Financial Accounting: Tools for Business Decision Making

1. Financial Accounting:Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS Prepared by: Ellen L. Sweatt Georgia Perimeter College

2. Reporting and Analyzing Investments Chapter 12 `

3. Chapter 12Reporting and Analyzing Investments After studying Chapter 12, you should be able to: • Identify the reasons corporations invest in stocks and debt securities. • Explain the accounting for debt investments. • Explain the accounting for stock investments. • Describe the purpose and usefulness of consolidated financial statements. • Indicate how debt and stock investments are valued and reported in the financial statements. • Distinguish between temporary and long-term investments.

4. Page 542 in Book Reasons Companies Invest

5. Excess Cash • Excess cash is often invested to earn, through interest and dividends, a greater return that would be earned from holding funds in the bank. • Companies experiencing seasonal fluctuations in sales often have excess cash at the end of an operating cycle. • Excess cash may result from economic cycles. During periods of economic growth, companies may generate excess cash.

6. Page 541 in Book Temporary Investments and the Operating Cycle

7. Investment Income • Although banks earn most of their earnings by lending money, they also generate earnings by investing in debt and equity securities. • Pension funds and mutual funds invest excess funds for speculative reasons. • Pension funds and mutual funds invest in common stock of other corporations hoping the investment will increase in value and thus result in positive returns.

8. Invest for Strategic Reasons • A company may purchase a noncontrolling interest in another firm in a related industry to establish a presence. • A corporation may purchase a controlling interest in another company in order to enter a new industry without incurring the tremendous cost and risks associated with starting from scratch. • A company may purchase a company in the same industry.

9. Vertical and Horizontal Acquisition • Vertical acquisition would occur if Nike purchased a chain of athletic shoe stores. • Horizontal acquisition would occur if Nike purchased Reebok.

10. Debt Investments • Investments in government and corporation bonds • In accounting for debt investments, entries are required to record: • the acquisition • the interest revenue • the sale

11. Debt Investments • Apply the cost principal • The charge to the investment account includes all cost associated with The acquisition, such as brokerage fees. Jan 1 Debt investments 54,000 Cash 54,000 To record purchase of 50 Doan, Inc., bonds

12. Bond Interest • The bonds pay interest of $3,000 semiannually on July 1 and January 1. • The entry to record the receipt of interest on July 1 is: July 1 Cash 3,000 Interest Revenue 3,000 (To record receipt of interest on Doan, Inc., bonds)

13. Accrued Bond Interest • If the buyer’s (Kuhl) fiscal year ends on December 31, the following adjusting entry is needed to accrue interest of $3,000 earned since July 1:Dec. 31 Interest Receivable 3,000 Interest Revenue 3,000 (To accrue interest on Doan, Inc., bonds)

14. Bond Interest • Interest Receivable is reported as a current asset in the balance sheet. • Interest Revenue is reported under Other Revenues and Gains in the income statement. • When the interest is received on January 1, the entry is: Jan. 1 Cash 3,000 Interest Receivable 3,000 (To record receipt of accrued interest)

15. Sale of Bonds • Assume that Kuhl sells the bonds for $58,000 on January 1, 1999, after receiving the interest due. Remember, the bonds were purchased for $54,000. • Therefore Kuhl must record a gain of $4,000. The entry to record the sale of the bonds is as follows: 1/1 Cash 58,000 Debt Investments 54,000 Gain on sale of Debt Investments 4,000 (To record sale of Doan Inc. bonds)

16. Stock Investments • Investments in the capital stock of corporations • When a company holds stock and/or debt of several different corporations, the group of securities is identified as an investment portfolio. • The accounting for investments in common stock is based on the extent of the investor's influence over the operating and financial affairs of the issuing corporation (the investee).

17. Stock Investments • In some cases, depending on the degree of investor influence, net income of the investee is considered to be income of the investor. • The presumed influence may be negated by extenuating circumstances. • A company that acquires 25% interest in another company in a "hostile" take-over may not have any significant influence over the investee. • Companies are required to use judgment instead of blindly following the guidelines.

18. Stock Investments Factors that should be considered in determining an investor's influence are whether : (1) the investor has representation on the investee's board of directors; (2) the investor participates in the investee's policy-making process; (3) there are material transactions between the investor and the investee; and (4) the common stock held by other stockholders is concentrated or dispersed.

19. Page 545 in Book Accounting Guidelines for Stock Investments

20. Cost Method • Under the cost method, the investment is recorded at cost, and revenue is recognized only when cash dividends are received. • Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

21. Acquisition of Stock • On July 1, 1996, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock at $40 per share plus brokerage fees of $500. • The entry for the purchase is: July 1 Stock Investments 40,500 Cash 40,500 (To record purchase of 1,000 shares of Beal common stock)

22. Recording Dividends • The following entry is required to record a $2.00 per share dividend received by Sanchez Corporation on December 31: Dec. 1 Cash (1,000 x $2) 2,000 Dividend Revenue 2,000 (To record receipt of cash dividend)

23. Sale of Stock When stock is sold, the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the stock is recognized as a gain or a loss.

24. Sale of Stock • Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation stock on February 10, 1997. • Since the stock cost $40,500, a loss of $1,000 has been incurred. • The entry to record the sale is: 1/1 Cash 39,500 Loss on Sale of Stock Investments 1,000 Stock Investments 40,500 (To record sale of Beal common stock)

25. Sale of Stock • A loss would be reported under Other Expenses and Losses in the income statement. • A gain on a sale would be shown under Other Revenues and Gains.

26. Holdings Between 20% and 50% • When an investor company owns only a small portion of the shares of stock of another company (the investee), the investor cannot exercise control over the company. • When an investor owns between 20% and 50% of the common stock of a corporation it is generally presumed the investor has significant influence over the financial and operating activities of the investee.

27. Holdings Between 20% and 50% • At this level of investment, the investor probably has a representative on the investee's board of directors. • With a representative on the board, the investor begins to exercise some control over the investee--and the investee company in some sense really becomes part of the investor company.

28. Equity Method An accounting method in which the investment in common stock is initially recorded at cost, and the investment account is then adjusted annually to show the investor’s equity in the investee

29. Equity Method Failure to recognize the investors share of net income until a cash dividend is declared ignores the fact that the investor and investee are, in some sense, one company.

30. Acquisition of Stock • Assume Milar Corporation acquires 30% of the common stock of Beck Company of $120,000 on January 1, 1998. • The entry to record this transaction is: Jan. 1 Stock Investments 120,000 Cash 120,000 (To record purchase of Beck common stock)

31. Revenue and Dividends • For 1998 Beck reports net income of $100,000 and declares and pays a $40,000 cash dividend. • Milar is required to record (1) its share of Beck's income, $30,000 (100,000 x 30%), and (2) the reduction in the investment account for the dividends received, $12,000 ($40,000 x 30%).

32. Revenue and Dividends 12/31 Stock Investments 30,000 Revenue from Investment in Beck Company 30,000 (To record 30% equity in Beck's 1998 net income) 12/31 Cash 12,000 Stock Investments 12,000 (To record dividends received) During the year the investment account has increased by $18,000 ($30,000 - $12,000).

33. Holdings of More than 50% • A company that owns more than 50% of the common stock of another entity is known as the parent company. • The entity whose stock is owned by the parent company is called the subsidiary (affiliated) company.

34. Consolidated Financial Statements • When a company owns more than 50% of the common stock of another company, consolidated financial statements are usually prepared. • Consolidated financial statements present the assets and liabilities controlled by the parent company and the aggregate profitability of the subsidiary companies.

35. Consolidated Financial Statements • Prepared in addition to the financial statements for each of the individual parent and subsidiary companies • Especially useful to the stockholders, board of directors, and management of the parent company • Inform creditors, prospective investors, and regulatory agencies as to the magnitude and scope of operations of the companies under common control

36. Valuation and Reporting of Investments • Many argue that fair value - the amount for which a security could be sold in a normal market - offers the best approach because it represents the expected cash realizable value of securities. • Others contend that unless a security is going to be sold soon, the fair value is not relevant because the price of the security will likely change again.

37. Valuation and Reporting of Investments Debt and stock investments are classified into the following three categories: • Trading securities • Available-for-sale securities • Held-to-maturity securities

38. Trading Securities • Securities bought and held primarily for sale in the near term to generate income on short-term price differences • Reported at fair value referred to as mark-to-market accounting • Changes from cost are reported in net income.

39. Available-for-Sale Securities • Securities that may be sold in the future • Reported at fair value referred to as mark-to-market accounting • Changes from cost are reported in the stock-holders’ equity section.

40. Held-to-Maturity Securities • Debt securities that the investor has the intent and the ability to hold to maturity • More will be covered in advanced courses

41. Investment Portfolio • Under the accounting standards for reporting investments in debt securities and equity investments of less than 20% that were introduced in 1993, companies can choose which of the three categories of securities to use for an investment. • Unfortunately, under these new standards, companies can "window-dress" their reported earnings results - that is, make net income look better than it really was.

42. Investment Portfolio • Gains and losses on investments classified as available-for-sale are not included in income, but rather are recorded an adjustment to equity. • A company wanting to manage its reported income can sell those available-for-sale investments that have unrealized losses and not sell those available-for-sale investments that have unrealized losses, deferring the losses until a later period.

43. Temporary and Long-Term Investments For balance sheet presentation, investments must be classified as either temporary or long-term.

44. Temporary Investments • Temporary investments are securities held by a company that are: • readily marketable and • intended to be converted into cash within the next year or operating cycle, whichever is longer. • Readily Marketable - an investment is readily marketable when it can be sold easily whenever the need for cash arises.

45. Temporary Investments • Because of their high liquidity, temporary investments are listed immediately below Cash in the current asset section of the balance sheet. • Temporary investments are shown at their fair value.

46. Long-Term Investments • Long-term investments are generally reported in a separate section of the balance sheet immediately below Current Assets. • Long-term investments in available-for-sale securities are reported at fair value and investments in common stock accounted for under the equity method are reported at equity.

47. Gains and Losses on Investments • Gains and losses on investments, whether realized or unrealized, must be presented in the financial statements. • In the income statement, gains and losses, as well as interest and dividend revenue, are reported in the nonoperating section under the following categories: • Other Revenue and GainsOther Expenses and Losses Interest Revenue Loss on Sales of Investments Dividend Revenue Unrealized Loss--Income Gain on Sale of Investments Unrealized Gain--Income

48. Gains and Losses on Investments • In an earlier section, it was noted that an unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders' equity. • Assuming Dawson Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000.

49. Page 555 in Book Gains and Losses on Investments DAWSON INC. Partial Balance Sheet Stockholders' equity Common stock $ 3,000,000 Retained earnings 1,500,000 Total paid-in capital 4,500,000 and retained earnings Less: Unrealized loss on (100,000) available-for-sale securities Total stockholders' equity $ 4,400,000

50. Gains and Losses on Investments • Note that the presentation of the loss is similar to the presentation of the cost of treasury stock in the stockholders' equity section. • Reporting the unrealized gain or loss in the stockholders' equity section serves two important purposes: • It reduces the volatility of net income due to fluctuations in fair value, and • It informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value.