investments and fair value accounting

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Investments and

Investments and

Fair Value Fair Value

AccountingAccounting

Chapter 15Chapter 15Chapter 15Chapter 15

Learning ObjectivesLearning Objectives

1.1. Describe why companies invest in debt and Describe why companies invest in debt and equity securities.equity securities.

2.2. Describe and illustrate the accounting for debt Describe and illustrate the accounting for debt investments.investments.

3.3. Describe and illustrate the accounting for equity Describe and illustrate the accounting for equity investments.investments.

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

5.5. Describe fair value accounting and its Describe fair value accounting and its implications for the future.implications for the future.

6.6. Describe and illustrate the computation of Describe and illustrate the computation of dividend yield.dividend yield.


Learning Learning Objective

ObjectiveDescribe why companies invest

Describe why companies invest

in debt and equity securities.

in debt and equity securities.

11

Investing Cash in Current OperationsInvesting Cash in Current Operations

o Cash may be used to replace worn-out Cash may be used to replace worn-out equipment or to purchase new, more equipment or to purchase new, more efficient, and productive equipment. efficient, and productive equipment.

o Cash may be reinvested in the company to Cash may be reinvested in the company to expand its current operations. expand its current operations.

o Cash may be used to pay suppliers or Cash may be used to pay suppliers or other creditors.other creditors.

Investing Cash in Temporary Investing Cash in Temporary InvestmentsInvestmentso Instead of letting excess cash remain idle Instead of letting excess cash remain idle

in a checking account, most companies in a checking account, most companies invest this cash in securities such as:invest this cash in securities such as: Debt securitiesDebt securities, which are notes and bonds , which are notes and bonds

that pay interest and have a fixed maturity that pay interest and have a fixed maturity date. date.

Equity securitiesEquity securities, which are preferred and , which are preferred and common stock that represent ownership in a common stock that represent ownership in a company and do not have a fixed maturity company and do not have a fixed maturity date.date.

Investing Cash in Temporary Investing Cash in Temporary InvestmentsInvestmentso These debt securities and equity securities These debt securities and equity securities

are termed are termed InvestmentsInvestments, or , or Temporary Temporary InvestmentsInvestments, and are reported in the , and are reported in the Current Assets section of the balance Current Assets section of the balance sheet. sheet.

Investing Cash in Temporary Investing Cash in Temporary InvestmentsInvestmentso The primary objective of investing in The primary objective of investing in

temporary investments is to:temporary investments is to: earn interest incomeearn interest income

receive dividendsreceive dividends

realize gains from increases in the market price realize gains from increases in the market price of the securities. of the securities.

Investing Cash in Long-Term Investing Cash in Long-Term InvestmentsInvestmentso Long-term investments often involve the Long-term investments often involve the

purchase of a significant portion of the purchase of a significant portion of the stock of another company. Such stock of another company. Such investments have a strategic purpose:investments have a strategic purpose: Reduction of costsReduction of costs

Replacement of managementReplacement of management

ExpansionExpansion

IntegrationIntegration



ObjectiveDescribe and illustrate the

Describe and illustrate the

accounting for debt investments.

accounting for debt investments.

22

Purchase of BondsPurchase of Bonds

o Homer Company purchases $18,000 of Homer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March Reserve Bank at their par value on March 17, 2014, plus accrued interest for 45 17, 2014, plus accrued interest for 45 days. The bonds have an interest rate of days. The bonds have an interest rate of 6%, payable on July 31 and January 31, 6%, payable on July 31 and January 31, 2015. 2015.

$18,000 × 6% × (45/360)

Interest RevenueInterest Revenue

o On July 31, Homer Company receives a On July 31, Homer Company receives a semiannual interest payment of $540 semiannual interest payment of $540 ($18,000 × 6% × 1½). The $540 interest ($18,000 × 6% × 1½). The $540 interest includes $135 of accrued interest that includes $135 of accrued interest that Homer Company purchased with the Homer Company purchased with the bonds on March 17.bonds on March 17.

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

(continued)

INTEREST INTEREST REVENUEREVENUE

INTEREST INTEREST REVENUEREVENUE


o Homer Company’s accounting period ends Homer Company’s accounting period ends on December 31. Thus, an adjusting entry on December 31. Thus, an adjusting entry must be made to accrue interest for five must be made to accrue interest for five months. The following adjusting entry months. The following adjusting entry records the accrued interest:records the accrued interest:

$18,000 × 6% × 5/12


o For the year ended December 31, 2014, For the year ended December 31, 2014, Homer Company would report Interest Homer Company would report Interest revenue of $855 ($405 + $450) as part of revenue of $855 ($405 + $450) as part of Other income on the income statement.Other income on the income statement.


o Homer Company receives interest of $540 Homer Company receives interest of $540 on January 31, 2015. Notice that Interest on January 31, 2015. Notice that Interest Receivable is credited for $450 to reflect Receivable is credited for $450 to reflect that this amount is a receivable from that this amount is a receivable from 2014. Interest Revenue of $90 is the 2014. Interest Revenue of $90 is the interest earned from January 1 through interest earned from January 1 through January 31, 2015.January 31, 2015.

Sale of BondsSale of Bonds

o On January 31, 2015, Homer Company On January 31, 2015, Homer Company sells the Treasury bonds at 98. The sale sells the Treasury bonds at 98. The sale results in a loss of $360.results in a loss of $360.

Proceeds from sale Proceeds from sale ($18,000 × 98%) ($18,000 × 98%) $17,640$17,640

Less book value (cost)Less book value (cost) of the bonds of the bonds 18,000 18,000

Loss on sale of bondsLoss on sale of bonds $ (360)$ (360)

Reported as part of Other income (loss) on the income statement

Sale of BondsSale of Bonds

o There is no accrued interest upon the sale There is no accrued interest upon the sale since the interest payment date is also since the interest payment date is also January 31. The entry to record the sale is January 31. The entry to record the sale is as follows:as follows:





accounting for equity

accounting for equity investments.

investments.

33

Accounting for Equity InvestmentsAccounting for Equity Investments

o A company may invest in the preferred or A company may invest in the preferred or common stock of another company. The common stock of another company. The company investing in another company’s company investing in another company’s stock is thestock is the investorinvestor. .

o The company whose stock is purchased is The company whose stock is purchased is the the investee.investee.

ACCOUNTING ACCOUNTING FOR EQUITY FOR EQUITY

INVESTMENTSINVESTMENTS

Less Than 20% OwnershipLess Than 20% Ownership

o Investments of less than 20% of the Investments of less than 20% of the investee’s outstanding stock are investee’s outstanding stock are accounted for by using the accounted for by using the cost methodcost method. . Under the cost method, entries are Under the cost method, entries are recorded for the following transactions:recorded for the following transactions: Purchase of stockPurchase of stock

Receipt of dividendsReceipt of dividends

Sale of stockSale of stock

Purchase of StockPurchase of Stock

o On May 1, Bart Company purchases 2,000 On May 1, Bart Company purchases 2,000 shares of Lisa Company common stock at shares of Lisa Company common stock at $49.90 per share plus a brokerage fee of $49.90 per share plus a brokerage fee of $200. $200.

Receipt of DividendsReceipt of Dividends

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

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

Sale of StockSale of Stock

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

The gain is reported as part of Other income on Bart Company’s income statement.

Between 20%─50% OwnershipBetween 20%─50% Ownership

o If the investor purchases between 20% If the investor purchases between 20% and 50% of the outstanding stock of the and 50% of the outstanding stock of the investee, the investor is considered to investee, the investor is considered to have significant influence over the have significant influence over the investee, and the investment is accounted investee, and the investment is accounted for using the for using the equity methodequity method..

Between 20%─50% OwnershipBetween 20%─50% Ownership

o Under the equity method, the investment Under the equity method, the investment account is adjusted for the investor’s account is adjusted for the investor’s share of the share of the net income net income and and dividends dividends of of the investee. These adjustments are as the investee. These adjustments are as follows:follows: Net income: Recorded as an increase in the Net income: Recorded as an increase in the

investment account. investment account.

Dividends: Decrease the investment account.Dividends: Decrease the investment account.

Purchase of StockPurchase of Stock

Simpson Inc. purchased a 40% interest in Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on Flanders Corporation’s common stock on January 2, 2014 for $350,000.January 2, 2014 for $350,000.

Recording Investee Net IncomeRecording Investee Net Income

For the year ended December 31, 2014, For the year ended December 31, 2014, Flanders Corporation reported net income of Flanders Corporation reported net income of $105,000.$105,000.

Income of Flanders Corporation Income of Flanders Corporation may be may be reported separately or as part of reported separately or as part of Other Other IncomeIncome on Simpson Inc.’s income statement. on Simpson Inc.’s income statement.

Recording Investee DividendsRecording Investee Dividends

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

RECORDING RECORDING INVESTEE INVESTEE

DIVIDENDSDIVIDENDS

Sale of StockSale of Stock

On January 1, 2015, Simpson Inc. sold On January 1, 2015, Simpson Inc. sold Flanders Corporation’s stock for $400,000, a Flanders Corporation’s stock for $400,000, a gain of $26,000, calculated as follows:gain of $26,000, calculated as follows:

More Than 50% OwnershipMore Than 50% Ownership

o If the investor purchases more than 50% If the investor purchases more than 50% of the outstanding stock of the investee, of the outstanding stock of the investee, the investor is considered to have control the investor is considered to have control over the investee. The purchase is termed over the investee. The purchase is termed a a business combinationbusiness combination..

More Than 50% OwnershipMore Than 50% Ownership

o A corporation owning all or a majority of A corporation owning all or a majority of the voting stock of another corporation is the voting stock of another corporation is called a called a parent companyparent company. The corporation . The corporation that is controlled is called the that is controlled is called the subsidiary subsidiary companycompany..

o At the end of the year, the financial At the end of the year, the financial statements of the parent and subsidiary statements of the parent and subsidiary are combined, and are combined, and consolidated financialconsolidated financial statementsstatements are issued. are issued.



ObjectiveDescribe and illustrate valuing

Describe and illustrate valuing

and reporting investments in the

and reporting investments in the

financial statements.

financial statements.

44

Trading SecuritiesTrading Securities

o Trading securitiesTrading securities are debt and equity are debt and equity securities that are purchased and sold to securities that are purchased and sold to earn short-term profits from changes in earn short-term profits from changes in their market prices.their market prices.


o Trading securities are reported as current Trading securities are reported as current assets on the balance sheet.assets on the balance sheet.

o Trading securities are valued as a portfolio Trading securities are valued as a portfolio (group) of securities using their fair (group) of securities using their fair values. values. Fair valueFair value is the market price that is the market price that would be received for a security if it were would be received for a security if it were sold.sold.

o Changes in fair value of the portfolio are Changes in fair value of the portfolio are recognized as an recognized as an unrealizedunrealized gaingain or or lossloss for the period.for the period.


o Maggie Company purchased a portfolio of Maggie Company purchased a portfolio of trading securities during 2014. On trading securities during 2014. On December 31, 2014, the cost and fair December 31, 2014, the cost and fair values of the securities were as follows:values of the securities were as follows:


o The adjusting entry on December 31, The adjusting entry on December 31, 2014, to record the fair value of the 2014, to record the fair value of the securities ($25,300) is as follows: :securities ($25,300) is as follows: :

Unrealized Gain on Trading Investments is reported on the income statement.

TRADING TRADING SECURITIESSECURITIES

Available-for-Sale SecuritiesAvailable-for-Sale Securities

o Available-for-sale securitiesAvailable-for-sale securities are debt and are debt and equity securities that are neither held for equity securities that are neither held for trading, held to maturity, nor held for trading, held to maturity, nor held for strategic reasons.strategic reasons.


o Maggie Company purchased three Maggie Company purchased three securities during 2014 as available-for-sale securities during 2014 as available-for-sale securities. On December 31, 2014, the securities. On December 31, 2014, the cost and fair values of the securities were cost and fair values of the securities were as follows:as follows:


o On December 31, the adjusting entry On December 31, the adjusting entry credits a stockholders’ equity account credits a stockholders’ equity account instead of an income statement account. instead of an income statement account. The $1,300 increase in fair value is The $1,300 increase in fair value is credited to Unrealized Gain (Loss) on credited to Unrealized Gain (Loss) on Available-for-Sale Investments.Available-for-Sale Investments.

Added to current Added to current assetsassetsAdded to Added to

stockholders’ equitystockholders’ equity

AVAILABLE-AVAILABLE-FOR-SALE FOR-SALE

SECURITIESSECURITIES

Equal

Held-To-Maturity SecuritiesHeld-To-Maturity Securities

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

SUMMARYSUMMARY



ObjectiveDescribe fair value accounting

Describe fair value accounting

and its implications for the

and its implications for the future.future.

55

Fair Value AccountingFair Value Accounting

o Fair valueFair value is the price that would be is the price that would be received for selling an asset or paying off received for selling an asset or paying off a liability.a liability.

o Fair value assumes that the asset is sold Fair value assumes that the asset is sold or the liability is paid off under or the liability is paid off under normalnormal rather than distressed conditions.rather than distressed conditions.

Trends to Fair Value AccountingTrends to Fair Value Accounting

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

Trends to Fair Value AccountingTrends to Fair Value Accounting

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

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

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

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

Trend to Fair Value AccountingTrend to Fair Value Accounting

o Potential disadvantages of using fair Potential disadvantages of using fair values:values: Fair values may not be readily obtainable for Fair values may not be readily obtainable for

some assets or liabilities.some assets or liabilities.

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

Using fair values could result in more Using fair values could result in more fluctuations in accounting reports because fair fluctuations in accounting reports because fair values change from year to year.values change from year to year.

Statement Effect of Fair Value Statement Effect of Fair Value AccountingAccounting

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

Balance SheetBalance Sheet. The unrealized gain or loss on . The unrealized gain or loss on changes in fair value must also be recorded. changes in fair value must also be recorded. One method reports these as part of One method reports these as part of stockholders’ equity on the balance sheet.stockholders’ equity on the balance sheet.

(continued)

Statement Effect of Fair Value Statement Effect of Fair Value AccountingAccountingo Income StatementIncome Statement. Instead of recording . Instead of recording

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





computation of dividend yield.

computation of dividend yield.

66

Dividend Yield =Dividends per Share of Common Stock

Market Price per Share of Common Stock

News CorporationNews Corporation:

Dividend Yield =$0.19

$16.98= 1.1%

Dividend YieldDividend Yield

o The The dividend yielddividend yield measures the rate of measures the rate of return to stockholders based on cash return to stockholders based on cash dividends distributed. Dividend yield is dividends distributed. Dividend yield is calculated as follows:calculated as follows:


AppendixAppendix

Comprehensive

Comprehensive

IncomeIncome

Comprehensive

Comprehensive

IncomeIncome

Comprehensive IncomeComprehensive Income

o Comprehensive incomeComprehensive income is defined as all is defined as all changes in stockholders’ equity during a changes in stockholders’ equity during a period, except those resulting from period, except those resulting from dividends and stockholders’ investments.dividends and stockholders’ investments.


o Other comprehensive income Other comprehensive income items items include unrealized gains and losses on include unrealized gains and losses on available-for-sale securities as well as available-for-sale securities as well as other items such as foreign currency and other items such as foreign currency and pension liability adjustments.pension liability adjustments.

o The cumulative effect of other The cumulative effect of other comprehensive income is reported on the comprehensive income is reported on the balance sheet, as balance sheet, as accumulated other accumulated other comprehensive incomecomprehensive income..


o Companies may report comprehensive Companies may report comprehensive income in the financial statements as income in the financial statements as follows:follows: On the income statementOn the income statement

In a separate statement of comprehensive In a separate statement of comprehensive incomeincome

In the statement of stockholders’ equityIn the statement of stockholders’ equity

COMPREHENSICOMPREHENSIVE INCOMEVE INCOME


Investments and

Investments and

Fair Value Fair Value

AccountingAccounting

The EndThe EndThe EndThe End

investments and fair value accounting

Documents

debt investments

investing cash

equity investments

equity securities

excess cash

termed investments

reporting investments

learning objectivedescribe