chapter 15 investments skyline college lecture notes

Chapter 15

Investments

Skyline College

Lecture Notes

Copyright © Houghton Mifflin Company. All rights reserved. 15–2

Recognition of Investments

When are purchases of investments recorded?

When are sales of investments recorded?

On which statement are income and gains or losses from investments recorded?

The date of purchase

The date of sale

The income statement


Valuation of Investments

At the time of purchase, investments are valued at cost (cost principle) and includes commissions and fees

After the purchase: Value is adjusted to reflect subsequent conditions

Changes in market value Changes caused by passage of time Changes in the operations of the investee company


How Are Investments Classified?

Short-Term Investments Long-Term Investments

Maturity of more than 90 days but are intended to be held only until cash is needed for current operations

Intended to be held for more than one year

Trading securities Available-for-sale securities

Held-to-maturity securities

Debt or equity securities bought sold in the near term

debt or equity securities that do not meet the criteria for either trading or held-to-maturity securities

Debt securities to hold until their maturity date


Ownership Interests

Noninfluential and noncontrolling

investment

Owns less than 20 percent of the stock of another company and has no influence on the other company’s operations

Influential but noncontrolling

investment

Owns 20 to 50 percent of another company’s stock; can exercise significant influence over that company’s operating and financial policies

Controlling investment

Owns more than 50 percent of another company’s stock and can exercise control over that company’s operating and financial policies


Ethics of Investing

Insider Trading

Making use of inside information for personal gain is unethical and illegal

Officers and employees of a company are not allowed to buy or sell stock in the company or in the firm whose shares the company is buying until the company releases investment information to the public


Discussion: Ethics on the Job

The sales director of a leading pharmaceutical company discloses information about a breakthrough drug that will likely be approved by the FDA for distribution in the U.S. to one of the company’s vendors. The vendor subsequently purchases a large block of stock in the pharmaceutical company.

Q. Do you think the vendor qualifies as an “insider” and has engaged in “insider trading”? Why or why not?

The vendor qualifies as a “temporary” insider, with respect to the information.


Trading Securities

Short-term investments, bought and sold to generate profits on the changes in their prices

Classified as current assets, valued at fair value, which is usually the same as market value

The change in the fair value of a company’s total trading portfolio for the period is recognized as an unrealized gain/loss on the income statement


Trading Securities Illustrated

Jackson Company purchases 10,000 shares of stock in IBM Corporation for $900,000 ($90 per share) and 10,000 shares of stock in Microsoft for $300,000 ($30 per share) on October 25, 20x7.

Record the investment in trading securities:

20x7 Oct. 25 Short-Term Investments 1,200,000 Cash 1,200,000 Investment in stocks for trading

($900,000 + $300,000)


Trading Securities Illustrated (cont’d)

At year end, IBM’s stock price has decreased to $80 per share and Microsoft’s stock price has risen to $32 per share. The trading portfolio is now valued at $1,120,000. It has lost $80,000 in value.

Record the adjustment in value at year end: 20x7 Dec. 31 Unrealized Loss on Investments 80,000 Allowance to Adjust Short-Term

Investments to Market 80,000

Recognition of unrealized loss on trading portfolio

Security Market Value

Cost Gain (Loss)

IBM (10,000 shares) $ 800,000 $ 900,000

Microsoft (10,000 shares) 320,000 300,000

Totals $1,120,000 $1,200,000 $(80,000)

The unrealized loss appears on the income statement. It is unrealized because the securities have not been sold.


Trading Securities Illustrated (cont’d)

Assume Jackson sells its 10,000 shares of stock in Microsoft for $35 per share on March 2, 20x8. A realized gain is recorded.

20x8 Mar. 2 Cash 350,000 Short-Term Investments 300,000 Realized Gain on Investments 50,000 Sale of 10,000 shares of stock in

Microsoft for $35 per share; cost was $60 per share

The realized gain is unaffected by the adjustment for the unrealized loss at the end of 20x7. The two transactions are independent of each other.


Year-End Adjustment for Trading Securities

Security Market Value Cost Gain (Loss)

IBM $ 950,000 $ 900,000

Apple 116,000 128,000

Totals $1,066,000 $1,028,000 $38,000

This amount represents the target amount for the ending balance of the Allowance to Adjust Short-Term Investments to Market account. Since

the account had a credit balance of $80,000 at the end of 20x7, the journal entry to adjust should debit the account for $118,000.

20x8 Dec. 31 Allowance to Adjust Short-Term Inv. To Market 118,000 Unrealized Gain on Investments 118,000

Assume that Jackson’s portfolio of trading securities appears as follows at the end of 20x8:


Noninfluential and Noncontrolling Investments

Debt or equity securities not classified as trading or held-to-maturity securities

If equity securities, must be less than 20 percent of ownership

Account for using cost-adjusted-to-market method• Record at cost• Adjust periodically through an allowance account for

changes in market value

Available-for-sale securities:

15–14

Noninfluential and Noncontrolling Investment (cont’d)

Long-term if expected to be held for more than a year Unrealized gain or loss from adjustment reported in

stockholders’ equity section of balance sheet Determine total cost and total market value at end of

each accounting period for long-term stock investments

Total market value < total cost

The dollar amount of the difference should be equal to the credit balance in the Allowance to Adjust Long-Term Investments to Market account

Total market value > total cost

The dollar amount of the difference should be equal to the debit balance in the Allowance to Adjust Long-Term Investments to Market Account


June 1, 20x7: Paid cash for the following long-term investments: 10,000 shares of Herald Corporation common stock (representing 2 percent of outstanding stock) at $25 per share; 5,000 shares of Taza Corporation common stock (representing 3 percent of outstanding stock) at $15 per share.

20x7 June 1 Long-Term Investments 325,000 Cash 325,000 Investments in Herald common stock (10,000

shares x $25 = $250,000) and Taza common stock (5,000 shares x $15 = $75,000)

Investment:

Available-for-Sale Securities Illustrated


Dec. 31, 20x7: The market price of Herald and Taza stock at year end is $21 and $17 respectively.

20x7 Dec. 31 Unrealized Loss on Long-Term Investments 30,000 Allowance to Adjust Long-Term

Investments to Market

30,000 To record reduction of long-term

investment to market

Year-End Adjustment:

Company Shares Market Price Total Market Total Cost Herald 10,000 $21 $210,000 $250,000 Taza 5,000 17 85,000 75,000

$295,000 $325,000

Total Cost – Total Market Value = $325,000 – $295,000 = $30,000

Available-for-Sale Securities Illustrated (cont’d)


April 1, 20x8: Change in policy required sale of 2,000 shares of Herald Corporation common stock at $23.

20x8 Apr. 1 Cash 46,000 Loss on Sale of Investments 4,000 Long-Term Investments 50,000 Sale of 2,000 shares of Herald common

stock


2,000 x $23 = $46,000 2,000 x $25 = 50,000 Loss $ 4,000


July 1, 20x8: Received cash dividend from Taza Corporation equal to $0.20 per share.

20x8 July 1 Cash 1,000 Dividend Income 1,000 Receipt of cash dividend from Taza stock

5,000 x $0.20 = $1,000



Dec. 31, 20x8: The market price at year end for Herald and Taza stock is $24 and $13, respectively.

Company Shares Market Price Total Market Total Cost Herald 8,000 $24 $192,000 $200,000 Taza 5,000 13 65,000 75,000

$257,000 $275,000

Total Cost – Total Market Value = $275,000 – $257,000 = $18,000

The Allowance to Adjust Long-Term Investments to Market account and the Unrealized Loss on Long-Term Investments account must both be adjusted to carry a balance of $18,000. Since the accounts already contain $30,000, they must be adjusted by $12,000.


20x8 Dec. 31 Allowance to Adjust Long-Term Investments to Market 12,000 Unrealized Loss on Long-Term Investments 12,000 To record adjustment in long-term investment

so it is reported at market


Influential but Noncontrolling Investment

Use the equity method to account for a stock investment when ownership is 20 percent or more and influential in nature

Equity Method1. Record the original purchase of the stock at cost

2. record its share of the company’s income as an increase in the Investment account and a credit to an income account. (Or loss as a decrease in the Investment account and debit to a loss account.)

3. When investor receives a cash dividend, Cash is increased and the Investment account is decreased.


On January 1, ITO Corporation acquired 40 percent of the voting stock of Quay Corporation for $180,000.

Jan. 1 Investments in Quay Corporation 180,000 Cash 180,000 Investment in Quay Corporation

common stock

Equity Method Illustrated

During the year, Quay Corporation reported net income of $80,000 and paid cash dividends of $20,000.

Investment in Quay Corporation 32,000 Income, Quay Corporation Investment 32,000 Recognition of 40% of income reported

by Quay Corporation 40% x $80,000 = $32,000

Cash 8,000 Investment in Quay Corporation 8,000 Cash dividend from Quay Corporation

40% x $20,000 = $8,000

15–22

Controlling Investment

Ownership of more than 50 percent of a company’s voting stock

Forms a parent-subsidiary relationship

Parent

Investing company

Subsidiary

More than 50 percent of voting stock owned by another

company

Both are separate legal entities and prepare separate

financial statements. Combine into consolidated statements.


Consolidated Balance Sheet

Purchase MethodA way to prepare consolidated financial statements in which similar accounts from separate statements of the parent and subsidiaries are combined

SubsidiaryParent

Transactions between the entities should not be included in

the consolidated financial statements. Eliminations appear

only on the work sheets when preparing consolidated financial

statements.


Consolidated Balance Sheet (cont’d)

What kind of transactions might occur between a parent company and a subsidiary? Purchases and sales between parent and subsidiary

• Are only transfers between different parts of the business Receivables and payables between parent and subsidiary

• Do not represent amounts due or receivable from outside parties Investment in subsidiary account

• On parent company’s balance sheet• In stockholders’ equity section of subsidiary

These accounts should be eliminated for the purpose of consolidated financial statements


Accounts Parent

Company Subsidiary

Company

Cash $100,000 $25,000 Other assets 760,000 60,000 Total assets $860,000 $85,000 Liabilities $ 60,000 $10,000 Common stock 600,000 55,000 Retained earnings 200,000 20,000 Total liabilities and stockholders’ equity $860,000 $85,000

Suppose Parent Company purchases 10 percent of the stock of Subsidiary Company for an amount exactly equal to Subsidiary’s book value, which is $75,000 ($85,000 – $10,000).

Investment in Subsidiary Company 75,000 Cash 75,000 Purchase of 100 percent of Subsidiary

Company at book value

100 Percent Purchase at Book Value

We will use this balance sheet information to prepare a consolidated balance sheet under the purchase method.


Work Sheet for Preparing a Consolidated Balance Sheet


Less Than 100 Percent Purchase at Book Value

Must also account for minority interest: Interest of stockholders of the subsidiary owning less than

50 percent of the voting stock Equal to the percentage of ownership times the net assets

of the subsidiary Two ways to classify on consolidated balance sheet

1. Place between long-term liabilities and stockholders’ equity

2. Include in stockholders’ equity section before common stock

Financial statements are consolidated when more than 50 percent of the voting stock of a subsidiary is

purchased by the parent company.


Purchase at More or Less Than Book Value

Reasons to pay more than book valueParent wants to purchase a controlling interest in

subsidiarySubsidiary has something parent wants

• Such as a new process, market, different product, etc.

Reasons to pay less than book valueSubsidiary’s assets are not worth their

depreciated costSubsidiary may have suffered heavy losses

• Causing its stock to sell at low prices


Consolidated Income Statement

Prepared by combining revenues and expenses of the parent and subsidiary companies

Intercompany transactions are eliminated to prevent double counting of revenues and expenses.

• (Similar to eliminations for preparing a consolidated balance sheet)


Consolidated Income Statement (cont’d)

Sales and purchases between parent and subsidiary Income and expenses related to loans, receivables,

or bond indebtedness between parent and subsidiaryOther income and expense from intercompany

transactions

What kinds of intercompany transactions affect the consolidated income statement?


Parent Company made sales of $120,000 in goods to Subsidiary Company, which in turn sold all the goods to others. Subsidiary Company paid Parent Company $2,000 interest on a loan from the parent.

1. To eliminate $120,000 of intercompany sales:• Debit Sales and credit Cost of Goods Sold, $120,000

2. To eliminate $2,000 interest from an intercompany loan:• Debit Other Revenues and credit Other Expenses,

$2,000

Consolidated Income Statement (cont’d)


Worksheet for Preparing a Consolidated Income Statement


International Accounting

Multinational or transnational companies are those who operate in more than one country

Consolidation procedure

• Restate foreign subsidiary statements in the reporting currency before the consolidation takes place. For U.S. companies, the reporting currency is the U.S. dollar.


Held-to-Maturity Securities

Debt securities that management intends to hold to their maturity date

On December 1, 20x7, Webber Company pays $97,000 for U.S. Treasury bills, which are short-term debts of the federal government. The bills will mature in 120 days at $100,000.

20x7 Dec. 1 Short-Term Investments 97,000 Cash 97,000 Purchase of U.S. Treasury bills

that mature in 120 days

On Dec. 31, accrue the interest earned as follows:

20x7 Dec. 31 Short-Term Investments 750 Interest Income 750 Accrual of interest on U.S. Treasury bills

$3,000 x 30/120 = $750


Held-to-Maturity Securities (cont’d)

On December 31, 20x7, the U.S. Treasury bills would be shown on the balance sheet as short-term investments at their amortized cost of $97,750 ($97,000 + $750). When Webber Company receives the maturity value on March 31, 20x8, the following entry is recorded:

20x8 Mar. 31 Cash 100,000 Short-Term Investments 97,750 Interest Income 2,250 Receipt of cash at maturity of U.S.

Treasury bills and recognition of related income


Long-Term Investment in Bonds

At what value is the initial investment in bonds recorded?

At cost (often the price of the bonds plus the broker’s commission)

Available-for-Sale Bonds

Company plans to sell them at some point before their

maturity date

Accounted for at fair value

Held-to-Maturity Bonds

Company intends to hold the bonds until they are paid off

on their maturity date

Accounted for at cost, adjusted for amortization of

discount or premium

chapter 15 investments skyline college lecture notes

Documents

investee company

companys stock

jackson company purchases

leading pharmaceutical

sale securities

equity securities

shares of stock

sales of investments