Corporate finance accounting 14e by warren reeve duchac chapter investment

Appendix

D

Investments

Corporate Financial
Accounting
14e

Warren
Reeve
Duchac

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Investments
(slide 1 of 5)

•

Most companies generate cash from their operations.

o

This cash can be used for the following purposes:



Investing in current operations



Investing in temporary investments to earn additional revenue



Investing in long-term investments in stock of other companies for strategic reasons

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Investments
(slide 2 of 5)

•

Cash is often used to support the current operating activities of a company.

o

For example, cash may be used to replace worn-out equipment or to purchase new, more
efficient, and productive equipment.

•

In addition, cash may be reinvested in the company to expand its current
operations.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Investments
(slide 3 of 5)

•

A company may temporarily have excess cash that is not needed for use in its
current operations.

o

Instead of letting excess cash remain idle in a checking account, most companies invest
their excess cash in securities such as:



Debt securities, which are notes and bonds that pay interest and have a fixed maturity date.



Equity securities, which are preferred and common stock that represent ownership in a company and
do not have a fixed maturity date.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investments
(slide 4 of 5)

•

Investments in debt securities and equity securities, termed investments or
temporary investments, are reported in the current assets section of the balance
sheet.

•

The primary objective of investing in temporary investments is to:

o

earn interest revenue.

o

receive dividends.

o

realize gains from increases in the market price of the securities.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investments
(slide 5 of 5)

•

Long-term investments often involve the purchase of a significant portion of the
stock of another company.

o

Such investments usually have a strategic purpose, such as reduction of costs or expansion
into new markets.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Debt Investments at Cost

•
•
•
•

Debt securities include notes and bonds issued by corporations and governmental organizations.
Most companies invest excess cash in bonds as investments to earn interest revenue.
Most bond investments are recorded at cost.
Typical transactions for bond investments include the following:

o

Purchase of bonds

o

Interest revenue

o

Sale of bonds

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Purchase of Bonds

•

The purchase of bonds is recorded by debiting an investments account for the cost of acquiring
the bonds.

o

•

This cost includes any fees charged by a broker in acquiring the bonds.

If the bonds are purchased between interest dates, the buyer must also pay the seller any
accrued interest since the last interest payment date.

o

Any accrued interest is debited to an interest receivable account rather than to the investment account.

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Sale of Bonds
(slide 1 of 2)

•

The sale of bond investments normally results in a gain or loss.

o

If the proceeds from the sale exceed the balance of the investment account, then a gain is
recorded.

o

If the proceeds are less than the balance of the investment account, a loss is recorded.

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Sale of Bonds

(slide 2 of 2)

•

The gain or loss on the sale of bond investments is reported as part of Other
revenue (loss) on the income statement.

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Equity Investments
(slide 1 of 2)

•

A company may invest in the preferred or common stock of another company.

o

The company investing in another company’s stock is the investor.

o

The company whose stock is purchased is the investee.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Equity Investments
(slide 2 of 2)

•

The percent of the investee’s outstanding stock purchased by the investor
determines the degree of control that the investor has over the investee. This, in
turn, determines the accounting method used to record the stock investment.

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Cost Method: Less Than 20% Ownership
(slide 1 of 2)

•

If the investor purchases less than 20% of the outstanding stock of the investee, the
investor is considered to have no control over the investee.

o

In this case, it is assumed that the investor purchased the stock primarily to earn dividends
or to realize gains on price increases of the stock.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cost Method: Less Than 20% Ownership
(slide 2 of 2)

•

Investments of less than 20% of the investee’s outstanding stock are accounted for
by using the cost method.

•

Under the cost method, entries are recorded for the following:

o

Purchase of stock

o

Receipt of dividends

o

Sale of stock

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Equity Method: Between 20%–50% Ownership
(slide 1 of 2)

•

If a company (investor) purchases between 20% and 50% of the outstanding stock
of another company (investee), the investor is considered to have significant
influence over the investee.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Equity Method: Between 20%–50% Ownership
(slide 2 of 2)

•

Investment of between 20% and 50% are accounted for using the equity method.

o

Under the equity method, a stock investment is recorded at its initial cost. However, the investor’s share of the
investee’s operating results and dividends are also recorded in the investment account as follows:



Net Income: The investor records its share of the net income of the investee as an increase (debit) in the investment
account. Its share of any net loss is recorded as a decrease (credit) in the investment account.



Dividends: The investor’s share of cash dividends received from the investee are recorded as decreases (credits) to
the investment account.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Consolidation: More Than 50% Ownership
(slide 1 of 2)

•

If the investor purchases more than 50% of the outstanding stock of the investee,
the investor is considered to have control over the investee.

•

The purchase of more than 50% ownership of the investee’s stock is termed a
business combination.

•

The corporation owning all or a majority of the voting stock of another corporation is
called a parent company.

•

The corporation that is controlled is called the subsidiary company.

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Consolidation: More Than 50% Ownership
(slide 2 of 2)

•

At the end of the year, the financial statements of the parent and subsidiary are
combined and reported as a single company. These combined financial statements
are called consolidated financial statements.

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Reporting Investments

•

Debt and equity securities are financial assets that are often traded on public
exchanges such as the New York Stock Exchange. As a result, their market value
can be observed and, thus, objectively determined.

o

For this reason, generally accepted accounting principles (GAAP) allows the following
securities to be reported at their fair market values:



Trading securities



Available-for-sale securities



Held-to-maturity securities

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Trading Securities
(slide 1 of 4)

•

Trading securities are debt and equity securities that are purchased to earn shortterm profits from changes in their market prices.

•

Because trading securities are held as a short-term investment, they are reported
as a current asset on the balance sheet.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trading Securities
(slide 2 of 4)

•

Trading securities are valued as a portfolio (group) of securities using the securities’
fair values.

o

Fair value is the market price that the company would receive for a security if it were sold.



A change in the fair value of the portfolio (group) of trading securities is recognized as an unrealized
gain or loss for the period.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Trading Securities
(slide 3 of 4)

•

An adjusting entry is made on December 31, 20Y1, to record the fair value of the portfolio of trading securities.

o

Valuation Allowance for Trading Investments is created to maintain a record of the original cost of the securities.

o

If the fair value of the portfolio of trading securities is more than the cost:



o

The adjustment debits Valuation Allowance for Trading Investments and credits Unrealized Gain on Trading Investments for the difference.

–

Unrealized Gain on Trading Investments is reported separately or as Other revenue on the income statement.

–

Valuation Allowance for Trading Investments is shown on the balance sheet as an addition to Trading Investments (at cost).

If the fair value of the portfolio of trading securities is less than the cost:



The adjustment debits Unrealized Loss on Trading Investments and credits Valuation Allowance for Trading Investments for the difference.

–

Unrealized Loss on Trading Investments is reported on the income statement as Other expenses.

–

Valuation Allowance for Trading Investments is shown on the balance sheet as a deduction from Trading Investments (at cost).

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Trading Securities
(slide 4 of 4)

•

Over time, the valuation allowance account is adjusted to reflect the difference
between the cost and fair value of the portfolio.

o

Thus, increases in the valuation allowance account from the beginning of the period will
result in an adjustment to record an unrealized gain.

o

Likewise, decreases in the valuation allowance account from the beginning of the period will
result in an adjustment to record an unrealized loss.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Available-for-Sale Securities
(slide 1 of 3)

•

Available-for-sale securities are debt and equity securities that are recorded at
fair value but are not classified as trading securities.

•

Changes in the fair values of available-for-sale securities are not reported on the
income statement, but are reported directly in stockholders’ equity.

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Available-for-Sale Securities
(slide 2 of 3)

•

An adjusting entry is made on December 31, 20Y1, to record the fair value of the available-for-sale securities.

o

If the fair value of the portfolio of available-for-sale securities is more than the cost:



The adjustment debits Valuation Allowance for Available-for-Sale Investments and credits Unrealized Gain on Available-for-Sale Investments for the
difference.

o

–

Unrealized Gain (Loss) on Available-for-Sale Investments is reported as an addition in the stockholders’ equity section on the balance sheet.

–

Valuation Allowance for Available-for-Sale Investments is shown on the balance sheet as an addition to Available-for-Sale Investments (at cost).

If the fair value of the portfolio of available-for-sale securities is less than the cost:



The adjustment debits Unrealized Gain (Loss) on Available-for-Sale Investments and credits Valuation Allowance for Available-for-Sale Investments
for the difference.

–

Unrealized Gain (Loss) on Available-for-Sale Investments is reported as a deduction in the stockholders’ equity section on the balance sheet.

–

Valuation Allowance for Available-for-Sale Investments is shown on the balance sheet as a deduction from Available-for-Sale Investments (at cost).

®

© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.