.

This means if Unlimited Decadence sells the 200 shares of Fox Company stock, the $600 increase in market value already recognized must be reversed when the gain is recognized on the income statement.

Market Value Method

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If 200 shares of Fox Company are sold for $4,800, what is the gain and how is it recorded?

The gain is calculated as follows:

Market Value Method

-$600 (Unrealized Increase in

Market Value of Investments)

-$4,600 (Available-

for-sale Securities)

+$800 (Gain on Sale of

Investment

Cash received 4,800$ Cost of stock (4,000)$ Gain on sale 800$

Assets Stockholders’ Equity

+$4,800 (Cash)

When the gain is reported on the

income statement, the related

unrealized gain account must be

eliminated

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Equity Method A company whose investment in the common stock of another company enables it to

have significant influence (but not control) over the operations of the other company uses the equity method to account for the investment.

Under GAAP, significant control exists when the investee owns between 20% and 50% of the investee’s common stock.

Under the equity method, the investee accounts for its investment using the following formula:

Investment = Cost + Income earned - Dividends Received

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Equity Method


The investor company records as income its share of the investee company’s net income, which increases the investment account.

The investor company records as dividend income its share of dividends paid by the investee company, which decrease the investment account.

Income Earned = Investee’s Net Income X Investor’s Ownership %

Dividends Received = Investee’s Dividends Paid X Investor’s Ownership %

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On January 1, 2004, suppose Unlimited Decadence purchased 30% of Sanchez Sugar Company’s common stock for $60,000.

This is an equity investment because ownership is at least 20% but not more than 50%. How is this recorded?

Accounting for Equity Method Transactions

-$60,000 (Cash)


(Investment in Sanchez Sugar

Company)

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An the end of 2004, Sanchez reports net income of $40,000 and pays dividends of $10,000.

Using the equity investment formula, how is the income earned and dividends received calculated?



Income Earned = $40,000 net income X 30% = $12,000

Dividends Received = $10,000 dividend paid X 30% = $3,000

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The share of net income earned by Unlimited Decadence is $12,000. This increases the investment account and is also reported as income on the income statement in 2004.



(Investment in Sanchez Sugar

Company)

+$12,000 (Income from Investment in

Sanchez Sugar Company)

Income Earned = $40,000 net

income X 30% = $12,000

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The share of dividends received by Unlimited

Decadence is $3,000. This increases cash

and decreases the investment account in

2004.


-$3,000 Investment in

Sanchez Sugar Company)


+$3,000 (Cash) Dividends Received = $10,000 dividend

paid X 30% = $3,000

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Equity Method

At the end of 2004, Unlimited Decadence's

30% interest in Sanchez Sugar Company is

reported on the balance sheet at $69,000,

summarized as follows:

Investment, 1/1/04 60,000$ Share of investee's net income 12,000$ Share of investee's dividends (3,000)$ Investment, 12/31/04 69,000$

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Consolidated Financial Statements

When an investor company owns more that 50% of the common stock of another company, the investor has control over the investee.

In this situation, the investor is called the parent company and the investee is called the subsidiary company.

The parent and subsidiary companies are legally separate entities and keep separate accounting records. Users are interested in financial statements that report their combined activities.

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Consolidated Financial Statements

Consolidated financial statements are a single set of financial statements that combine the parent company with all other companies over which it has control.

The underlying GAAP reasoning is that the parent and its controlled subsidiaries represent a single economic entity for financial reporting purposes.

This is another good illustration of where economic substance takes precedent over legal form in GAAP.

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Segment Reporting

Even though a company files consolidated financial statements, information about reporting operating segments must also be provided under GAAP.

A company may have many operating segments, but GAAP only requires additional information about those segments that qualify as reportable segments by meeting certain reporting tests, such as profit or revenue.

Reportable segments must provide their profit or loss, assets, and general information such as products and geographic areas.

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Consolidated Financial Statements and Segment Reports

Exhibit 23-4

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Investments in Held-to-Maturity Bonds

An investor company may invest in bonds that it expects to hold until maturity.

These investment do not qualify as available-for-sale investments under the market value method.

When a company purchases bonds as an investment and has both the intent and the ability to hold bonds until maturity, the investments are reported at their cost.

If the purchase involved a discount or premium, then the investment is reported at its amortized cost.

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Zero-Coupon Bonds

Recall from Chapter 22 that zero-coupon bonds pay no interest each period.

These investments are always purchased at a discount, and the different between the purchase price and the maturity value is interest which is accrued over time by the buyer and the seller.

As the interest is recognized, this is called amortizing the discount.

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For example, assume Beany Biscuit Company purchased for $385,500 (at a 10% yield) all of Unlimited Decadence’s 10-year $1,000,000 face value zero-coupon bonds on January 1, 2004.

Purchase price = $1,000,000 X 0.3855 (Table 20-1 - present value of a single sum for 10 periods at 10%) = $385,500

Recording the Purchase of Zero-Coupon Bonds

-$385,500 (Cash)

+$385,500(Investment in

Held-to-Maturity Bonds)


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The interest income for the first year is then

computed as follows:

XBook Value of

Bonds Payable at Beg. of Period

Book Value of Bonds Payable at

Beg. of Period=

Interest Revenue

X $385,500$385,500 = $38,55010%10%

Yield (the market rate)

Yield (the market rate)

Recording the Interest Revenue on Zero-Coupon Bonds

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To report the interest revenue on the zero coupon bonds, Beany Biscuit Company would increase its investment in its held-to-maturity bonds and increase interest revenue for $38,550.



+$38,550 Investment in

(Held-to-maturity Bonds)

+$38,550 (Interest Revenue)

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Periodic Interest Discount BondDate payment Revenue amortized Book Value

1-Jan-04 Purchased $ 385,500 385,500$ 1-Jan-05 -$ 38,550$ 38,550$ 424,050$ 1-Jan-06 -$ 42,405$ 42,405$ 466,455$ 1-Jan-07 -$ 46,646$ 46,646$ 513,101$ 1-Jan-08 -$ 51,310$ 51,310$ 564,411$ 1-Jan-09 -$ 56,441$ 56,441$ 620,852$ 1-Jan-10 -$ 62,085$ 62,085$ 682,937$ 1-Jan-11 -$ 68,294$ 68,294$ 751,230$ 1-Jan-12 -$ 75,123$ 75,123$ 826,353$ 1-Jan-13 -$ 82,635$ 82,635$ 908,989$ 1-Jan-14 -$ 91,011$ 91,011$ 1,000,000$ 1-Jan-14 1,000,000$ 0

By looking at a bond amortization schedule, it is easier to see how the pieces fit together:


Interest revenue for 2005 is then calculated as

$424,050 X 10% = $42,405; each

time interest revenue is

reported, the bond’s book

value increases for the discount

amortized.

1 chapter 23 investments in stocks and bonds of other companies

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