Investments and Fair Value Accounting

15 Investments and Fair Value Accounting Principles of Financial Accounting, 11e Reeve • Warren • Duchac

1 Describe why companies invest in debt and equity securities. 15-4

1 Investing Cash in Current Operations Cash may be used to replace worn out equipment or to purchase new, more efficient, and productive equipment. Cash may be reinvested in the company to expand its current operations. Cash may be used to pay suppliers or other creditors.

1 Investing Cash in Temporary Investments Debt securities are notes and bonds that pay interest and have a fixed maturity date. Equity securities are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

1 Investing Cash in Temporary Investments These debt securities and equity securities are termed Investments, or Temporary Investments, and are reported in the Current Assets section of the balance sheet.

1 Investing Cash in Long-Term Investments Long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments have a strategic purpose: • Reduction of costs • Replacement of management • Expansion • Integration

2 Describe and illustrate the accounting for debt investments. 15-9

$18,000 × 6% × (45/360) 2 Purchase of Bonds Homer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March 17, 2010 (45 days after the last interest payment date). The bonds have an interest rate of 6%, payable on July 31 and January 31.

($540 – $135) or [$18,000 × 6% × (135/360)] 2 Interest Revenue On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × ½).

2 Accrued Interest Homer Company’s accounting period ends on December 31. The following adjusted entry is required to record the accrued interest: Homer Company would report Interest Revenue on its 2010 income statement at $855 ($405 + $450).

2 Semiannual Receipt of Interest Homer Company receives interest of $540 on January 31, 2011. Notice that Interest Receivable is credited for $450 to reflect this is a receivable from 2010. Interest Revenue of $90 is the interest earned from January 1 through January 31, 2011.

Reported as part of Other Income (Loss) on the income statement 2 Sale of Bonds On January 31, 2011, Homer Company sells Treasury bonds at 98. The sale results in a loss of $360. Proceeds from sale ($18,000 × 98%) $17,640 Less book value (cost) of the bonds 18,000 Loss on sale of bonds $(360)

2 Example Exercise 15-1 Bond Transactions Journalize the entries to record the following selected bond investment transactions for Tyler Company: • Purchased for cash $40,000 of Tyler Company 10% bonds at 100 plus accrued interest of $320. • Received the first semiannual interest. • Sold $30,000 of the bonds at 102 plus accrued interest of $110. 15-15

For Practice: PE 15-1A, PE 15-1B Follow My Example 15-1 2 Example Exercise 15-1 (continued) • Investments—Tyler Company Bonds…………………… 40,000 • Interest Receivable…………………………………………. 320 • Cash…………………………………………………….. 40,320 • Cash ($40,000 × 10% × ½)………………………………….. 2,000 • Interest Receivable…………………………………… 320 • Interest Revenue……………………………………… 1,680 • Cash [($30,000 × 102%) + $110 accrued interest]………. 30,710 • Interest Revenue……………………………………… 110 • Gain on Sale of Investments………………………... 600 • Investments—Tyler Company Bonds……………... 30,000 15-16

3 Describe and illustrate the accounting for equity investments. 15-17

3 Accounting for Equity Investments A company may invest in the preferred or common stock of another company. The company investing in another company’s stock is the investor. The company whose stock is purchased is the investee.

3 Exhibit 1 Stock Investments

3 Less Than 20% Ownership Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method.

3 Purchase of Stock (Cost Method) On May 1, Bart Company purchases 2,000 shares of Lisa Company common stock at $49.90 per share plus a brokerage fee of $200.

3 Receipt of Dividends (Cost Method) On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company. Dividend Revenueis reported as part of Other Income on Bart Company’s income statement.

Proceeds from sale [(54.50 × 1,500 shares) – $160 $81,590 Book value (cost) of the stock ($100,000/2,000 shares) × 1,500 75,000 Gain on sale of investments $ 6,590 3 Sale of Stock (Cost Method) On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission.

3 Example Exercise 15-2 Stock Transactions On September 1, 1,500 shares of Monroe Company are acquired at a price of $24 per share plus a $40 brokerage fee. On October 14, a $0.60 per share dividend was received on the Monroe Company stock. On November 11, 750 shares (half) of Monroe Company’s stock were sold for $20 per share, less a $45 brokerage fee. Prepare the journal entries for the original purchase, dividends, and sale. 15-24

Follow My Example 15-2 For Practice: PE 15-2A, PE 15-2B 3 Example Exercise 15-2 (continued) Sept. 1 Investments—Monroe Company Stock……………. 36,040 Cash…………………………………………………. 36,040* *(1,500 shares × $24 per share) + $40 Oct. 14 Cash ……………………………………………………….. 900 Dividend Revenue………………………………… 900* *$0.60 per share × 1,500 shares Nov. 11 Cash ……………………………………………………….. 14,955* Loss on Sale of Investments………………………….. 3,065 Investments—Monroe Company Stock………. 18,020** *(750 shares × $20) – $45 **$36,040 × 1/2 15-25

3 Between 20% and 50% Ownership If the investor purchases between 20% and 50% of the outstanding stock of the investee, the investor is considered to have significant influence over the investee and the investment is accounted for using the equity method.

3 Purchase of Stock (Equity Method) Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2010 for $350,000.

3 Recording Investee Net Income (Equity Method) For the year ending on December 31, 2010, Flanders Corporation reported net income of $105,000. Income of Flanders Corporation, if significant,is reported as Other Income on Simpson Inc.’s income statement.

3 Recording Investee Dividends (Equity Method) During the year, Flanders declared and paid cash dividends of $45,000.

3 Sale of Stock (Equity Method) On January 1, 2011, Simpson Inc. sold Flanders Corporation’s stock for $400,000 a gain of $26,000 calculated as follows: Proceeds from sale $400,000 Book value of stock investment 374,000 Gain on sale $ 26,000

3 Example Exercise 15-3 Equity Method On January 2, Olson Company acquired 35% of the outstanding stock of Bryant Company for $140,000. For the year ending December 31, Bryant Company earned income of $44,000 and paid dividends of $20,000. Prepare the entries for Olson Company for the purchase of the stock, share of Bryant income, and dividends received from Bryant Company. 15-32

For Practice: PE 15-3A, PE 15-3B Follow My Example 15-3 3 Example Exercise 15-3 (continued) Jan. 2 Investment in Bryant Company Stock.……………. 140,000 Cash…………………………………………………. 140,000 Dec. 31 Investment in Bryant Company Stock………………. 15,400* Income of Bryant Company……………………... 15,400 *Record 35% of Bryant income, 35% × $44,000 Dec. 31 Cash……………………………………………………….. 7,000* Investment in Bryant Company Stock………… 7,000 *35% × $20,000 15-33

3 More Than 50% Ownership If the investor purchases more than 50% of the outstanding stock of the investee, the investor is considered to have control over the investee. The purchase is termed a business consolidation.

3 More Than 50% Ownership A corporation owning all or a majority of the voting stock of another company is called a parent company. The corporation that is controlled is called the subsidiary company.

4 Describe and illustrate valuing and reporting investments in the financial statements. 15-36

4 Trading Securities Trading securities are debt and equity securities that are purchased and sold to earn short-term profits from changes in their market prices.

4 Maggie Company purchased a portfolio of trading securities during 2009. On December 31, 2009, the cost and fair values of the securities were as follows:

4 The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows: The Unrealized Gain on Trading Investments, if significant,is reported on the income statement.

4 On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as a trading security for $12 per share, including a brokerage commission.

4 On December 31, 2010, the cost and fair valuation of the portfolio of trading securities are as follows:

4 Based on the above analysis, the adjusting entry on December 31, 2010, is as follows:

4 The valuation allowance for trading investments account after the December 31, 2010 adjusting entry, has a credit balance of $3,100. Valuation Allowance for Trading Investments 2009 Dec. 31 Adj. 1,300 Dec. 31 Bal. 1,300 2010 Jan. 1 Bal. 1,300 2010 Dec. 31 Adj. 4,400 Dec. 31 Bal. 3,100

4 Example Exercise 15-4 Valuing Trading Securities at Fair Value On January 1, 2010, Valuation Allowance for Investments had a debit balance of $23,500. On December 31, 2010, the cost of the trading securities portfolio was $79,200, and the fair value was $95,000. Prepare the December 31, 2010, adjusting journal entry to record the unrealized gain or loss on trading investments. 15-46

Follow My Example 15-4 For Practice: PE 15-4A, PE 15-4B 4 Example Exercise 15-4 (continued) 2010 Dec. 31 Unrealized Loss on Trading Investments………….. 7,700 Valuation Allowance for Trading Investments 7,700* To record decrease in fair value of trading investments. Valuation allowance for trading investments, January 1, 2010 $23,500 Dr. Trading investments at cost, December 31, 2010 $79,200 Trading investments at fair value, December 31, 2010 95,000 Valuation allowance for trading investments, December 31, 2010 15,800 Dr. *Adjustment $ 7,700 Cr. 15-47

4 Held-To-Maturity Securities Held-to-maturity securities are debt investments, such as notes or bonds, that a company intends to hold until their maturity date.

4 Available-For-Sale Securities Available-for-sale securities are debt and equity securities that are not classified as trading or held-for-maturity securities.

4 Maggie Company purchased securities during 2009 as available-for-sale securities instead of trading securities. On December 31, 2009, the cost and fair values of the securities are as follows:

4 The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows:

4 A credit balance in Unrealized Gain (Loss) on Available-for-Sale Investments is added to stockholders’ equity, while a debit balance is subtracted from stockholders’ equity.

Investments and Fair Value Accounting