BUS 120: Financial AccountingChapter 13: Investments

Dr. Al Taccone

Chapter 13: What you should learn

• Why corporations invest in debt and stock securities• Accounting for debt investments

* Recording acquisitions of bonds* Recording bond interest* Recording sale of bonds

• Accounting for stock investments* Holdings of less than 20%* Holdings of between 20% and 50%* Holdings of greater than 50%

• Balance sheet presentation of investments

Temporary Investments and the Operating Cycle

• Many companies may have temporarily idle cash on hand pending the start of the next operating cycle.

• Until the cash is needed in operations, these excess funds may be invested to earn interest and dividends.

WHY CORPORATIONS INVEST

Reason Typical Investment

To house excess cash untilneeded

Low-risk, high-liquidity, short-termsecurities such as government-issued securities

To generate earnings Debt securities (banks and otherfinancial institutions); and stocksecurities (mutual funds andpension funds)

To meet strategic goals Stocks of companies in a relatedindustry or in an unrelated industrythat the company wishes to enter

Temporary vs. Long-term Investments

Temporary investments:

• Securities held by a company that are:

1. Readily marketable

2. 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 for temporary investments.

Debt Investments

• Investments in government and corporation bonds.

• Entries are required to record:1. Acquisition of the bonds2. Interest revenue earned on the bonds3. Sale of the bonds

• The cost principle applies—cost includes all expenditures necessary to acquire these investments.

54,000 54,000

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES AT

ACQUISITION

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES AT

ACQUISITIONKuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2002, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:

Kuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2002, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR BOND

INTEREST

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR BOND

INTEREST

3,000 3,000

3,000 3,000

3,000 3,000

The bonds pay $3,000 interest on July 1 and January 1 ($50,000 X 12% X ½). The July 1 entry is:

It is necessary to accrue $3,000 interest earned since July 1 at year-end. The December 31 entry is:

When the interest is received on January 1, the entry is:

58,000 54,000 4,000

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR SALE OF

BONDS

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR SALE OF

BONDSAny difference between the net proceeds (sales price less brokerage fees) from the sale of bonds and the cost of the bonds is recorded as a gain or loss. Kuhl Corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2003, after receiving the interest due. Since the securities cost $54,000, a gain of $4,000 has been realized. The entry to record the sale is:

Any difference between the net proceeds (sales price less brokerage fees) from the sale of bonds and the cost of the bonds is recorded as a gain or loss. Kuhl Corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2003, after receiving the interest due. Since the securities cost $54,000, a gain of $4,000 has been realized. The entry to record the sale is:

STOCK INVESTMENTSSTOCK INVESTMENTS

Stock investments are investments in the capital stock of corporations. When a company holds stock or debt of various corporations, the group of securities is identified as an investment portfolio.

40,500 40,500

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

PURCHASE OF STOCK INVESTMENT

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

PURCHASE OF STOCK INVESTMENT

In accounting for stock investments of less than 20%, the cost method is used. The investment is recorded at cost and revenue is recognized only when cash dividends are received. On July 1, 2002, 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:

In accounting for stock investments of less than 20%, the cost method is used. The investment is recorded at cost and revenue is recognized only when cash dividends are received. On July 1, 2002, 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:

2,000 2,000

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

DIVIDEND REVENUE

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

DIVIDEND REVENUE

Entries are required for any cash dividends received during the time the stock is held. If a $2 per share dividend is received by Sanchez Corporation on December 31 the entry is:

Entries are required for any cash dividends received during the time the stock is held. If a $2 per share dividend is received by Sanchez Corporation on December 31 the entry is:

Dividend Revenue is reported under Other Revenue and Gains in the income statement. Since dividends do not accrue, adjusting entries are not made to accrue dividends.

Dividend Revenue is reported under Other Revenue and Gains in the income statement. Since dividends do not accrue, adjusting entries are not made to accrue dividends.

39,500 1,000 40,500

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

SALE OF STOCK INVESTMENT (GAINS or LOSSES)

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS LESS THAN 20%

SALE OF STOCK INVESTMENT (GAINS or LOSSES)

When stock is sold, the difference between the net proceeds from the sale and the cost of the stock is recognized as a gain or loss. Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation common stock on February 10, 2003. Because the stock cost $40,500, a loss of $1,000 has been incurred. The entry to record the sale is:

When stock is sold, the difference between the net proceeds from the sale and the cost of the stock is recognized as a gain or loss. Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation common stock on February 10, 2003. Because the stock cost $40,500, a loss of $1,000 has been incurred. The entry to record the sale is:

Accounting for Stock Investments Holdings Between 20% and 50%

• Usually presumed that the investor has significant influence over the financial and operating activities of the investee.

• The investor should record its share of net income of the investee in the year when it is earned.

• Equity Method: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.

• Each year the following transactions are required:1. Debit the investment account and credit revenue for

its share of the investee’s net income.2. Credit dividends received to the investment account.

120,000

120,000

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20%

AND 50%

RECORD THE STOCK INVESTMENT

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20%

AND 50%

RECORD THE STOCK INVESTMENTMilar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2002. The entry to record this transaction is:Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2002. The entry to record this transaction is:

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20%

AND 50%

DIVIDEND REVENUE

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20%

AND 50%

DIVIDEND REVENUE

Date Account Titles and Explanation Debit Credit(1)

Dec. 31 Stock Investments Revenue from Investment in Beck Company

(To record 30% equity in Beck’s 2002 net Income)

30,000

30,000

12,000

12,000

Beck reports 2002 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 net income, $30,000 (30% X $100,000) and 2 the reduction in the investment account for the dividends received, $12,000 ($40,000 X 30%). The entries are:

Beck reports 2002 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 net income, $30,000 (30% X $100,000) and 2 the reduction in the investment account for the dividends received, $12,000 ($40,000 X 30%). The entries are:

INVESTMENT AND REVENUE ACCOUNTS AFTER POSTING

INVESTMENT AND REVENUE ACCOUNTS AFTER POSTING

After posting the transactions for the year, the investment and revenue accounts will show the above results. During the year, the investment account has increased by $18,000 – which represents Milar’s 30% equity in the $60,000 increase in Beck’s retained earnings ($100,000 - $40,000). Milar will also report $30,000 of revenue from its investment, which is 30% of Beck’s net income of $100,000. Milar would report only $12,000 (30% X $40,000) of dividend revenue if the cost method were used.

After posting the transactions for the year, the investment and revenue accounts will show the above results. During the year, the investment account has increased by $18,000 – which represents Milar’s 30% equity in the $60,000 increase in Beck’s retained earnings ($100,000 - $40,000). Milar will also report $30,000 of revenue from its investment, which is 30% of Beck’s net income of $100,000. Milar would report only $12,000 (30% X $40,000) of dividend revenue if the cost method were used.

Accounting for Stock Investments Holdings of More than 50%

• A company that owns more than 50% of the common stock of another company is known as the parent company.

• The company whose stock is owned by the parent company is called the subsidiary (affiliated) company.

• The parent company is perceived to have a controlling interest in the subsidiary company due to the stock ownership.

• When one company owns more than 50% of the common stock of another company, consolidated financial statements are usually prepared.

Valuation and Reporting of Investments

• Debt and stock investments are classified into 3 categories of securities:

1. Trading securities—held with the intention of selling them in a shortperiod of time (usually less than a onemonth).

2. Available-for-sale securities—may be sold inthe future (usually held beyond one month).

3. Held-to-maturity securities—debt securities that the investor has the intent and ability to hold to maturity.

PACE CORPORATIONBalance Sheet

December 31, 2002

AssetsCurrent assets Cash $ 21,000 Temporary investments, at fair value 60,000 Accounts receivable $ 84,000

Less: Allowance for doubtful accounts 4,000 80,000

Merchandise inventory, at FIFO cost 130,000 Prepaid insurance 23,000

Total current assets 314,000Investments Investment in bonds 100,000

Investments in stock of less than 20% owned companies, at fair value 50,000 Investment in stock of 20% – 50% owned company, at

equity 150,000 Total investments 300,000Property, plant, and equipment

Land 200,000 Buildings $ 800,000 Less: Accumulated depreciation 200,000 600,000

Equipment 180,000 Less: Accumulated depreciation 54,000 126,000

Total property, plant, and equipment 926,000Intangible assets Goodwill (Note 1) 100,000

Patents 70,000

Total intangible assets 170,000

Total assets $ 1,710,000

ILLUSTRATION: COMPREHENSIVE BALANCE SHEET

ILLUSTRATION: COMPREHENSIVE BALANCE SHEET

The comprehensive balance sheet for Pace Corporation includes the following assets:

1 Temporary Investments,

2 Investments of less than 20%, and

3 Investments of 20% - 50%.

The comprehensive balance sheet for Pace Corporation includes the following assets:

1 Temporary Investments,

2 Investments of less than 20%, and

3 Investments of 20% - 50%.

ILLUSTRATION: COMPREHENSIVE BALANCE SHEET

ILLUSTRATION: COMPREHENSIVE BALANCE SHEET

The comprehensive balance sheet for Pace Corporation includes the following element of stockholders’ equity: Unrealized Gain on Available-for-Sale Securities. Reporting the unrealized gain or loss in the stockholders’ equity section: 1 reduces the volatility of net income due to fluctuations in fair value and 2 still informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value.

The comprehensive balance sheet for Pace Corporation includes the following element of stockholders’ equity: Unrealized Gain on Available-for-Sale Securities. Reporting the unrealized gain or loss in the stockholders’ equity section: 1 reduces the volatility of net income due to fluctuations in fair value and 2 still informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value.