Principles of financial accounting 12e by needles crosson appendix a

APPENDIX

A

Accounting for Investments

Principles of
Accounting
12e
Needles
Powers
Crosson
© human/iStockphoto


Concepts and Management Issues
Related to Investments
 A company invests in the stock or debt
securities of other firms for one or more of
the following reasons:
– A company may temporarily have excess funds
on which it can earn a return.
– Investments may be an integral part of the
company’s business, as in the case of a bank.
– A company may invest in other firms for the
purpose of partnering with or controlling them.

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Recognition

 Purchases and sales of investments are
recorded on the date on which they are
made.
 Income from investments is reported as other
income on the income statement. Any gains
or losses are also reported on the income
statement.
 Gains and losses appear as adjustments in
the operating activities section of the
statement of cash flows. The cash amounts
of purchases and sales of investments
appear in the investing activities section of

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Valuation
 Investments are valued according to the cost
principle—that is, their cost at the time they
are purchased, including any commissions or
fees.
 However, after purchase, the value of the
investments on the balance sheet is adjusted
to reflect subsequent conditions, including:
– Changes in the market value or fair value of the
investments
– Changes caused by the passage of time (as in
amortization)
– Changes in the operations of the investee
companies

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Valuation
 Long-term investments must be evaluated
annually for any impairment or decline in
value that is more than temporary. If such an
impairment exists, a loss on the investment
must be recorded.
 Under certain circumstances, companies are
required to measure investments at fair
value.
– Fair value is not difficult to determine when there
is a ready market in which there are buyers and
sellers for an asset.
– However, if a ready market does not exist,
another valuation technique must be used.

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Classification
 Investments in debt and equity securities are
classified as either short-term or long-term.
– S ho rt-te rm inve s tme nts (or m arke table
s e curitie s ) have a maturity of more than 90 days
but are intended to be held only until cash is
needed for current operations.
– Lo ng -te rm inve s tme nts , which are intended to

be held for more than one year, are reported in
the investments section of the balance sheet.
 Although long-term investments may be just as
marketable as short-term assets, management intends
to hold them for an indefinite time.

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Classification
 Short-term and long-term investments must be
further classified as trading securities, available-forsale securities, or held-to-maturity securities.
– Trading s e c uritie s are debt or equity securities bought and
held principally for the purpose of being sold in the near
term.
– Available -fo r-s ale s e c uritie s are debt or equity securities
that do not meet the criteria for either trading or held-tomaturity securities. They may be short- or long-term
depending on management’s intentions.
– He ld-to -maturity s e c uritie s are debt securities that
management intends to hold until their maturity date.

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Accounting for Equity Investments
– In general, the percentage of ownership in another
company’s stock has the following effects:
 No ninflue ntial and no nc o ntro lling inve s tme nt: A firm
that owns less than 20 percent of the stock of another
company has no influence on the other company’s

operations.
 Influe ntial but no nc o ntro lling inve s tme nt: A firm that
owns between 20 to 50 percent of another company’s
stock can exercise s ignificant influe nce over that
company’s operating and financial policies. Indications
of significant influence include representation on the
board of directors, participation in policymaking,
exchange of managerial personnel, and technological
dependency between the two companies.
 Co ntro lling inve s tme nt: A firm that owns more than 50
percent
of May
another
company’s
exercise
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All Rights Reserved.
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copied or duplicated, orstock
posted to a can
publicly accessible
website, incontrol
whole or in part.


Ethics of Investing
 When a company engages in investment
transactions, there is always the possibility
that its employees may use their knowledge
about the transactions for personal gain.

– Ins ide r trading , or making use of inside
information for personal gain, is unethical and
illegal.
 Before a publicly held company releases significant
information about an investment to its stockholders and
the general public, its officers and employees are not
allowed to buy or sell stock in the company or in the firm
whose shares the company is buying.
 Only after the information is released to the public can
insiders engage in such trading.
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Short-Term Investments in Trading Securities
 Trading securities are always short-term
investments and are frequently bought and
sold to generate profits on short-term
changes in their prices.
– They are classified as current assets on the
balance sheet and are valued at fair value, which
is usually the same as market value.
– An increase or decrease in the fair value of a
company’s total trading portfolio is included in net
income in the period in which the increase or
decrease occurs.
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Available-for-Sale Securities
 Short-term available-for-sale securities are

accounted for in the same way as trading
securities, with two exceptions:
– An unrealized gain or loss is reported as other
comprehensive income (loss).
– If a decline in the value of a security is considered
permanent, it is charged as a loss on the income
statement.

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Long-Term Investments in Equity Securities
 The accounting treatment of long-term
investments in equity securities, such as
common stock, depends on the extent to
which the investing company can exercise
control over the other company.

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Noninfluential and Noncontrolling Investment
(slide 1 of 3)

 Available-for-sale securities are debt or equity
securities than cannot be classified as trading or
held-to-maturity securities.
– When long-term equity securities are involved, a further
criterion for classifying them as available for sale is that
they be noninfluential and noncontrolling investments of

less than 20 percent of the voting stock.
– Accounting for long-term available-for-sale securities
requires using the c o s t-adjus te d-to -marke t me tho d.
 With this method, the securities are initially recorded at
cost and are thereafter adjusted periodically for changes
in market value by using an allowance account.

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Noninfluential and Noncontrolling Investment
(slide 2 of 3)

– The unrealized gain/loss resulting from the adjustment is
reported as other comprehensive income (loss).
– At the end of the accounting period, the total cost and the
total market value of these long-term investments must be
determined.
 If the total market value is less than the total cost, the
difference must be credited to a contra-asset account
called Allowance to Adjust Long-Term Investments to
Market.
 The debit part of the entry is treated as a temporary
decrease and does not appear as a loss on the income
statement. It is shown in an account called Unrealized
Loss on Long-Term Investments, which is reported on a
statement of other comprehensive income.
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Noninfluential and Noncontrolling Investment
(slide 3 of 3)

 If the market value exceeds the cost, the allowance
account is added to Long-Term Investments, and the
unrealized gain appears on the statement of other
comprehensive income.

– When a company sells its long-term investments
in stock, the difference between the sale price and
the cost of the stock is recorded and reported as
a realized gain or loss on the income statement.
– Dividend income from such investments is
recorded by a debit to Cash and a credit to
Dividend Income.

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An Influential but Noncontrolling Investment
 When a firm owns between 20 to 50 percent of
another company’s stock, the e quity me tho d should
be used to account for the stock investment.
– The three main features of this method are as follows:
 The investor records the original purchase of the stock at cost.
 The investor records its share of the company’s periodic net
income as an increase in the Investment account, with a
corresponding credit to an income account. It records its share
of any periodic loss as a decrease to the Investment account,
with a corresponding debit to a loss account.

 When the investor receives a cash dividend, the Cash account
is increased, and the Investment account is decreased.

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A Controlling Investment
 Ownership of more than 50 percent of the
voting stock is required for accounting
recognition of control.
– When a firm has a controlling interest in another
company, a parent-subsidiary relationship is said
to exist. The investing company is the pare nt
c o mpany; the other company is a s ubs idiary.
– The FASB requires that the parent company and
its subsidiaries combine their financial statements
into a single set of statements called
c o ns o lidate d financ ial s tate me nts .
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Investments in Debt Securities
 When a company purchases debt securities,
it records them at cost plus any commissions
or fees.
 Like investments in equity securities, shortterm investments in debt securities are
valued at fair value at the end of the period
and are accounted for as trading securities or
available-for-sale securities.
 However, the accounting treatment is

different if they qualify as held-to-maturity
securities.
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Held-to-Maturity Securities
 Held-to-maturity securities are debt securities
that management intends to hold to their
maturity date.
 Such securities are recorded at cost and are
valued on the balance sheet at cost adjusted
for the effects of interest.

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Long-Term Investments in Bonds
 Like all investments, investments in bonds
are recorded at cost, which, in this case, is
the price of the bonds plus the broker’s
commission.
– When bonds are purchased between interest payment
dates, the purchaser must also pay an amount equal to the
interest that has accrued on the bonds since the last
interest payment date.
– Then, on the next interest payment date, the purchaser
receives an interest payment for the whole period.
 The payment for accrued interest should be recorded as
a debit to Interest Income, which will be offset by a
credit to Interest Income when the interest is received.

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Long-Term Investments in Bonds
 Subsequent accounting for long-term bond
investments depends on the classification of the
bonds.
– Most long-term bond investments are classified as
available-for-sale securities. Such bonds are accounted for
at fair value, which is usually the market value.
– When bonds are intended to be held to maturity, they are
accounted for not at fair value but at cost, adjusted for the
amortization of their discount or premium.
 The procedure is similar to accounting for long-term
bond liabilities, except that separate accounts for
discounts and premiums are not used.

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