Investments and fair value accounting

1. Investments and fair value accounting

2. Why Companies Invest Cash from the operations of the company is used for: • Investing in current operations • Investing in temporary investments • Investing in long-term investments

3. Investing Cash in Current Operations Companies uses cash in order to continue and/or expand its current operations. Cash is also used to pay its expenses, interest to its creditors, dividends and suppliers of merchandise.

4. Investing in Temporary Investments Most companies invest their excess cash from operations in temporary investments such as: • Debt securities, which are notes and bonds that promises to pay interest until its maturity date. • Equity securities, which are preferred and common stock that represent ownership in a company The reason of investing in temporary investments is to: • Earn interest revenue • Receive dividends • Realize gains from increases in the market price of securities

5. Investing in Long-Term Investments Companies may invest in the debt or equity of another company as a long-term investment and can be held for the same reason as temporary investments. However, long-term investments involves a large portion of the stock of another company and have strategic purposes such as: • Reduction of costs: When one company buys another to reduce administrative expenses. • Replacement of management: The acquiring company tends to improve the operations of a mismanaged company. • Expansion: The acquiring company wanted to expand and serve customers better. • Integration: A company may integrate operations by acquiring a supplier or customer. Acquiring a supplier may provide a more stable supply and acquiring a customer may provide a market for the company’s products or services.

6. Debt Investments Purchase of bonds is recorded by debiting an investments account for the purchase price. If the bond is bought between interest dates, the purchase price includes the accrued interest because the seller earned the accrued interest, but the buyer will receive it. Interest revenue is the earnings that the company receives from investments. Sale of a bond investment result to a gain or loss. If the earnings from the sale exceeds the book value of the bond then a gain is recorded and vice-versa.

7. Equity Investments Less than 20% ownership is accounted for using the cost method. Purchase of stock is recorded at its cost. Any brokerage commissions are included as part of the cost. Receipt of dividends is reported as part of other income on the income statement. Sale of a stock investment result to a gain or loss. If the earnings from the sale exceeds the book value of the stock then a gain is recorded and vice-versa.

8. Between 20% to 50% ownership are accounted for using the equity method. The stock is recorded initially at its cost, including any brokerage commission. The investment account is adjusted for the investor’s share of the net income and dividends of the investee. Net Income: The investor records its share of the net income of the investee as an increase in the investment account and vice versa. Dividends: The investor’s share of cash dividends received from the investee decreases the investment account.

9. More than 50% ownership is termed as business combination. Companies may combine to perform more efficiently, expand or acquire know-how. The company owning all or a majority of the stocks is called the parent company and the corporation that is controlled is called the subsidiary company. The parent and subsidiary corporations continue to maintain separate accounting records and financial statements. At the end of the period, the financial statements are combined and reported as a single entity. These are called consolidated financial statements.

10. Trading Securities Trading securities are purchased and sold to earn short-term profits from the changes in their market prices. These are reported as a current asset because it is held as a short-term investment. These are valued using the securities’ fair values. Fair value is the market price that the company will earn if a security is sold. The changes in fair value are recognized as an unrealized gain or loss.

11. Available-for-Sale Securities Available-for-sale securities are neither held for trading, held to maturity or held for strategic reasons. It is recorded similar to the trading securities except for the changes in fair values. The changes in fair values are reported as part of the equity and is excluded from the income statement.

12. Held-to-Maturity Held-to-maturity securities, such as notes or bonds, are held by companies until the maturity date to earn interest revenue. Only securities with maturity dates are classified as held-to-maturity securities, if it matures within a year, it is reported as a current asset. If it is maturing beyond a year then it is reported as a noncurrent asset. Held-to-maturity securities are recorded at their cost. If the interest rate of the bond differs from the interest rate in the market, the bonds may be purchased at a premium or discount.