Chapter 2. Short term investments

WHAT YOU WILL LEARN IN THIS CHAPTER:

Purpose and classification of short term investmentsTypes of short term investments Debt investments Bond purchases Equity investmentsControls for short-term investmentsEthics related to short-term investments

It is common for a business to have excess cash on hand:

Investments

3. Customers advance payments

2. Seasonal sales

1. Healthy profits

Example: Dell Computers:

1. Customers pay in advance before the computer is built.

2. They pay their suppliers in a month or two

3. The advance payments are not needed for a while and can therefore be invested to earn interest

Debt investments

Reinvest back into the business (new hires, upgrade equipment, etc)1. Distribute to shareholders (owners)2. Keep it in the bank3. Invest outside company

Investments

What can businesses do to manage temporary surplus cash?

Why would a business invest outside a company?

PICTURE OF A BANK

Low interest earned from a bank.

PICTURE OF A FACTORY

Higher returned when invested with other businesses who need the cash

Debt investments

Investments

Cash is listed first because it’s the most liquid asset

Short term investments are less liquid than cash but more liquid then Accounts Receivable or Inventory

Debt investments

Classifying Short Term Investments

Investments

Investments can be Debt or Equity based

Debt: where the loan (principle) is expected to be paid back with interest.

Picture of a bank

Equity: buying ownership in an organization with expectation of sharing in profits and making a profit on the investment.

Picture of a factory

Debt investments

Investments

Invest cash in the form of a savings account with a bank. What happens to the equity of the business?- 10,000

+ 10,000Increase

Decrease

No change

Debt investments

Correct. There is no change to equity because one asset has been exchanged for another.

Animate after answer

No change to equity

No change to equity: One asset is exchanged for another.

- 10,000

+ 10,000

Dr. Cash, Cr. Investment – no change to equity

Cr. Cash, Dr. Investment – no change to equity

Cr. Cash, Dr. Investment –equity increases

Dr. Cash, Cr. Investment –equity decreases

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Investments

IT: animate after the answer

Debt investments

Investing in the form of debtInvestments

Cash is invested with the expectation of interest in return for the loan (principle). The higher the risk the higher the expected return.

Picture of a bank Low risk = low interest rate

Picture of a factoryHigh risk = higher interest rate

+5,000 (Dr)+5,000 (Cr)

Interest received is not regarded as a regular form of revenue (income).

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Investments Investing in the form of debt

IT: Flash revenue and “equity increases” with animation

Equity increases

100,000

60,000

40,000

Revenues less COGS = $40,000 Gross Profit.

Interest is not considered as regular day to day revenue

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Investments Investing in the form of debt

illustration #1

105,000

60,000

45,000

Adding interest revenue results in a $45,000 gross profit.

illustration #2

100,000

60,000

40,000

100,000

60,000

40,000

5,000

No change

“If you cannot measure it, you cannot manage it”

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Investments Investing in the form of debt

IT: flash No Change with arrow

Large font and bold

IT: flash $5,000

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+1,000 (Cr)

+1,000 (Dr)

When interest is received in the same month in which it is earned, cash increases together with equity ( revenue earned).

Investments Investing in the form of debt

Equity increases

Interest is not always received at the end of every month but must still be recognized.

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+1,000 (Cr)

+1,000 (Dr)

+1,000 (Dr)Since interest owing is not a regular Accounts Receivable which should be used for trade receivables only.

Investments Investing in the form of debt

IT: Move this down slowly with Animation 2

If the interest amounts are material then a special subsidiary ledger can be set up to carefully control amounts owing.

IT: fade out the $1,000 on cash when presenting the accounts receivable $1,000 with animation #2

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Test your knowledge

Exercise: Invest $10,000 on January 1st. $100 interest is earned but will not be received until February 3rd. Which of the following is correct?

Dr. Accounts receivable, Cr. Revenue –equity increases

Cr. Accounts receivable, Dr. Revenue – equity increases

Dr. Other Assets, Cr. Other Revenue – equity increases

Dr. Other Assets, Cr. Other Revenue – no change to equity

Investments

Since the interest due is not a trade receivable, it is recorded as Other Assets and since the revenue is not regarded as day to day trading revenue, it is regarded as Interest Revenue. Equity increases because the value of the assets increased.

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Test your knowledge

In February, $100 of interest that was accrued in January is actually paid in February. Which of the following is correct?

Dr. Cash, Cr. Interest Revenue –equity increases

Cr. Accounts receivable, Dr. Cash – equity increases

Dr. Cash, Cr. Other Revenue – equity increases

Dr. Cash, Cr. Other Assets – no change to equity

Investments

When collecting amounts owing, there is no change to equity because one asset is exchanged for another asset. (Other assets exchanged with cash).

No change to equity

Animate after answer

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Investments

A common way of investing cash is in the form of bonds.

The primary difference between traditional loans and bonds.

Bonds are bought on sold on the open market.

Traditional loans are negotiated directly between the parties on an individual bases.

Debt investments

A traditional loan involves the lending of money to another person or business.

Bonds are loans made to institutions like businesses or municipalities.

One asset is exchanged for another asset therefore no change to equity:

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Investments Debt investments

Bonds are bought and sold through brokers in exchange for a fee (brokerage fee)

There are two ways to record the brokerage fee.

1. Capitalize the brokerage fees by adding the fee to the cost of the bond

- 10,500 (Cr)

+ 10,500 (Dr)

Equity decreases by $500

- 10,500 (Cr)

+ 10,000 (Dr)

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Investments Investing in the form of debt

+ 500 (Dr)

If the business buys and sells bonds on a regular bases it is better to expense the fees so they can be tracked on the income statement.

The GAAP Rule of Consistency requires that one method or the other should be used.

2. Expense the brokerage fee

IT: Flash the $500 with A1

Since the brokerage fee is capitalized, the cost of the bond and the brokerage fee is recorded as an asset with no change to equity

Dr. Cash $104,000, Cr. Investment $104,000 Equity decreases by $4,000

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Investments Test your knowledge

Invest $100,000 in the form of bonds and pay $4,000 for brokerage fees which are to be capitalized. Which of the following is correct?

Cr. Cash $104,000, Dr. Investment $104,000 Equity increases by $4,000

Cr. Cash $104,000, Dr. Investment $104,000 No change to equity

Dr. Cash $104,000, Cr. Investment $100,000 & Dr Brokerage fee expense $4,000 Equity decreases by $4,000

The brokerage fee is expensed under Other Expenses because brokerage fees are not part of day to day operations. Only the expense of $300 decreases equity.

Dr. Cash $10,000, Cr. Investment $10,000 Equity decreases by $300

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Investments Test your knowledge

Invest $10,000 in the form of bonds and pay $300 for brokerage fees which are to be expensed. Which of the following is correct?

Cr. Cash $10,300, Dr. Investment $10,300 Equity increases by $300

Cr. Cash $ 10,300, Dr. Investment $ 10,300 No change to equity

Dr. Cash $ 10,300, Cr. Investment $ 10,000 & Dr Other Expense $300 Equity decreases by $300

Animate after answer

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Investments Investing in the form of bonds

Value of Bond$100,000

Bearing interest of 12% per annum

($1,000 per month)

January 1,000 February 1,000 March 1,000 April 1,000 May 1,000 June 1,000 July 1,000 August 1,000 September 1,000 October 1,000 November 1,000 December 1,000

When a bond is purchased, it is “linked” to interest receivable until the bond matures. (IT: highlight all months)

If the bond is purchased on the first day of January and interest is paid every 6 months, then the bond holder will have earned $6,000 interest. (IT: highlight all months)

If the bond is purchased on the last day of January and interest is paid every 6 months, then the bond holder will earn $5,000 interest. (IT: highlight Feb – June)

The bond holder will still receive all 6 months worth of interest but one months worth of interest has not been earned. IT: highlight arrow and not earned

Not earned

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Companies normally pay interest twice a year on bonds. What if bonds are purchased between interest payment dates?

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-100,000 (Cr)

Buy $100,000 in bonds on January 31st. The bonds yield interest payments of 12% paid semi annually on June 30 and December 31st.

Investments

1. Pay $100,000 for the bonds. (IT: flash the $100,000 entries on the left)

+100,000 (Dr)

Investing in the form of bonds

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Investments Investing in the form of bonds

+ 6,000 (Dr)On June 30th you will receive the first interest payment of $6,000 but only $5,000 of the interest has been earned. (February to June).

$6,000 profit

If the full amount of $6,000 is not adjusted, it will overstate the profit.

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Investments Investing in the form of bonds

Reminder: The seller had already earned the $1,000 interest relating to January, which was included in the selling price of the bond.

-100,000 (Cr)

$100,000 was paid for the bond

$100,000 (Dr)

-1,000 (Cr) “overpayment”

$1,000 was paid for interest attached to the bond (Interest for January)

No change to equity

+1,000 (Dr)

To offset the “overpayment”, and to balance the balance sheet, a temporary account is debited which will be cleared when the payment is actually received on June 30th.

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Combining the two transactions into a compound journal entry.

Investments

+1,000 (Dr)

+101,000 (Cr)

+100,000 (Dr)

Investing in the form of bonds

Debit CreditInvestment 100,000 Other assets 1,000 Cash 101,000

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When $6,000 interest is received in June only $5,000 will have been earned (February to June).

Investments

+1,000 (Dr)

+ 6,000 (Dr)

1. Receive a payment of $6,000 relating to 6 months of interest attached to the bond.

+5,000 (Cr)

2. Only $5,000 should be recognized (interest revenue)

Reminder: Other assets was only used as a temporary account to offset the $1,000 interest paid. This was necessary to keep the balance sheet in balance.

Investing in the form of bonds

-1,000 (Cr)

Other assets is now zero

3. Offset Other Assets to clear the account with no impact to equity.

Profit increased $5,000

“Overpayment” which needs to

be cleared

IT: flash with A1

IT: flash with A2

IT: flash with A3

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+ 6,000 (Dr)

+100,000 (Dr) Debit CreditCash 6,000 Revenue 5,000 Other assets 1,000

Summary of journal entry

+ 5,000 (Cr)

-1,000 (Cr)

Summary of debt investment (Maybe better to create this in PDF format)

1. Excess cash is invested outside the business to attract a higher rate of return than lying unused in the business.

2. The cash can be invested in the form of debt or equity. Debt investments expect the loan to be repaid with interest. Equity is in the form of ownership with the expectation of sharing in the profits and/or making a profit on the principle amount invested.

3. Interest on loans and bonds do not always correspond to the date in which they are earned but must still be recognized as earned revenue.

5. When a bond is purchased between the interest payment dates, the interest that is not earned is paid to the seller when buying the bond. The amount is adjusted when the interest payment is made.

4. Brokerage fees can be capitalized or expensed depending on the material value of the fees.

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Investments

Moodle exercises

Investments Investing in the form of equity

WHAT YOU WILL LEARN IN THIS CHAPTER:

Purpose and classification of short term investmentsTypes of short term investments

Debt investmentsBond purchasesEquity investments

Controls for short-term investmentsEthics related to short-term investments

Investments Investing in the form of equity

New York Stock Exchange Toronto Stock Exchange Tokyo Stock Exchange

Equity investment involves buying ownership in the form of shares usually in publicly traded companies.

The buyer of the shares expects to receive their share of the profits called a dividend and also hope to make a profit when selling the shares.

Investments Investing in the form of equity

We are now going to change the manner in which the exercises are done.Chad, we need to demonstrate this. Let’s discuss.

Investments Investing in the form of equity

When buying shares in a company, the investment is recorded in the same manner as a bond.

Brokerage fees can be capitalized

Brokerage fee

IT: Fade out this arrow before animation 2

Brokerage fees can also be expensed

Brokerage fee

Investments Investing in the form of equity

Invest $100,000 worth of shares in Trimore Manufacturers and add $3,000 relating to brokers fees which are to be capitalized.

Debit CreditInvestment 103,300 Cash 103,300

IT: click on cash and investment

Investments Investing in the form of equity

Trimore Manufacturing informs you that you are to receive a dividend of $5,000 relating to this period but will only receive the cash next period. Record the journal entry.

Dividends earned but not received.

IT: click other assets and other revenue

Debit CreditOther assets 5,000 Interest revenue 5,000

Investments Investing in the form of equity

Change to the value of the share.

The GAAP Rule of Conservatism requires that the value of a share not be recorded at a higher price than paid before being sold.

100,000

Shares will often increase and decrease in value on a daily basis.

IT: fade out the “up” arrows before presenting the “down” arrows

Conversely equity decreases as the value of the shares decrease (Unrealized Loss)

Equity increases as the value of the shares increase, (Unrealized Gain)

Investments Investing in the form of equity

The value of the investment decreased from $103,000 to $102,000. Adjust your records with the correct journal entry

The loss is called “unrealized” because the shares have not yet been sold.

Decreasing the value of the shares.

IT: click other expenses and and investment

Debit CreditOther expenses 1,000 Investment 1,000

Investments Investing in the form of equity

Increasing the value of the shares.

The value of the investment ended last month with a value of $102,000. The market has improved increasing the value of the shares by $500. Make the appropriate adjustment.

The gain is called “unrealized” because the shares have not actually been sold.

IT: click other assets and other revenue

Debit CreditInvestment 500 Other revenue 500

Investments Investing in the form of equity

This month the value of the shares increased by another $1,500. The value of the investment at the end of last month was $102,500. keeping in mind that the original cost was $103,000 make the correct adjustment.

The GAAP Rule of Conservatism requires that until the shares are sold the value cannot be recorded at a higher value than the original cost

Increasing the value of the shares.

Debit CreditInvestment 500 Other revenue 500

IT: click other assets and other revenue

Investments Investing in the form of equity

The next month the shares that are valued on the books for $103,000 are finally sold for $105,000 less a $3,000 brokerage fee which is to be capitalized. Make the appropriate entry.

The brokerage fees created a loss on the sale of the investment which is recorded as Other Expenses

Increasing the value of the shares.

IT: click cash, other assets and other expenses

Debit CreditCash 102,000 Loss on sale of investment 1,000 Investment 103,000

Investments Investing in the form of equity

Summary PDF followed by Boodle quiz