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Chapter 12: Investments

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

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

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

Market Value Method (Trading and Available-for-sale securities)


Initial

acquisition of investment is recorded at cost. In periods after acquisition, the securities are reported at market value.
Unrealized (holding) gains and losses related to changes in the market value of securities are recognized.
the gains or losses are unrealized because the stock has not yet been sold

Market Value Method


At

the end of each accounting period, 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 $1,000): Unrealized holding losses 1,000 Allowance to adjust investments to market 1,000

Market Value Method


The treatment of Unrealized Losses depends on the classification of the investment: For trading securities, 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, 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.e., not retained earnings), 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)

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

Retained Earnings Total Stockholders' Equity

50,000 125,000 (8,000) 27,000 $ 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 .

Market Value Method - 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 $10,000 and a net book value of $9,500 is sold for $9,200.

Cash Loss on sale Allowance to adj. to market Investment

9,200 300 500 10,000

Market Value Method - 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. The other side of the entry is to the Unrealized Holding Gain/Loss account (in stockholders equity that is, accumulated other comprehensive income ). [This is also called a "Reclassification Adjustment" from unrealized to realized gain or loss.]

Market Value Method - AFS


Example: An investment (available-for-sale) with a cost of $10,000 and a net book value of $9,500 is sold for $9,200. Cash 9,200 Loss on sale (to income statement) 800 Investment 10,000 Allowance to adjust to market Unrealized holding loss (OCIAOCI) 500 500

Market Value Method: Example


Assume that Motorola purchases shares of Dell stock. The following transactions and events occur: 1 On 11/27/20A, Motorola purchases 10,000 shares of Dell on the open market at a cost of $80 per share 2 On 12/31/20A, 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, Dell shares are trading at $90 per share 5 On 7/6/20C, 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.

Trading Purchase of Stock


11/27/20A Record the investment at COST Investment Cash 800,000 800,000

10,000 shares $80 per share

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 -- 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)

Allowance to adjust to market 200,000 Unrealized gain (income stmt) 200,000* *Market value (1,000,000) book value (800,000)

Trading Income Earned on Stock


4/15/20B Dividends received from stock (classified as passive investments) are considered income Cash Investment revenue 2,500 2,500

10,000 shares $0.25 per share dividend = $2,500

Trading Change in Value at Year End


12/31/20B Market value is $900,000 (down from $1,000,000 in previous year) Unrealized loss (income stmt) 100,000 Allowance to adjust to market 100,000 Balance required in Allowance account = $100,000 debit Balance in Allowance account as of 12/31/03 = $200,000 debit Therefore, credit the Allowance account by $100,000

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 950,000 Investment 800,000 Allowance to adjust to market 100,000 Gain on sale (income statement) 50,000 Gain = Selling price (950,000) Book value (900,000)

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?

Available-for-Sale - Purchase of Stock


11/27/20A Record the investment at COST Investment Cash 800,000 800,000

10,000 shares $80 per share

AFS 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 -- 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) 200,000 200,000*

*Market value (1,000,000) book value (800,000)

AFS Income Earned on Stock


4/15/20B Dividends received from a passive investment in stock are considered income. Cash Investment revenue 2,500 2,500

10,000 shares $0.25 per share dividend = $2,500

AFS Change in Value at Year End


12/31/20B Market value is $900,000 (down from $1,000,000 in previous year) Unrealized loss (OCI) 100,000 Allowance to adjust to market 100,000

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) 950,000 800,000 150,000*

*Gain = Selling price (950,000) Cost (800,000) Unrealized holding gain (OCI) 100,000 Allowance to adjust to market

100,000

Held-to-maturity securities (bonds)


On 1/1/Year 1, Alpha Company acquires bonds with a par value of $1,000,000. The bonds mature in 14 years and pay interest annually on 12/31 at 8%. The market rate of interest when Alpha acquires the bonds is 10%. At 12/31/Year 1, the market rate of interest is 11%. 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.

Held-to-maturity securities (bonds)


Acquisition price: FV = $1,000,000, PMT = $80,000, i = 10%, n = 14, END PV = $852,666

Entry on 1/1/Year 1: Bond investment 852,666 Cash 852,666

Held-to-maturity securities (bonds)


Entry on 12/31/Year 1? Cash Bond investment Interest revenue *$852,666 10% 80,000 5,267 85,267*

Bond book value on 12/31/Year 1? = $852,666 + $5,267 = $857,933 Entry on 12/31/Year 2: Cash Bond investment Interest revenue *$857,933 10%

80,000 5,793 85,793*

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

Equity Method Example


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

Equity Method Example


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

Equity Method Example


Sports Films net income for the year ending 12/31/20A is $1,600,000. Record the appropriate journal entry on TSN s books at 12/31/20A. Revenue recorded for % of Co. owned.
Investment 480,000 Investment revenue
*$1,600,000 30%

480,000*

Equity Method Example


What if in January 20B TSN sells its interest in Sports Films. How would you determine the gain or loss on sale? Investment book value = $2,000,000 - $60,000 + $480,000 = $2,420,000

Equity Method Example


Proceeds from sale = $3,000,000 Cash 3,000,000 Investment 2,420,000 Gain on sale 580,000 Proceeds from sale = $2,100,000 Cash Loss on Sale Investment 2,100,000 320,000 2,420,000

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. The acquired company is the subsidiary. Consolidated financial statements must be prepared.

report the financial information from two or more different companies as if they were one company

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