11-115-1 investments and fair value accounting 15 principles of financial accounting, 11e reeve...

11-115-1

Investments and Fair Value Accounting

15

Principles of Financial Accounting, 11eReeve • Warren • Duchac

11-215-2

Describe why companies invest in debt and equity securities.

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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.

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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.

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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.

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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:1. Reduction of costs2. Replacement of management3. Expansion

4. Integration

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Describe and illustrate the accounting for debt investments.

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Purchase of BondsHomer 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.

$18,000 × 6% × (45/360)

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Interest Revenue

On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × ½).

($540 – $135) or [$18,000 × 6% × (135/360)]

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Homer Company’s accounting period ends on December 31. The following adjusted entry is required to record the accrued interest:

Accrued Interest

Homer Company would report Interest Revenue on its 2010 income statement at $855 ($405 + $450).

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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.

Semiannual Receipt of Interest

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On January 31, 2011, Homer Company sells Treasury bonds at 98. The sale results in a loss of $360.

Sale of Bonds

Proceeds from sale ($18,000 × 98%) $17,640Less book value (cost) of the bonds 18,000Loss on sale of bonds $(360)

Reported as part of Other Income (Loss) on the income statement

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Example Exercise 15-1

Bond Transactions

2

Journalize the entries to record the following selected bond investment transactions for Tyler Company:

1. Purchased for cash $40,000 of Tyler Company 10% bonds at 100 plus accrued interest of $320.

2. Received the first semiannual interest.

3. Sold $30,000 of the bonds at 102 plus accrued interest of $110.

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Example Exercise 15-1 (continued) 2

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For Practice: PE 15-1A, PE 15-1B

1. Investments—Tyler Company Bonds…………………… 40,000Interest Receivable…………………………………………. 320

Cash……………………………………………………..40,3202. Cash ($40,000 × 10% × ½)………………………………….. 2,000Interest Receivable……………………………………320Interest Revenue………………………………………1,680

3. Cash [($30,000 × 102%) + $110 accrued interest]………. 30,710Interest Revenue………………………………………110Gain on Sale of Investments………………………...600Investments—Tyler Company Bonds……………...30,000

Follow My Example 15-1

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Describe and illustrate the accounting for equity investments.

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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.

Accounting for Equity Investments

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Stock Investments

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Exhibit 1

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

Less Than 20% Ownership

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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.

Purchase of Stock (Cost Method)

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On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company.

Receipt of Dividends (Cost Method)

Dividend Revenue is reported as part of Other Income on Bart Company’s income statement.

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On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission.

Sale of Stock (Cost Method)

Proceeds from sale [(54.50 × 1,500 shares) – $160 $81,590Book value (cost) of the stock ($100,000/2,000 shares) × 1,500 75,000Gain on sale of investments $ 6,590

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Example Exercise 15-2

Stock Transactions

3

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.

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Example Exercise 15-2 (continued) 3

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Sept. 1 Investments—Monroe Company Stock……………. 36,040Cash………………………………………………….

36,040**(1,500 shares × $24 per share) + $40

Oct. 14 Cash……………………………………………………….. 900Dividend 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

For Practice: PE 15-2A, PE 15-2B

Follow My Example 15-2

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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.

Between 20% and 50% Ownership

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Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2010 for $350,000.

Purchase of Stock (Equity Method)

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For the year ending on December 31, 2010, Flanders Corporation reported net income of $105,000.

Recording Investee Net Income (Equity Method)

Income of Flanders Corporation, if significant, is reported as Other Income on Simpson Inc.’s income statement.

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During the year, Flanders declared and paid cash dividends of $45,000.

Recording Investee Dividends (Equity Method)

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On January 1, 2011, Simpson Inc. sold Flanders Corporation’s stock for $400,000 a gain of $26,000 calculated as follows:

Sale of Stock (Equity Method)

Proceeds from sale $400,000Book value of stock investment 374,000Gain on sale $ 26,000

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Example Exercise 15-3

Equity Method

3

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.

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Example Exercise 15-3 (continued) 3

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Jan. 2 Investment in Bryant Company Stock.……………. 140,000Cash………………………………………………….

140,000Dec. 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

For Practice: PE 15-3A, PE 15-3B

Follow My Example 15-3

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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.

More Than 50% Ownership

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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.

More Than 50% Ownership

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Describe and illustrate valuing and reporting investments in the financial statements.

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15-36

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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.

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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:

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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.

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

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

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

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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 Investments2009

Dec. 31 Adj. 1,300Dec. 31 Bal. 1,3002010

Jan. 1 Bal. 1,3002010

Dec. 31 Adj. 4,400Dec. 31 Bal. 3,100

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Example Exercise 15-4

Valuing Trading Securities at Fair Value

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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.

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Example Exercise 15-4 (continued) 4

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Dec. 31 Unrealized Loss on Trading Investments………….. 7,700Valuation Allowance for Trading Investments 7,700* To record decrease in fair value of

trading investments.

For Practice: PE 15-4A, PE 15-4B

2010

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 95,000Valuation allowance for trading investments, December 31, 2010 15,800 Dr.*Adjustment $ 7,700 Cr.

Follow My Example 15-4

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

Held-To-Maturity Securities

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

Available-For-Sale Securities

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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:

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

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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.

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On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as an available-for-sale security for $12 per share, including brokerage commission.

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On December 31, 2010, the cost and fair valuation of the portfolio of available-for-sale securities are as follows:

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Calculating the Adjustment Amount for the Valuation Account

Valuation allowance for available-for-sale $1,300 Dr.

Available-for-sale investments at cost $27,600

Available-for-sale investments at fair value 24,500

Valuation allowance foravailable-for-sale investments,December 31, 2010 3,100 Cr.

Adjustment $4,400 Cr.

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Based on the calculations on Slide 56, the following December 31, 2010, adjusting entry should be made:

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Example Exercise 15-5

Valuing Available-for-Sale Securities at Fair Value

4

On January 1, 2010, Valuation Allowance for Available-for-Sale Securities has a credit balance of $9,000. On December 31, 2010, the cost of the available-for-sale securities was $45,700 and the fair value was $37,200.

Prepare the adjusting journal entry to record the unrealized gain or loss for available-for-sale investments on December 31, 2010.

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Example Exercise 15-5 (continued) 4

15-60 For Practice: PE 15-5A, PE 15-5B

Dec. 31 Valuation Allowance for Available-for-Sale Investments 500*

Unrealized Gain (Loss) on Available-for- Sale Investments 500 To record increase in fair value of

available-for-sale securities.

2010

Valuation allowance for available-for-sale investments, January 1, 2010 $9,000 Cr. Available-for-sale investments at cost, December 31, 2010 $45,700 Available-for-sale investments at fair value, December 31, 2010 37,200Valuation allowance for available-for-sale investments, December 31, 2010 8,500 Cr.*Adjustment $ 500 Dr.

Follow My Example 15-5

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Summary of Valuing and Reporting Investments

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Exhibit 2

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Describe fair value accounting and its implications for the future.

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Fair Value Accounting

Fair value is the price that would be received for selling an asset or paying off a liability. Fair value assumes that the asset is sold or the liability paid off under normal rather than under distress conditions.

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Trends to Fair Value Accounting

A current trend for the FASB and other accounting regulators is to adopt accounting principles using fair values for valuing and reporting assets and liabilities.

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Trends to Fair Value Accounting

Factors contributing to this trend include the following:1. Current generally accepted accounting

principles are a hybrid of varying measurement methods that often conflict with each other.

(continued)

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2. A greater percentage of the total assets of many companies consists of financial assets such as receivables and securities.

3. The world economy has created pressure on accounting regulators to adopt a worldwide set of accounting principles and standards.

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Disadvantages of Fair Value Accounting

Several potential disadvantages include the following:1. Fair value may not be readily obtainable

for some assets or liabilities resulting in subjectivity.

(continued)

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2. Fair values make it more difficult to compare companies if companies use different methods of determining (measuring) fair values.

3. Using fair values will result in more fluctuations in accounting reports because fair values normally change from year to year.

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Effect of Fair Value Accounting on the Financial Statements—Balance Sheet

1. When an asset or liability is reported at its fair value, any difference between the asset’s original cost or prior period’s fair value must be recorded.

2. The unrealized gain or loss on changes in fair value must be recorded. One method reports these as part of stockholders’ equity.

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Effect of Fair Value Accounting on the Financial Statements—Income Statement

Instead of recording the unrealized gain or loss on changes in fair value as part of stockholders’ equity, the unrealized gains or losses may be reported on the income statement.

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Dividend Yield

The dividend yield indicates the rate of return to stockholders in terms of cash dividends distributed.

Dividend Yield =Dividends per Share of Common

Stock

Market Price per Share of Common StockMattel

:Dividend Yield =

$0.75

$19.09= 3.93%

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Appendix 1: Accounting for Held-to-Maturity Investments

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Prices of Bonds1. If the bond rate of interest is more

than the market rate of interest for equivalent investments, bonds are purchased at a premium.

2. If the bond rate of interest is less than the market rate of interest for equivalent investments, bonds are purchased at a discount.

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Amortization of a Premium on a Bond Investment

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Amortization of a Discount on a Bond Investment

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Purchase of bonds on April 1, 2010.

Receipt of semiannual interest on October 1.

(continued)

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Adjusting entry for accrued interest on December 31.

Adjusting entry for amortization of discount on December 31 using the straight-line method.

(continued)

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The bonds mature on April 1, 2020.

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