Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
3
Chapter 12
Reporting 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
Reasons Companies Invest
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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
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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
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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
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Vertical and Horizontal
Acquisition
Vertical acquisition would
occur if Nike purchased a
chain of athletic shoe stores.
Horizontal acquisition would
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Debt Investments
Investments in government and
corporation bonds
In accounting for debt investments,
entries are required to record:
the acquisition
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•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
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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,
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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:
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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
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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
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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
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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.
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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.
Accounting Guidelines for
Stock Investments
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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
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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
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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
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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
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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)
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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
.
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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
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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
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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
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Equity Method
Failure to recognize the
investors share of net
income until a cash dividend
is declared ignores the fact
that the investor and
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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
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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
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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).
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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
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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
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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
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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
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Debt and stock investments are
classified into the following three
categories:
Trading securities
Available-for-sale securities
Held-to-maturity securities
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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
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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
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Held-to-Maturity Securities
Debt securities that
the investor has the
intent and the
ability to hold to
maturity
More will be
covered in
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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,
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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.
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Temporary and Long-Term
Investments
For balance sheet
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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
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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.
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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
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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 Gains Other Expenses and Losses
Interest Revenue Loss on Sales of Investments
Dividend Revenue Unrealized Loss--Income
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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
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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
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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
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