Reporting and Analysing Investments

CHAPTER

12

Reasons Companies InvestReasons Companies Invest

Illustration 12-1

• Investments in money market instruments Investments in money market instruments (short-term) and bonds (long-term)(short-term) and bonds (long-term)

• In accounting for debt investments, entries In accounting for debt investments, entries are required to record:are required to record:– Acquisition Acquisition – Interest revenueInterest revenue– SaleSale

• Are recorded at cost including brokerage Are recorded at cost including brokerage fees fees

Debt InvestmentsDebt Investments

Field Corporation acquires 50 Forbes, Inc. 12%, Field Corporation acquires 50 Forbes, Inc. 12%, 10-year, $1,000 bonds on January 1 for $54,000.10-year, $1,000 bonds on January 1 for $54,000.

Acquisition of BondsAcquisition of Bonds

Jan. 1 Debt investmentsJan. 1 Debt investments

CashCash

54,00054,000

54,00054,000

To record purchase of 50 Forbes, Inc. bondsTo record purchase of 50 Forbes, Inc. bonds

Bond InterestBond Interest

The bonds pay interest of $3,000 semi-annually The bonds pay interest of $3,000 semi-annually on July 1 and January 1. The entry to record on July 1 and January 1. The entry to record the receipt of interest on July 1 is:the receipt of interest on July 1 is:

July 1 CashJuly 1 Cash

Interest RevenueInterest Revenue

3,0003,000

3,0003,000

To record receipt of interest on Forbes bondsTo record receipt of interest on Forbes bonds

Accrued Bond InterestAccrued Bond Interest

If the buyer’s (Field) fiscal year ends on If the buyer’s (Field) fiscal year ends on December 31, the following adjusting entry is December 31, the following adjusting entry is needed to accrue interest of $3,000 earned needed to accrue interest of $3,000 earned since July 1:since July 1:

Dec. 31 Interest ReceivableDec. 31 Interest Receivable

Interest RevenueInterest Revenue

3,0003,000

3,0003,000

To accrue interest on Forbes bondsTo accrue interest on Forbes bonds

Sale of BondsSale of Bonds

Field sells the bonds for $58,000 on January 1, 2005, after Field sells the bonds for $58,000 on January 1, 2005, after receiving the interest due. The bonds were purchased for receiving the interest due. The bonds were purchased for $54,000. Field must record a gain of $4,000. The entry to $54,000. Field must record a gain of $4,000. The entry to record the sale of the bonds is as follows:record the sale of the bonds is as follows:

Jan. 1 CashJan. 1 Cash

Debt InvestmentsDebt Investments

Gain on sale of Debt InvestmentsGain on sale of Debt Investments

58,00058,000

54,00054,000

4,0004,000

To record sale of Forbes bondsTo record sale of Forbes bonds

Equity InvestmentsEquity Investments

• Investments in the share capital (preferred or Investments in the share capital (preferred or common) of corporationscommon) of corporations

• Accounting for investments in common Accounting for investments in common shares is based on the extent of the investor's shares is based on the extent of the investor's degree of influencedegree of influence over the operating and over the operating and financial affairs of the issuing corporation (the financial affairs of the issuing corporation (the investee)investee)

Equity InvestmentsEquity Investments

• Factors to consider in determining degree Factors to consider in determining degree of influence are whether:of influence are whether:– Investor has representation on the Investor has representation on the

investee's board of directorsinvestee's board of directors– Investor participates in the investee's Investor participates in the investee's

policy-making processpolicy-making process– Material transactions exist between the Material transactions exist between the

investor and the investeeinvestor and the investee– Common shares that are held by other Common shares that are held by other

shareholders are concentrated or dispersedshareholders are concentrated or dispersed

Accounting Guidelines – Accounting Guidelines – Equity InvestmentsEquity Investments

Illustration 12-3

Cost MethodCost Method(Less than 20%)(Less than 20%)

• Record investment at costRecord investment at cost• Cost includes all expenditures necessary to Cost includes all expenditures necessary to

acquire these investments, such as the price acquire these investments, such as the price paid plus brokerage fees (commissions), if anypaid plus brokerage fees (commissions), if any

• Recognize revenue when cash dividends are Recognize revenue when cash dividends are declareddeclared

Acquisition of SharesAcquisition of Shares

On July 1, 2004, Passera Corporation acquires 1,000 On July 1, 2004, Passera Corporation acquires 1,000 shares (10% ownership) of Beal Corporation shares (10% ownership) of Beal Corporation common shares at $40 per share, plus brokerage common shares at $40 per share, plus brokerage fees of $500.fees of $500.

July 1 Equity InvestmentsJuly 1 Equity Investments

CashCash

40,50040,500

40,50040,500

To record purchase of 1,000 Beal common sharesTo record purchase of 1,000 Beal common shares

DividendsDividends

Passera Corporation receives $2 per share Passera Corporation receives $2 per share dividend on December 31.dividend on December 31.

Dec. 31 Cash (1,000 x $2)Dec. 31 Cash (1,000 x $2)

Dividend RevenueDividend Revenue

2,0002,000

2,0002,000

To record receipt of cash dividendTo record receipt of cash dividend

Sale of SharesSale of Shares

Net Proceeds from the SaleNet Proceeds from the Sale (sales price less brokerage fees) (sales price less brokerage fees)- Cost of the SharesCost of the Shares= Gain (Loss)= Gain (Loss)

Sale of SharesSale of Shares

Passera Corporation receives net proceeds of Passera Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation $39,500 on the sale of its Beal Corporation shares on February 10, 2005.shares on February 10, 2005.

Feb. 10 CashFeb. 10 Cash

Loss on Sale of Equity Loss on Sale of Equity Investments Investments

Equity InvestmentsEquity Investments

39,50039,500

1,0001,000

40,50040,500

To record sale of Beal common sharesTo record sale of Beal common shares

Equity MethodEquity Method(More than 20%)(More than 20%)

• Investment in common shares is initially Investment in common shares is initially recorded at costrecorded at cost

• Investment account adjusted annually to Investment account adjusted annually to show the investor’s equity in the investeeshow the investor’s equity in the investee

• Investor has Investor has significant influencesignificant influence over over investeeinvestee

Acquisition of SharesAcquisition of Shares

Milar Corporation acquires 30% of the common Milar Corporation acquires 30% of the common shares of Beck Inc. for $120,000 on January 1, 2004.shares of Beck Inc. for $120,000 on January 1, 2004.

Jan. 1 Equity Investments Jan. 1 Equity Investments

CashCash

120,000120,000

120,000120,000

To record purchase of Beck common sharesTo record purchase of Beck common shares

Net Earnings (Loss) and DividendsNet Earnings (Loss) and Dividends

• For 2004, Beck reports net earnings of $100,000 For 2004, Beck reports net earnings of $100,000 and declares and pays a $40,000 cash dividend and declares and pays a $40,000 cash dividend

• Milar is required to record:Milar is required to record:– Its share of Beck's earnings, $30,000 (100,000 x Its share of Beck's earnings, $30,000 (100,000 x

30%)30%)– The reduction in the investment account for the The reduction in the investment account for the

dividends received, $12,000 ($40,000 x 30%) dividends received, $12,000 ($40,000 x 30%)

Revenue and DividendsRevenue and Dividends

Dec. 31 Equity Investments Dec. 31 Equity Investments

Revenue from InvestmentRevenue from Investment in Beck Company in Beck Company

30,00030,000

30,00030,000

To record 30% equity in Beck's 2004 netTo record 30% equity in Beck's 2004 netearningsearnings

Dec. 31 CashDec. 31 Cash

Equity InvestmentsEquity Investments

12,00012,000

12,00012,000

To record dividends receivedTo record dividends received

During the year the investment account increased by During the year the investment account increased by

$18,000 ($30,000 - $12,000)$18,000 ($30,000 - $12,000)

Cost and Equity Methods Cost and Equity Methods ComparedCompared

Account Titles and Explanations Debit Credit Account Titles and Explanations Debit Credit

Equity Investment--Beck 120,000 Equity Investment--Beck 120,000 Cash 120,000 Cash 120,000

No entry Equity Investment--Beck 30,000 Revenue from Investment 30,000

Cash 12,000 Cash 12,000 Dividend Revenue 12,000 Equity Investment--Beck 12,000

Equity Method

Acquistion

Investee reports earnings

Investee pays dividends

Cost Method

Controlling InterestControlling Interest

• Controlling interestControlling interest is usually granted when is usually granted when one company holds more than 50% of the one company holds more than 50% of the common shares of another companycommon shares of another company

• Investor and investee are, in some sense, one Investor and investee are, in some sense, one companycompany– Investor: Investor: parent companyparent company– Investee: Investee: subsidiary companysubsidiary company

ConsolidatedConsolidatedFinancial StatementsFinancial Statements

• Inform creditors, investors, and others of the Inform creditors, investors, and others of the magnitude and scope of operations of magnitude and scope of operations of companies under common controlcompanies under common control

• Present assets and liabilities controlled by Present assets and liabilities controlled by parent and the aggregate profitability of parent and the aggregate profitability of subsidiary companiessubsidiary companies

• Prepared in addition to financial statements Prepared in addition to financial statements for individual parent and subsidiary for individual parent and subsidiary companiescompanies

Short- and Long-Term InvestmentsShort- and Long-Term Investments

• Investments include:Investments include:– Short-term paper (certificates of deposit, Short-term paper (certificates of deposit,

treasury bills, commercial paper)treasury bills, commercial paper)– Debt securities (government and corporate Debt securities (government and corporate

bonds)bonds)– Equity securities (preferred and common Equity securities (preferred and common

shares)shares)• These can be classified as either These can be classified as either short-termshort-term

or or long-termlong-term

Short- and Long-Term InvestmentsShort- and Long-Term Investments

• Short-term investments are debt or equity Short-term investments are debt or equity securities, held by a company, that aresecurities, held by a company, that are– Readily marketableReadily marketable– IntendedIntended to be converted into cash in the near to be converted into cash in the near

futurefuture• Investments that do not meet both of the above Investments that do not meet both of the above

criteria are classified as criteria are classified as long-term investmentslong-term investments

Valuation of InvestmentsValuation of Investments

• Value of debt and equity investments may Value of debt and equity investments may fluctuate greatly during the time they are heldfluctuate greatly during the time they are held

• ConservatismConservatism requires accountants to use the requires accountants to use the lower of cost and market (LCM) rulelower of cost and market (LCM) rule

• Application of the LCM rule varies depending Application of the LCM rule varies depending on whether the investment is short- or long-on whether the investment is short- or long-termterm

Valuation of Short-Term Valuation of Short-Term InvestmentsInvestments

• LCM normally applied to total portfolioLCM normally applied to total portfolio• Allowance to Reduce Cost to Market ValueAllowance to Reduce Cost to Market Value

used to record the difference between cost used to record the difference between cost and market valueand market value

• Allowance account is a Allowance account is a contra assetcontra asset account account deducted from the cost of the investments to deducted from the cost of the investments to arrive at the LCM valuationarrive at the LCM valuation

Reporting of Short-Term Reporting of Short-Term InvestmentsInvestments

Current AssetsCurrent Assets

CashCash

Short-term investments, at costShort-term investments, at cost

Less: Allowance to reduce cost to Less: Allowance to reduce cost to market valuemarket value

Short-term investments, at marketShort-term investments, at market

$140,000$140,000

2,0002,000

$xxxxxx$xxxxxx

138,000138,000

Valuation of Long-Term Valuation of Long-Term InvestmentsInvestments

• LCM applied to LCM applied to individualindividual investments investments• Carrying values Carrying values notnot adjusted to reflect temporary adjusted to reflect temporary

fluctuations in market valuefluctuations in market value• When market falls below cost and the decline is When market falls below cost and the decline is

not temporarynot temporary, reduce investment to market value, reduce investment to market value• Investment is credited directly; no allowance Investment is credited directly; no allowance

account is usedaccount is used

Evaluating Investment Portfolio Evaluating Investment Portfolio PerformancePerformance

• Time sale of Time sale of investments before investments before year-endyear-end

• Misclassification of Misclassification of investments as short- investments as short- and long-termand long-term

• Short-term investmentsShort-term investments– Report at LCM in current asset section of balance Report at LCM in current asset section of balance

sheetsheet– Disclose market valueDisclose market value– Present after Cash or combined with Cash as a Present after Cash or combined with Cash as a

cash equivalentcash equivalent if highly liquidif highly liquid• Long-term investmentsLong-term investments

– Separate section of the balance sheet Separate section of the balance sheet immediately below Current Assetsimmediately below Current Assets

– Report at cost or at equity (if significant influence)Report at cost or at equity (if significant influence)

Balance Sheet PresentationBalance Sheet Presentation

Statement of Earnings Statement of Earnings PresentationPresentation

• Gains and losses on investments, interest Gains and losses on investments, interest and dividend revenue are reported in the and dividend revenue are reported in the non-operating section of the Statement of non-operating section of the Statement of EarningsEarnings

Cash Flow Statement PresentationCash Flow Statement Presentation

• Information on the cash inflows and outflows Information on the cash inflows and outflows that resulted from investment transactions are that resulted from investment transactions are reported in the investing activities section of reported in the investing activities section of the Cash Flow Statementthe Cash Flow Statement