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Chapter 12

Chapter 12. Investments. Objectives of The Chapter. To learn the accounting for investments in stock (with ownership less than 20%) and bonds.

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Chapter 12

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  1. Chapter 12 Investments

  2. Objectives of The Chapter • To learn the accounting for investments in stock (with ownership less than 20%) and bonds. • To learn the accounting for investments in stock with significant influence on investee’s operating and dividend policy (i.e., ownership is between 20% ~ 50%). • To learn the accounting for consolidated financial statements (i.e., ownership is more than 50%).

  3. Types of Investments Equity Investments: invest in corporate Stock (i.e., common stock, preferred stock, and stock options). Debt Investments: invest in U.S. treasury bills, municipal securities, corporate bonds, commercial papers. Investment in equity or debt securities provides an opportunity to park cash in a financial instrument with an earning power

  4. Reasons of Investments • Invest excess cash for short period of time (i.e., invest in highly liquid securities such as treasury bills). • Invest cash in securities to generate earnings (i.e., banks invest in debt securities; mutual funds invest in equity securities). • Invest in equity securities of a supplier or a customer to gain influence.

  5. Acquisition of Bonds • Initial Recording: at cost. • Interest revenue and realized gains (or losses) from sales of investments are reported in the income statement. • Example: CGS Corp. Acquires 80 Creative Corp. 6%, 5-year, $1,000 bonds on 12/1/20x7 for the face value plus the brokerage fees of $1,000. Interests are paid semiannually. The related entries for this transaction are:

  6. Acquisition of Bonds (contd.) • 12/1/x7 Investment in bonds 81,000 • Cash 81,000 • Purchase of 80 Creative bonds • 12/31/07 Interest Receivable 400 • Interest Revenue 400 • Record the one-month accrued interest • $80,000x 6% x 1/12 Short-Term Investments & Receivables

  7. Acquisition of Bonds (contd.) • 6/1/x8 CGS collects the 6-month interest: • Cash 2,400 • Interest Receivable 400 • Interest Revenue 2,000 Short-Term Investments & Receivables

  8. Sale of Bonds • CGS sells the investment in Creative bonds on 6/1/20x8 after receiving the interest due for net proceeds of $90,000 (i.e., sales price minus the brokerage fees). The entry to record this transaction is: • Cash 90,000 • Investment in bonds 81,000 • Gain on sale of investment in bonds 9,000 L-T Investments and International Operations

  9. Acquisition of Stock (Holdings of Less than 20%) • Valuation: • Initial Recording: at cost. • Dividends and realized gains (or losses) from sales of investments are reported in the income statement. L-T Investments and International Operations

  10. Acquisition of Stock (Holdings of Less than 20%) – An Example • On11/18/08, EDS acquires 2,000 shares (5% ownership) of Freddy Corp. common stock for $30 per share plus brokerage fees of $1,000. • Freddy pays cash dividend $1 per share on 12/2/08. At year end, the market value of Ford stock is $65,000. • On 12/27/08, EDS sells Freddy stock for $35 per shares and pays brokerage fees of $1,000.

  11. Acquisition of Stock- An Example (contd.) • 11/18/08 Investments in stock 61,000 • Cash 61,000 • 12/2/08 Cash 2,000 • Dividend revenue 2,000 • 12/27/08 Cash 69,000* • Investment in stock 61,000 • Gain on sale of inv. In stock 8,000 • *$35x 2,000-$1,000 L-T Investments and International Operations

  12. Categories of Securities and End of Period Reporting for Investments Investments in stock (holdings less than 20%) and bonds can be classified into the following three categories: • 1. Trading securities: held for sale in the near future (debt or equity securities). • 2. Available-for-sale securities: held for sale sometime in the future (debt or equity securities. • 3. Held-to-maturity securities: debt securities that the investor has the intent and ability to hold to maturity.

  13. Reporting of Investments in Securities • Reporting of Trading Securities (TS): • (1) At purchase: Cost. • (2) End of Period: Market value. • the unrealized gains/ losses reported in the income statement. L-T Investments and International Operations

  14. Reporting of Investments (contd.) • Reporting of available-for-sale securities (ASS): • (1) At purchase: Cost. • (2) End of period: Market value. • The unrealized gains/ losses reported in the balance sheet statement as a separate component of stockholders’ equity. L-T Investments and International Operations

  15. Reporting of Investments (contd.) • Reporting of Held-to-maturity securities (HTM): • (1) At purchase: Cost. • (2) End of Period: Amortized cost. L-T Investments and International Operations

  16. Example A: Assume that Camp Corp. acquired the following securities on 1/1/x9 • Shares$ per share • A. Company’s common stock 100 $50 • B. Company’s common stock 300 $80 • C. Company’s preferred stock 200 $120 • D. Company’s 10% bonds with a face value of $15,000 at par. • Interests are paid on 6/30 and 12/31. • These securities are reported as trading securities by Camp Corp.

  17. Example A (contd.) • 1/1/x9 Initial recording • Investment in stock -Trading 68,000 * • Cash 68,000 • * Cost = 100 x 50 + 300 x 80 + 200 x 120 + 15,000 = 68,000 • 6/30/x9 • Cash 750 • Interest Revenue 750 • 12/31/x9 • Cash 750 • Interest Revenue 750 • Assuming Kent received $1,000 of dividends in 20x9: • Cash 1,000 • Dividends Revenue 1,000 L-T Investments and International Operations

  18. Example A (contd.) • At the end of 20x9, the market value for these securities is $71,000. The following entry is needed to adjust the value of investment in trading securities: 12/31/x9 Fair Value Adjustment – Trading Sec. 3,000 Unrealized Gain* on Investment -Income 3,000 To record unrealized gain on trading securities *reported in the income statement of 20x9

  19. Assets Investments - Trading Securities (at market value) $71,000 Liabilities . . . . Stockholders’ Equity Balance Sheet PresentationBalance Sheet 12/31/x9 L-T Investments and International Operations

  20. Example B: Assume that Camp Corp. acquired the following securities on 1/1/x9 • Shares$ per share • A. Company’s common stock 100 $50 • B. Company’s common stock 300 $80 • C. Company’s preferred stock 200 $120 • D. Company’s 10% bonds with a face value of $15,000 at par. • Interests are paid on 6/30 and 12/31. • These securities are reported as available-for-sale securitiesby Camp Corp.

  21. Example B (contd.) 1/1/x9 Initial recording Investment in stock –Available-for-Sale 68,000 Cash 68,000 6/30/x9 Cash 750 Interest Revenue 750 12/31/x9 Cash 750 Interest Revenue 750 Assuming Kent received $1,000 of dividends in 20x9: Cash 1,000 Dividends Revenue 1,000 L-T Investments and International Operations

  22. Example B (contd.) • At the end of 20x9, the market value for these securities is $71,000. The following entry is needed to adjust the value of available-for-sale securities market: 12/31/x9 Fair Value Adjustment – Avail.-for-Sale 3,000 Unrealized Gain* on Investment –Equity 3,000 To record unrealized gain on avail.-for-sale securities *reported in the balance sheet of 20x9

  23. Assets Investments - Available-for-Sale $71,000 Liabilities . . . . Stockholders’ Equity Unrealized gain on investments 3,000 Balance Sheet PresentationBalance Sheet 12/31/x9 L-T Investments and International Operations

  24. Income Statement (skip)for the period ended 12/31/x9 • Revenues $XXX • Expenses (including income tax) (XXX) • Net Income $XXX • Other Comprehensive Income: • Unrealized Gain on • Investment 3,000 • Less income tax (40%) (1,200)$1,800 • Comprehensive Income ........….. $XXX L-T Investments and International Operations

  25. Presentation of Realized and Unrealized Gain and Loss • The revenue and gains/losses related to the investments are presented in the income statement as follows (source: Financial Accounting by Weygandt, Kimmel and Kieso)

  26. Presentation – contd. • The unrealized gain/loss – equity(from the valuation of available-for-sale securities) is presented in the stockholders’ equity section of the balance sheet, NOT the income statement. • See Illustration 13-12 of WKK textbook for an example of balance sheet presentation on investments and the unrealized gain/loss on available-for-sale securities. L-T Investments and International Operations

  27. Investments in Debt Securities Held to Maturity • The GAAP for Investment in Debt securities held to maturity (FASB 115): • (a) Initial recording at cost. • (i.e., the present value of the investment in debt security). • (b) End of period reporting at amortized cost. • (c) Unrealized holding gains (or losses): not recognized. • (d) Interests and realized gains (Losses) from sale (if any) are included in income. L-T Investments and International Operations

  28. Example C : Held-to-Maturity • Assume that Emey Corp. purchases $100,000 of GNC 9% bonds on 7/1/20x1 at 99. Interests on the bond are paid on 7/1 and 12/31. Emey Corp intends to hold the bonds till their maturity date on 7/1/20x6. • 7/1/x1 (Initial recording at cost) = 99,000 • (Face amount - Discount) = 100,000 - 1000 • Investments in Bonds 100,000 • Cash 99,000 • Discount on Investment in Bonds 1,000 L-T Investments and International Operations

  29. Example E (contd.) • The discount ($1,000) will be amortized to increase the interest revenue using the effective interest method, unless the use of straight-line method does not result in a material difference on the amount of interest revenue recognized each year. L-T Investments and International Operations

  30. Example E (contd.) • The followings are subsequent entries for this investment (assuming the amortization method is straight-line method): • 12/31/x1 • Cash 4,500 • Interest Revenue 4,500 • To recognize interest revenue for 6 months. • Discount on Investment in Bonds 100 • Interest Revenue 100 • To amortize discount on bond investment for 6 months. L-T Investments and International Operations

  31. Example E (contd.) • 7/1/x2 • Cash 4,500 • Int. Revenue 4,500 • To receive semiannual interest. • Discount on Investment in Bonds 100 • Interest Revenue 100 • To amortize discount for six months. • . L-T Investments and International Operations

  32. Acquisition of Stock (Holding of 20% to 50%) • GAAP requires the use of equity method by an investor who is able to exercise significant influence over the operating and financial policies of an investee. • In the absence to the contrary, an investment of 20% to 50% in the outstanding common stock of the investee leads to the presumption of significant influence. • The investee companies are referred to as affiliates. L-T Investments and International Operations

  33. Equity Method • In some cases, the investors hold more than 20% of the outstanding common stock of an investee and do not have significant influence. The equity method should not be used to account for the investment in those cases. L-T Investments and International Operations

  34. Equity Method • A survey of 600 companies conducted by Accounting Trends & Techniques indicated 252 (42%) of the corporations surveyed used the equity method to account for their investments. L-T Investments and International Operations

  35. The Accounting Procedures of the Equity Method • The investment is recorded at cost of the shares acquired. • The investment is subsequently adjusted each period for the changes in the equity of the investee. L-T Investments and International Operations

  36. The Accounting Procedures of the Equity Method • For example, the investment account will be increased (decreased) by the investors’ proportionate shares of investees’ earnings (losses) and decreased by the dividends received.* • * This is due to investee’s net income will increase investee’s equity while dividends will decrease investee’s equity. L-T Investments and International Operations

  37. The Accounting Procedures of the Equity Method (contd.) • Therefore, the investor’s investment account = Acquisition Cost + Investor’s Share of Investee’s Income - Dividends Received L-T Investments and International Operations

  38. Equity Method: An Example • On 1/1/x9, Clibron Company purchases 4,200 shares of common stock of the Sam Corporation which has 16,800 shares of common stock outstanding on 1/1/x9. Thus, Cliborn has 25% of the ownership and significant influence is presumed to exist. The acquisition cost for the 4,200 shares is $125,000 (including $2,000 brokerage fees). • Also, Sam Corp. paid $20,000 dividends on 8/28/x9, and reported net income of 81,000 for 20x9. These events are recorded on Cliborn Company’s book as follows: L-T Investments and International Operations

  39. Equity Method Example (contd.) • To record the investment on 1/1/x9: Investment in stock 125,000 Cash 125,000 2. To record the receipt of dividends on 3/28/x9: Cash (20,000 x 25%) 5,000 Investment in stock 5,000 L-T Investments and International Operations

  40. Equity Method Example (contd.) • 3. To record Cliborn Company’s 25% share in the year’s net income: • 12/31/x9 • Investment in stock • ($81,000 x 25%) 20,250 • Investment Revenue 20,250 L-T Investments and International Operations

  41. Presentation on the B/S and I/S: • Balance Sheet • 12/31/x9 • Assets • Investment in Sam’s stock, at equity 140,250 • Income Statement • for the year ended 12/31/x9 • Other Revenue: • Investment Revenue 20,250 L-T Investments and International Operations

  42. Gain or Loss on Sales of an Equity-Method Investment (Skip p22, p23) • Gain or loss on sales of an equity-method investment is measured as the difference between the sale proceeds and the carrying amount of the investment. L-T Investments and International Operations

  43. Sale of Equity Investment: An Example (skip) • On 1/3/10, Clibor Sells 20% of its holding of Sam Corp. for net proceeds of $30,000. • Cash 30,000 • Investment in stock 28,050 * • Gain on Sale of Investment 1,950 • * 140,250 x 20% = 28,050 L-T Investments and International Operations

  44. Joint Venture • A joint venture is a separate entity or business project owned by a small group of investors. • A Joint venturer usually accounts for its investments using the equity method even if their shares are less than 20%. • This is because a joint venturer usually has significant influence on the investee company. L-T Investments and International Operations

  45. Accounting for Consolidated Subsidiaries • When a parent company purchased more than 50% of the outstanding common stock of subsidiary corporations, consolidated financial statements (F/S) should be prepared. • The consolidated F/S will combine the F/S of the parent company with those of majority-owned subsidiaries as if the parent and its subsidiaries were a single entity. L-T Investments and International Operations

  46. Income of A Consolidated Entity • The income of a consolidated entity is the net income of the parent plus the parent’s share (proportion) of the subsidiary’s net income. L-T Investments and International Operations

  47. Accounting for Consolidated Subsidiaries (contd.) • A work sheet is used to facilitate the combining of the financial statements of the parent company and the subsidiaries. • A. Parent corporation owns all of subsidiary’s stock. • B. Parent company owns less than 100% of subsidiary’s stock. L-T Investments and International Operations

  48. A. Parent Corporation Owns All of Subsidiary’s Stock • Some accounts are eliminated: • a. the parent company’s investment in subsidiary account and the subsidiary’s equity accounts because these two accounts represent the same thing – subsidiary’s equity which is also represented by assets and liabilities of the subsidiary in the combined financial statements). L-T Investments and International Operations

  49. Parent Corporation Owns All of Subsidiary’s Stock (contd.) • b. The reciprocal of note receivable/payable accounts of the parent and subsidiary. • For an example of the consolidated balance sheet, see illustration 13-A2 on p616 of the textbook L-T Investments and International Operations

  50. B. Parent Company Owns Less Than 100% of Subsidiary’s Stock • A minority interest account (on the credit side as a liability) is used to account for the subsidiary’s equity which is held by stockholders other than the parent company. L-T Investments and International Operations

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