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Chapter 12

Investments Judith Paquette. Chapter 12. Financial Accounting, Seventh Edition. Discuss why corporations invest in debt and stock securities. Explain the accounting for debt investments. Explain the accounting for stock investments.

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Chapter 12

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  1. Investments Judith Paquette Chapter12 Financial Accounting, Seventh Edition

  2. Discuss why corporations invest in debt and stock securities. Explain the accounting for debt investments. Explain the accounting for stock investments. Indicate how debt and stock investments are reported in financial statements—valuing investments Distinguish between short-term and long-term investments. Study Objectives Note: Learning objective #4 is not included.

  3. Why Corporations Invest Corporations generally invest in debt or stock securities for one of three reasons. • Corporation may have excess cash. • To generate earnings from investment income. • For strategic reasons. Illustration 12-1 Temporary investments and the operating cycle

  4. They have Excess Cash $$$$$$$$$$ • If you have excess cash, it should be working for you! (working = earning interest $$$$$$$$) • But, it needs to be readily available when you need it (a “rainy day” fund) • Hence: invest in low risk funds that can be liquidated quickly

  5. They want to generate earnings from investment income Maybe liquidity isn’t an issue….they want to benefit from dividends and stockappreciation. So they invest in mutual funds and stocks.

  6. For Strategic Reasons—buying a related company Buying a large amount of stock in a company gives the company a certain amount of stock votes…even without a controlling interest, it gives the company an influence. Which company? -a related industry – e.g., Taco Bell buys stock in Chipotle, its competitor… WHY invest in your competitor?

  7. For Strategic Reasons –to influence Which company? -a related industry – e.g., Taco Bell buys stock in Chipotle, its competitor… WHY invest in your competitor? To expand its influence in its own industry.

  8. For Strategic Reasons—buying an unrelated company It still gives you some influence, but also something else. An Unrelatedindustry– e.g., Taco Bell buys stock in….Pfizer (pharmaceutical)…tacos and drugs….hmmmm….WHY would they do that?

  9. For Strategic Reasons- to DIVERSIFY An Unrelated industry– e.g., Taco Bell buys stock in…Pfizer (pharmaceutical)…tacos and drugs…. ….WHY would they do that? Diversifying its investment in different industries allows the company to (possibly) face less market risk by not putting all its investment in the same industry… If fast food sales go down, drug sales may not be affected as much.

  10. INVESTING IN ANOTHER COMPANY You have TWO choices: DEBT – LOAN $$ TO A COMPANY - BUY BONDS EQUITY – BECOME AN OWNER - BUY STOCK How do you make money with your investments?

  11. INVESTING – earning money • You have TWO choices: • DEBT – Interest Revenue (new account) • EQUITY 2 ways: • Dividends paid • Stock Appreciation (buy at a lower price, sell at a higher price) How does a company report its investments?

  12. INVESTING – Reporting INVESTMENTS are ASSETS (could be long term on short term) with a NORMAL BALANCE of DEBIT. You must clearly understand the difference between: • The Company’sownstock or bonds sold = • Common Stock, Equity, normal balance = credit or • Bonds Payable, LT Liabilties, normal balance = credit AND TheCompany’s investment in another company’s stock or debt purchased = Investments, Assets, normal balance = debit

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

  14. Accounting for Debt Investments – Acquisition Recording Acquisition of Bonds Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any. Note: Bonds are recorded at acquisition cost, NOT face value. SO 2 Explain the accounting for debt investments.

  15. Accounting for Debt Investments– Bond Interest Recording Bond Interest Calculate and record interest revenue based upon the FACE value of the bond times the interest rate times the portion of the year the bond is outstanding. Face Value: $1,000 for each bond Contract Interest Rate: 7% (for example) Annual interest revenue = 1,000 * .07 = $70

  16. Accounting for Debt Investments Sale of Bonds Credit the investment account for the cost of the bonds and record as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds. Note: if you only sell some of the bonds, you need to prorate the cost. If you go back to the chapter on Long Term Assets, this is the same as how we retire an asset…

  17. Accounting for Debt Instruments – example - Acquisition Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:

  18. Accounting for Debt Instruments – example - Acquisition Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is: Debt Investments 54,000 Jan. 1 Cash 54,000 An asset account, normal balance = debit Question: What type of account is Debt Investments? Hint: watch the wording, if it said “plus a brokerage fee of $1,000” the entry would be for $55,000.

  19. Accounting for Debt Instruments - interest Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is: *

  20. Accounting for Debt Instruments - interest Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is: July 1 Cash 2,000 * Interest revenue 2,000 Question: What type of account is Interest Revenue? A revenue account, normal balance = credit *($50,000 x 8% x ½ = $2,000)

  21. Accounting for Debt Instruments-year end interest accrual and payment Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1. Kuhl reports receipt of the interest on January 1 as follows.

  22. Accounting for Debt Instruments-year end interest accrual and payment Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1. Dec. 31 Interest receivable 2,000 Interest revenue 2,000 Kuhl reports receipt of the interest on January 1 as follows. Jan. 1 Cash 2,000 Interest receivable 2,000

  23. Accounting for Debt Instruments – sale of investment Illustration: Assume that Kuhl corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2011, after receiving the interest due. Prepare the entry to record the sale of the bonds. Cash 58,000 Jan. 1 Debt investments 54,000 Gain on sale of investments 4,000

  24. Accounting for Debt Instruments – practice • Let’s Practice: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees). Record: • Jan 1 - The acquisition • Jul 1 - The first semiannual interest revenue • Dec 31 The accrual of the second interest revenue. • Record these transactions for 2011

  25. Accounting for Debt Instruments – practice - continued • Let’s Practice: Assume that Jubilee Farms has only these bonds and three years have passed. It is now 2014 • Jan 1 – Received the semiannual interest • Jan 1 – Sold $70,000 of Whole Food bonds at 112. The broker charged $1,500 in fees. • Jul 1 - Received semiannual interest revenue • Dec 31 The accrued semiannual interest revenue. • Record these transactions for 2014 See End of Power Points for Solution

  26. Accounting for Stock Investments

  27. Accounting for Stock Investments For this class, you are ONLY responsible for learning about holdings of Less than 20% When do you get to learn about: Holdings between 20-50%? Holdings of OVER 50%? In greater detail: --Intermediate Accounting --Advanced Accounting --or….you can read about it in the textbook as a more general topic…

  28. Accounting for Stock Investments Holdings of Less than 20% Companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received. --This is similar to debt investments Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions).

  29. Investments in a corporation’s common stock. In accounting for common stock investments, the required entries to record: the acquisition the dividend revenue the sale Accounting for Stock Investments

  30. Holdings of Less than 20% - acquisition Illustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is:

  31. Holdings of Less than 20% - acquisition Illustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is: July 1 Stock investments 40,500 Cash 40,500

  32. Holdings of Less than 20% - dividends earned Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is: SO 3 Explain the accounting for stock investments.

  33. Holdings of Less than 20% - dividends earned Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is: Dec. 31 Cash 2,000 Dividend revenue 2,000

  34. Holdings of Less than 20% - sale of stock Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:

  35. Holdings of Less than 20% - sale of stock Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is: Feb. 10 Cash 39,500 Loss on sale of stock 1,000 Stock investments 40,500

  36. Accounting for Stock Instruments – practice - continued Let’s Practice: Frank’s Produce Conglomerate Company had the following transactions pertaining to stock investments. Feb. 1 - Purchased 500 shares of Jordan Company common stock (2% ownership position) for $5,000 cash, plus brokerage fees of $250. July 1 - Received cash dividends of $1 per share on Jordan common stock. Sept. 1 - Sold 250 shares of Jordan common stock for $3,000, less brokerage fees of $75. Dec. 1 - Received cash dividends of $1 per share on Jordan common stock. Record these transactions See End of Power Points for Solution

  37. Valuing and Reporting Investments Categories of Securities • Companies classify debt and stock investments into three categories: • Trading securities • Available-for-sale securities • Held-to-maturity securities These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%.

  38. Valuing and Reporting Investments Trading Securities • Companies hold trading securities with the intention of selling them in a short period. • Trading means frequent buying and selling, e.g., “day trading.” • Companies report trading securities at fair value, and report changes from cost as part of net income. This is called “mark to market” because it adjusts the value of the trading security to the market price.

  39. TRADING SECURITIES – ALERT! Trading Securities • Because they are valued at FAIR VALUE…. • This is a departure from the Cost Principle (see Chapter 1 where assets are recorded at their historic cost) • The change in trading securities’ “fair value” affects net income,even though they haven’t been sold! • This is called an “unrealized gain or loss”, but it still affects net income.

  40. Valuing and Reporting Investments Available-for-Sale Securities • Companies hold available-for-sale securities with the intent of selling these investments sometime in the future. • These securities can be classified as current assets or as long-term assets, depending on the intent of management. • Companies report securities at fair value, and report changes from cost as a component of the stockholders’ equity section—does NOT impact net income

  41. Trading Securities - example Illustration: Pace Company invests in two stocks classified as trading securities. On December 31, 2011 (when its fiscal year ends, it classified these securities at their current fair value:. The adjusting entry for Pace Corporation is: Dec. 31 Market adjustment—trading 7,000 Unrealized gain—income 7,000

  42. Available-for-Sale Securities Problem:How would the entries change if the securities were classified as available-for-sale? The entries would be the same except that the • Unrealized Gain or Loss—Equity account is used instead of Unrealized Gain or Loss—Income. • The unrealized loss would be deducted from the stockholders’ equity section rather than charged to the income statement.

  43. Available-for-Sale Securities - Example Illustration: Assume that Ingrao Corporation has two securities that it classifies as available-for-sale. Illustration 12-8 The adjusting entry for Ingrao Corporation is: Unrealized gain or loss—equity 9,537 Dec. 31 Market adjustment—available-for-sale 9,537

  44. Too many accounts? Remember: If it is a GAIN, it will be a credit balance (like revenue) If it is a LOSS, it will be a debit balance (like expense) If it is a GAIN or LOSS account, its balance will vary (debit for Loss, credit for Gain.

  45. Accounting for Debt Instruments – JUBILEE FARMS - continued Remember the earlier practice problem: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees). Now, let’s add the Year-end adjustment.

  46. Accounting for Debt Instruments – practice - continued Let’s Practice: On December 31, 2011: Assume that the FAIR VALUE of the bonds on Dec 31, 2011 WAS $192,000. These bonds are categorized as “available-for-sale securities. Prepare the adjusting journal entry for 2011. See End of Power Points for Solution

  47. Valuing and Reporting Investments Balance Sheet Presentation Short-Term Investments Also called marketable securities, 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. Long-Term Investments Investments that do not meet both criteria are classified as long-term investments.

  48. Income Statement Presentation – Gains/Losses Presentation of Realized and Unrealized Gain or Loss Nonoperating items related to investments

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