Investments and Fair Value Accounting

1. 15 Investments and Fair Value Accounting Student Version

2. 1 Describe why companies invest in debt and equity securities. 15-2

3. 1 Investing Cash in Temporary Investments Debt securities are notes and bonds that pay interest and have a fixed maturity date. Equity securities are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

4. 1 Investing Cash in Temporary Investments These debt securities and equity securities are termed Investments, or Temporary Investments, and are reported in the Current Assets section of the balance sheet.

5. 1 Investing Cash in Long-Term Investments Long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments have a strategic purpose: • Reduction of costs • Replacement of management • Expansion • Integration

6. 2 Describe and illustrate the accounting for debt investments. 15-6

7. $18,000 × 6% × (45/360) 2 Purchase of Bonds Homer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March 17, 2010 (45 days after the last interest payment date). The bonds have an interest rate of 6%, payable on July 31 and January 31.

8. ($540 – $135) or [$18,000 × 6% × (135/360)] 2 Interest Revenue On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × ½).

9. 2 Accrued Interest Homer Company’s accounting period ends on December 31. The following adjusted entry is required to record the accrued interest: Homer Company would report Interest Revenue on its 2010 income statement at $855 ($405 + $450).

10. 2 Semiannual Receipt of Interest Homer Company receives interest of $540 on January 31, 2011. Notice that Interest Receivable is credited for $450 to reflect this is a receivable from 2010. Interest Revenue of $90 is the interest earned from January 1 through January 31, 2011.

11. Reported as part of Other Income (Loss) on the income statement 2 Sale of Bonds On January 31, 2011, Homer Company sells Treasury bonds at 98. The sale results in a loss of $360. Proceeds from sale ($18,000 × 98%) $17,640 Less book value (cost) of the bonds 18,000 Loss on sale of bonds $(360)

12. 3 Describe and illustrate the accounting for equity investments. 15-12

13. 3 Less Than 20% Ownership Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method.

14. 3 Purchase of Stock (Cost Method) On May 1, Bart Company purchases 2,000 shares of Lisa Company common stock at $49.90 per share plus a brokerage fee of $200.

15. 3 Receipt of Dividends (Cost Method) On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company. Dividend Revenueis reported as part of Other Income on Bart Company’s income statement.

16. Proceeds from sale [(54.50 × 1,500 shares) – $160 $81,590 Book value (cost) of the stock ($100,000/2,000 shares) × 1,500 75,000 Gain on sale of investments $ 6,590 3 Sale of Stock (Cost Method) On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission.

17. 3 Between 20% and 50% Ownership If the investor purchases between 20% and 50% of the outstanding stock of the investee, the investor is considered to have significant influence over the investee and the investment is accounted for using the equity method.

18. 3 Purchase of Stock (Equity Method) Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2010, for $350,000.

19. 3 Recording Investee Net Income (Equity Method) For the year ending on December 31, 2010, Flanders Corporation reported net income of $105,000. Income of Flanders Corporation, if significant,is reported as Other Income on Simpson Inc.’s income statement.

20. 3 Recording Investee Dividends (Equity Method) During the year, Flanders declared and paid cash dividends of $45,000.

21. 3 Sale of Stock (Equity Method) On January 1, 2011, Simpson Inc. sold Flanders Corporation’s stock for $400,000 a gain of $26,000 calculated as follows: Proceeds from sale $400,000 Book value of stock investment 374,000 Gain on sale $ 26,000

22. 3 More Than 50% Ownership 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 is termed a business consolidation.

23. 4 Describe and illustrate valuing and reporting investments in the financial statements. 15-23

24. 4 Trading Securities Maggie Company purchased a portfolio of trading securities during 2009. On December 31, 2009, the cost and fair values of the securities were as follows:

25. 4 The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows: The Unrealized Gain on Trading Investments, if significant,is reported on the income statement.

26. 4

27. 4 On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as a trading security for $12 per share, including a brokerage commission.

28. 4 On December 31, 2010, the cost and fair valuation of the portfolio of trading securities are as follows:

29. 4 Based on the above analysis, the adjusting entry on December 31, 2010, is as follows:

30. 4 The valuation allowance for trading investments account after the December 31, 2010, adjusting entry has a credit balance of $3,100. Valuation Allowance for Trading Investments 2009 Dec. 31 Adj. 1,300 Dec. 31 Bal. 1,300 2010 Jan. 1 Bal. 1,300 2010 Dec. 31 Adj. 4,400 Dec. 31 Bal. 3,100

31. 4

32. 4 Held-To-Maturity Securities Held-to-maturity securities are debt investments, such as notes or bonds, that a company intends to hold until their maturity date.

33. 4 Available-For-Sale Securities Available-for-sale securities are debt and equity securities that are not classified as trading or held-for-maturity securities.

34. 4 Maggie Company purchased securities during 2009 as available-for-sale securities instead of trading securities. On December 31, 2009, the cost and fair values of the securities are as follows:

35. 4 The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows:

36. 4 On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as an available-for-sale security for $12 per share, including brokerage commission.

37. 4 On December 31, 2010, the cost and fair valuation of the portfolio of available-for-sale securities are as follows:

38. 5 Describe fair value accounting and its implications for the future. 15-38

39. 5 Fair Value Accounting Fair value is the price that would be received for selling an asset or paying off a liability. Fair value assumes that the asset is sold or the liability paid off under normal rather than under distress conditions.

40. 5 Disadvantages of Fair Value Accounting Several potential disadvantages include the following: • Fair value may not be readily obtainable for some assets or liabilities resulting in subjectivity. (continued)

41. 5 • Fair values make it more difficult to compare companies if companies use different methods of determining (measuring) fair values. • Using fair values will result in more fluctuations in accounting reports because fair values normally change from year to year.