slide 12-1 chapter 12 investments judith paquette financial accounting, seventh edition

1

Chapter 12

InvestmentsInvestmentsJudith Paquette Judith Paquette

Financial Accounting, Seventh Edition

2

1. Discuss why corporations invest in debt and stock securities.

2. Explain the accounting for debt investments.

3. Explain the accounting for stock investments.

5. Indicate how debt and stock investments are reported in financial statements—valuing investments

6. Distinguish between short-term and long-term investments.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Note: Learning objective #4 is not included.

3

Corporations generally invest in debt or stock securities for one of three reasons.

Why Corporations InvestWhy Corporations InvestWhy Corporations InvestWhy Corporations Invest

1. Corporation may have excess cash.

2. To generate earnings from investment income.

3. For strategic reasons. Illustration 12-1

Temporary investments

and the operating

cycle

4

They have Excess Cash $$$$$$$$$$They have Excess Cash $$$$$$$$$$They have Excess Cash $$$$$$$$$$They have Excess Cash $$$$$$$$$$

If you have excess cash, it should be working for you! (working = earning interest $$$$$$$$)

But, it needs to be readily available when you need it (a “rainy day” fund)

Hence: invest in low risk funds that can be liquidated

quickly

5

They want to generate earnings from They want to generate earnings from investment incomeinvestment incomeThey want to generate earnings from They want to generate earnings from investment incomeinvestment income

Maybe liquidity isn’t an issue….they want to benefit from dividends and stock

appreciation. So they invest in mutual funds and stocks.

6

For Strategic Reasons—buying a For Strategic Reasons—buying a relatedrelated company companyFor Strategic Reasons—buying a For Strategic Reasons—buying a relatedrelated company company

Buying a large amount of stock in a company gives the company a certain amount of stock votes…even without a

controlling interest, it gives the company an influence.

Which company?-a related industry – e.g., Taco Bell buys stock in

Chipotle, its competitor… WHY invest in your

competitor?

7

For Strategic Reasons –to For Strategic Reasons –to influenceinfluenceFor Strategic Reasons –to For Strategic Reasons –to influenceinfluence

To expand its influence in its own industry.

Which company? -a related industry – e.g., Taco Bell buys stock in Chipotle, its competitor… WHY invest in your competitor?

8

For Strategic Reasons—buying an For Strategic Reasons—buying an unrelatedunrelated company companyFor Strategic Reasons—buying an For Strategic Reasons—buying an unrelatedunrelated company company

It still gives you some influence, but also something else.

An Unrelated industry– e.g., Taco Bell buys stock

in….Pfizer (pharmaceutical)…tacos and

drugs….hmmmm….WHY would they do that?

9

For Strategic Reasons- to DIVERSIFYFor Strategic Reasons- to DIVERSIFYFor Strategic Reasons- to DIVERSIFYFor Strategic Reasons- to DIVERSIFY

Diversifying its investment in different industries allows the company to (possibly) face less market risk by not putting all its investment in the same industry… If fast food sales go down, drug sales may not be affected as much.

An Unrelated industry– e.g., Taco Bell buys stock in…Pfizer (pharmaceutical)…tacos and drugs…. ….WHY would they do that?

10

INVESTING IN ANOTHER COMPANYINVESTING IN ANOTHER COMPANYINVESTING IN ANOTHER COMPANYINVESTING IN ANOTHER COMPANY

You have TWO choices:

1.DEBT – LOAN $$ TO A COMPANY - BUY BONDS2.EQUITY – BECOME AN OWNER - BUY STOCK

How do you make money with your investments?

11

INVESTING – earning moneyINVESTING – earning moneyINVESTING – earning moneyINVESTING – earning money

You have TWO choices:

1.DEBT – Interest Revenue (new account)2.EQUITY 2 ways:

1. Dividends paid2. Stock Appreciation (buy at a lower price, sell at a

higher price)

How does a company report its investments?

12

INVESTING – ReportingINVESTING – ReportingINVESTING – ReportingINVESTING – Reporting

INVESTMENTS are ASSETS (could be long term on short term) with a NORMAL BALANCE of DEBIT.You must clearly understand the difference between:

The Company’s own stock or bonds sold = •Common Stock, Equity, normal balance = credit or•Bonds Payable, LT Liabilties, normal balance = credit

The Company’s investment in another company’s stock or debt purchased = Investments, Assets, normal balance = debit

AND

13

13

Investments in government and corporation bonds. Investments in government and corporation bonds.

In accounting for debt investments, the required In accounting for debt investments, the required entries to record:entries to record:the acquisition the acquisition the interest revenuethe interest revenuethe salethe sale

Accounting for Debt InvestmentsAccounting for Debt InvestmentsAccounting for Debt InvestmentsAccounting for Debt Investments

14

Accounting for Debt Investments – Accounting for Debt Investments – AcquisitionAcquisitionAccounting for Debt Investments – Accounting for Debt Investments – AcquisitionAcquisition

SO 2 Explain the accounting for debt investments.SO 2 Explain the accounting for debt investments.

Recording Acquisition of Bonds

Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

Note: Bonds are recorded at acquisition cost, NOT face value.

15

Accounting for Debt Investments– Bond Accounting for Debt Investments– Bond InterestInterestAccounting for Debt Investments– Bond Accounting for Debt Investments– Bond InterestInterest

Recording Bond Interest

Calculate and record interest revenue based upon the FACE value of the bond times the interest rate times the portion of the year the bond is outstanding.

Face Value: $1,000 for each bondContract Interest Rate: 7% (for example)

Annual interest revenue = 1,000 * .07 = $70

16

Accounting for Debt InvestmentsAccounting for Debt InvestmentsAccounting for Debt InvestmentsAccounting for Debt Investments

Sale of Bonds

Credit the investment account for the cost of the bonds and record as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds.

Note: if you only sell some of the bonds, you need to prorate the cost.

If you go back to the chapter on Long Term Assets, this is the same as how we

retire an asset…

17

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:

Accounting for Debt Instruments – example - Accounting for Debt Instruments – example - AcquisitionAcquisition


18

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000.

The entry to record the investment is:

Debt Investments 54,000

Cash 54,000



Jan. 1

Question: What type of account is Debt Investments?

An asset account,

normal balance = debit

Hint: watch the wording, if it said “plus a brokerage fee of $1,000” the entry would

be for $55,000.

19

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year,

$1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1.

The entry for the receipt of interest on July 1 is:

Accounting for Debt Instruments - Accounting for Debt Instruments - interestinterestAccounting for Debt Instruments - Accounting for Debt Instruments - interestinterest

*

20

Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is:

Accounting for Debt Instruments - Accounting for Debt Instruments - interestinterestAccounting for Debt Instruments - Accounting for Debt Instruments - interestinterest

Cash 2,000

Interest revenue 2,000

* ($50,000 x 8% x ½ = $2,000)

*July 1

Question: What type of account is Interest Revenue?

A revenue account,

normal balance = credit

21

Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1.

Accounting for Debt Instruments-year end Accounting for Debt Instruments-year end interest accrual and paymentinterest accrual and paymentAccounting for Debt Instruments-year end Accounting for Debt Instruments-year end interest accrual and paymentinterest accrual and payment

Kuhl reports receipt of the interest on January 1 as follows.

22

Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1.

Accounting for Debt Instruments-year end Accounting for Debt Instruments-year end interest accrual and paymentinterest accrual and paymentAccounting for Debt Instruments-year end Accounting for Debt Instruments-year end interest accrual and paymentinterest accrual and payment

Interest receivable 2,000

Interest revenue 2,000

Kuhl reports receipt of the interest on January 1 as follows.

Cash 2,000

Interest receivable 2,000

Dec. 31

Jan. 1

23

Illustration: Assume that Kuhl corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2011, after receiving the interest due. Prepare the entry to record the sale of the bonds.

Accounting for Debt Instruments – sale of investmentAccounting for Debt Instruments – sale of investmentAccounting for Debt Instruments – sale of investmentAccounting for Debt Instruments – sale of investment

Cash 58,000

Debt investments 54,000

Gain on sale of investments 4,000

Jan. 1

24

Let’s Practice: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees). Record:

a)Jan 1 - The acquisitionb)Jul 1 - The first semiannual interest revenuec)Dec 31 The accrual of the second interest revenue.

Record these transactions for 2011

Accounting for Debt Instruments – practiceAccounting for Debt Instruments – practiceAccounting for Debt Instruments – practiceAccounting for Debt Instruments – practice

25

Let’s Practice: Assume that Jubilee Farms has only these bonds and three years have passed. It is now 2014

a)Jan 1 – Received the semiannual interestb)Jan 1 – Sold $70,000 of Whole Food bonds at 112. The broker charged $1,500 in fees.c)Jul 1 - Received semiannual interest revenued)Dec 31 The accrued semiannual interest revenue.

Record these transactions for 2014

Accounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continued

See End of Power Points for Solution

26

Accounting for Stock InvestmentsAccounting for Stock InvestmentsAccounting for Stock InvestmentsAccounting for Stock Investments

Investor's Ownership Interest in another Company Influence Accounting

Less than 20% Insignificant

The accounting depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation.

Between 20-50% Significant

More than 50% CONTROLLING!

27

For this class, you are ONLY responsible for learning about holdings of Less than 20%


When do you get to learn about:Holdings between 20-50%?Holdings of OVER 50%?

In greater detail:--Intermediate Accounting--Advanced Accounting

--or….you can read about it in the textbook as a more general topic…

28

Companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received. --This is similar to debt investments

Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions).

Holdings of Less than 20%


29

29

Investments in a corporation’s common stock. Investments in a corporation’s common stock.

In accounting for common stock investments, the In accounting for common stock investments, the required entries to record:required entries to record:the acquisition the acquisition the dividend revenuethe dividend revenuethe salethe sale


30

Holdings of Less than 20% - Holdings of Less than 20% - acquisitionacquisitionHoldings of Less than 20% - Holdings of Less than 20% - acquisitionacquisitionIllustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 pershare plus brokerage fees of $500. The entry for the purchase is:

31

July 1

Holdings of Less than 20% - Holdings of Less than 20% - acquisitionacquisitionHoldings of Less than 20% - Holdings of Less than 20% - acquisitionacquisitionIllustration: On July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Kali Corporation common stock. Sanchez pays $40 pershare plus brokerage fees of $500. The entry for the purchase is:

Stock investments 40,500

Cash 40,500

32 SO 3 Explain the accounting for stock investments.SO 3 Explain the accounting for stock investments.

Holdings of Less than 20% - dividends Holdings of Less than 20% - dividends earnedearnedHoldings of Less than 20% - dividends Holdings of Less than 20% - dividends earnedearned

Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:

33

Dec. 31

Holdings of Less than 20% - dividends Holdings of Less than 20% - dividends earnedearnedHoldings of Less than 20% - dividends Holdings of Less than 20% - dividends earnedearned

Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:

Cash 2,000

Dividend revenue 2,000

34

Holdings of Less than 20% - sale of Holdings of Less than 20% - sale of stockstockHoldings of Less than 20% - sale of Holdings of Less than 20% - sale of stockstockIllustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:

35

Feb. 10

Holdings of Less than 20% - sale of Holdings of Less than 20% - sale of stockstockHoldings of Less than 20% - sale of Holdings of Less than 20% - sale of stockstockIllustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:

Cash 39,500

Loss on sale of stock 1,000

Stock investments 40,500

37

Let’s Practice: Frank’s Produce Conglomerate Company had the following transactions pertaining to stock investments.

Feb. 1 - Purchased 500 shares of Jordan Company common stock (2% ownership position) for $5,000 cash, plus brokerage fees of $250.

July 1 - Received cash dividends of $1 per share on Jordan common stock.

Sept. 1 - Sold 250 shares of Jordan common stock for $3,000, less brokerage fees of $75.

Dec. 1 - Received cash dividends of $1 per share on Jordan common stock.

Record these transactions

Accounting for Stock Instruments – practice - Accounting for Stock Instruments – practice - continuedcontinued

Accounting for Stock Instruments – practice - Accounting for Stock Instruments – practice - continuedcontinued


38

Valuing and Reporting InvestmentsValuing and Reporting InvestmentsValuing and Reporting InvestmentsValuing and Reporting Investments

Categories of Securities

Companies classify debt and stock investments

into three categories:

Trading securities

Available-for-sale securities

Held-to-maturity securities

These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%.

39


Trading Securities

Companies hold trading securities with the

intention of selling them in a short period.

Trading means frequent buying and selling, e.g.,

“day trading.”

Companies report trading securities at fair value,

and report changes from cost as part of net

income. This is called “mark to market” because

it adjusts the value of the trading security to the

market price.

40

TRADING SECURITIES – TRADING SECURITIES – ALERT!ALERT!TRADING SECURITIES – TRADING SECURITIES – ALERT!ALERT!

Trading Securities

Because they are valued at FAIR VALUE….

This is a departure from the Cost Principle (see

Chapter 1 where assets are recorded at their historic cost)

The change in trading securities’ “fair value”

affects net income, even though they haven’t

been sold!

This is called an “unrealized gain or loss”, but it

still affects net income.

41


Available-for-Sale Securities

Companies hold available-for-sale securities with the intent of selling these investments sometime in the future.

These securities can be classified as current assets or as long-term assets, depending on the intent of management.

Companies report securities at fair value, and report changes from cost as a component of the stockholders’ equity section—does NOT impact net income

42

Illustration: Pace Company invests in two stocks classified as trading securities. On December 31, 2011 (when its fiscal year ends, it classified these securities at their current fair value:.

Trading Securities - exampleTrading Securities - exampleTrading Securities - exampleTrading Securities - example

The adjusting entry for Pace Corporation is:Dec. 31Market adjustment—trading 7,000

Unrealized gain—income 7,000

43

Problem: How would the entries change if the securities were classified as available-for-sale?

The entries would be the same except that the

Unrealized Gain or Loss—Equity account is used instead

of Unrealized Gain or Loss—Income.

The unrealized loss would be deducted from the

stockholders’ equity section rather than charged to the

income statement.

Available-for-Sale SecuritiesAvailable-for-Sale SecuritiesAvailable-for-Sale SecuritiesAvailable-for-Sale Securities

44

Illustration: Assume that Ingrao Corporation has two securities that it classifies as available-for-sale.

The adjusting entry for Ingrao Corporation is:

Dec. 31Unrealized gain or loss—equity 9,537

Market adjustment—available-for-sale 9,537

Illustration 12-8

Available-for-Sale Securities - Available-for-Sale Securities - ExampleExampleAvailable-for-Sale Securities - Available-for-Sale Securities - ExampleExample

45

Too many accounts?Too many accounts?Too many accounts?Too many accounts?

Remember:

If it is a GAIN, it will be a credit balance (like revenue)

If it is a LOSS, it will be a debit balance (like expense)

If it is a GAIN or LOSS account, its balance will vary (debit for Loss, credit for Gain.

46

Remember the earlier practice problem: Jubilee Farms acquires $200,000, Whole Food Market, Inc. 7%, 10-year bonds on January 1, 2011, at face value directly from the company (no brokerage fees).

Now, let’s add the Year-end adjustment.

Accounting for Debt Instruments – JUBILEE FARMS - Accounting for Debt Instruments – JUBILEE FARMS - continuedcontinued

Accounting for Debt Instruments – JUBILEE FARMS - Accounting for Debt Instruments – JUBILEE FARMS - continuedcontinued

47

Let’s Practice: On December 31, 2011: Assume that the FAIR VALUE of the bonds on Dec 31, 2011 WAS $192,000. These bonds are categorized as “available-for-sale securities.

Prepare the adjusting journal entry for 2011.

Accounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continuedAccounting for Debt Instruments – practice - continued


49

Also called marketable securities, are securities

held by a company that are

(1) readily marketable and

(2) intended to be converted into cash within the

next year or operating cycle, whichever is

longer.

Short-Term Investments

Investments that do not meet both criteria are classified as long-term investments.

Balance Sheet Presentation


Long-Term Investments

50

Nonoperating items related to investments

Presentation of Realized and Unrealized Gain or Loss

Income Statement Presentation – Income Statement Presentation – Gains/LossesGains/LossesIncome Statement Presentation – Income Statement Presentation – Gains/LossesGains/Losses

Non Operating section of Income Statement

Other Revenue and Gains: Other Expenses and Losses:

Interest Revenue Loss on Sale of Debt Investments

Dividend Revenue Loss on Sale of Stock Investments

Gain on Sale of Debt Investments Unrealized Loss - Income

Gain on Sale of Stock Investments

Unrealized Gain - Income

51

Realized and Unrealized Gain or Loss

Balance Sheet Presentation – Avail. For Balance Sheet Presentation – Avail. For SaleSaleBalance Sheet Presentation – Avail. For Balance Sheet Presentation – Avail. For SaleSale

Unrealized gain or loss on available-for-sale securities are reported as a separate component of stockholders’ equity.

Illustration 12-11

52

Classified Balance Sheet (partial)

Illustration 12-12

53

Good Bye and Good Luck.

End of Chapter 12End of Chapter 12End of Chapter 12End of Chapter 12

Solutions to Coursepack problems to follow

54

SOLUTION TO JUBILEE FARMS: a) 2011

Jan. 1 Debt Investments 200,000Cash 200,000

To record purchaseJuly 1 Cash ($200,000 X .07 X 1/2) 7,000

Interest Revenue 7,000To record dividends Dec. 31 Interest Receivable 7,000

Interest Revenue 7,000To record dividends accrual

2014Jan. 1 Cash 7,000

Interest Receivable 7,000To record dividends payment

1 Cash [($70,000 X 1.12) – $1,500] 76,900Debt Investments 70,000Gain on Sale of Debt Investments 6,900

To record sales of bonds.July 1 Cash ($130,000 X .07 X 1/2) 4,550

Interest Revenue 4,550To record dividends Dec. 31 Interest Receivable 4,550

Interest Revenue 4,550To record dividends accrual

(b) 2011Dec. 31 Unrealized Gain or Loss—Equity 8,000

Market Adjustment— Available-for-Sale 8,000

To record market adjustment of bonds

55

SOLUTION TO FRANK’S PRODUCE CONGLOMERATE:

(a) Feb. 1 Stock Investments 5,250Cash ($5,000 + $250) 5,250

To record purchaseJuly 1 Cash (500 X $1) 500

Dividend Revenue 500To record dividend payment

Sept. 1 Cash ($3,000 – $75) 2,925Stock Investments ($5,250 X 1/2) 2,625Gain on Sale of Stock Investments ($2,925-2,625) 300

To record sale of stock

Dec. 1 Cash (250 X $1) 250Dividend Revenue 250

To record dividend payment

slide 12-1 chapter 12 investments judith paquette financial accounting, seventh edition

Documents