Financial Accounting: Tools for Business Decision Making, 2nd Ed.

Financial Accounting:Tools for Business Decision Making, 2nd Ed. ELS Kimmel, Weygandt, Kieso Prepared by: Ellen L. Sweatt Georgia Perimeter College

Reporting and Analyzing Investments Appendix D `

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.

Chapter 12Reporting and Analyzing Investments After studying chapter 12, you should be able to: • Indicate how debt and stock investments are valued and reported in the financial statements. • Distinguish between short-term and long-term investments.

Illustration 12-1 Temporary Investments and the Operating Cycle

Illustration 12-2 Reasons Companies Invest...

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.

Debt Investments... • Are investments in government and corporation bonds. • In accounting for debt investments, entries are required to record: • the acquisition • the interest revenue • the sale • Are recorded at cost including brokerage fees.

Debt Investments Kuhl Corporation acquires 50 Doan, Inc. 12%, 10-year, $1,000 on Jan. 1 for $54,000. Jan 1 Debt investments 54,000 Cash 54,000To record purchase of 50 Doan, Inc. bonds

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)

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)

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)

Sale of Bonds • Kuhl sells the bonds for $58,000 on January 1, 2002, after receiving the interest due. *The bonds were purchased for $54,000. • 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)

Stock Investments... • Are 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 investmentportfolio. • 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).

Stock Investments Factors to consider 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. (4) the common stock held by other stockholders is concentrated or dispersed.

Illustration 12-3 Accounting Guidelines - Stock Investments

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.

Acquisition of Stock On July 1, 2001, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock at $40 per share plus brokerage fees of $500. July 1 Stock Investments 40,500Cash 40,500 (To record purchase of 1,000 shares of Beal common stock)

Recording Dividends A $2.00 per share dividend is received by Sanchez Corporation on December 31: Dec. 31 Cash (1,000 x $2) 2,000 Dividend Revenue 2,000 (To record receipt of cash dividend)

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.

Sale of Stock • Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation stock on February 10, 2002. • Since the stock cost $40,500, a loss of $1,000 has been incurred. 1/1 Cash 39,500 Loss on Sale of Stock Investments 1,000 Stock Investments 40,500 (To record sale of Beal common stock)

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.

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

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.

Acquisition of Stock • Milar Corporation acquires 30% of the common stock of Beck Company of $120,000 on January 1,2001. Jan. 1 Stock Investments 120,000 Cash 120,000 (To record purchase of Beck common stock)

Revenue and Dividends • For 2001 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%).

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).

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.

Consolidated Financial Statements... • Are usually prepared when a company owns more than 50% of the common stock of another. • Present the assets and liabilities controlled by the parent company and the aggregate profitability of the subsidiary companies. • Are prepared in addition to the financial statements for each of the individual parent and subsidiary companies. • Are 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.

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.

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

Illustration 12-5 Trading Securities... • Are securities bought and held primarily for sale in the near term to generate income on short-term price differences. • Are reported at fair value referred to as mark-to-market accounting. • Changes from cost are reported in net income.

Illustration 12-5 Available-for-Sale Securities... • Are securities that may be sold in the future. • Are reported at fair value. • Changes from cost are reported in the stockholders’ equity section.

Illustration 12-5 Held-to-Maturity Securities... • Are debt securities that the investor has the intent and the ability to hold to maturity. • More will be covered in advanced courses.

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.

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.

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

Temporary Investments • Short-term investments are securities held by a company that are: • readily marketable - (can be sold easily whenever the need for cash arises) and • intended to be converted into cash within the next year or operating cycle, whichever is longer.

Temporary Investments • Because of their high liquidity, short-term investments (at fair value) are listed immediately below Cash in the current asset section of the balance sheet.

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 report at equity.

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: Illustration 12-9 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

Gains and Losses on Investments • Earlier, it was noted that an unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders' equity. • 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.

Illustration 12-10 Gains and Losses on Investments DAWSON INC. Balance Sheet (partial) 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

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.

Financial Accounting: Tools for Business Decision Making, 2nd Ed.