1. Chapter 15 Investments Skyline College Lecture Notes

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

3. 15–3 Copyright © Houghton Mifflin Company. All rights reserved. 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

4. 15–4 Copyright © Houghton Mifflin Company. All rights reserved. How Are Investments Classified? Short-Term InvestmentsLong-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 securitiesAvailable-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

5. 15–5 Copyright © Houghton Mifflin Company. All rights reserved. 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

6. 15–6 Copyright © Houghton Mifflin Company. All rights reserved. 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

7. 15–7 Copyright © Houghton Mifflin Company. All rights reserved. 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.

8. 15–8 Copyright © Houghton Mifflin Company. All rights reserved. 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

9. 15–9 Copyright © Houghton Mifflin Company. All rights reserved. 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:

10. 15–10 Copyright © Houghton Mifflin Company. All rights reserved. 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 $80,000 in value. Record the adjustment in value at year end: SecurityMarket Value CostGain (Loss) IBM (10,000 shares)$ 800,000$ 900,000 Microsoft (10,000 shares)320,000300,000 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.

11. 15–11 Copyright © Houghton Mifflin Company. All rights reserved. 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. 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.

12. 15–12 Copyright © Houghton Mifflin Company. All rights reserved. Year-End Adjustment for Trading Securities SecurityMarket ValueCostGain (Loss) IBM$ 950,000$ 900,000 Apple116,000128,000 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. Assume that Jackson’s portfolio of trading securities appears as follows at the end of 20x8:

13. 15–13 Copyright © Houghton Mifflin Company. All rights reserved. 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:

14. 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

15. 15–15 Copyright © Houghton Mifflin Company. All rights reserved. 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. Investment: Available-for-Sale Securities Illustrated

16. 15–16 Copyright © Houghton Mifflin Company. All rights reserved. Dec. 31, 20x7: The market price of Herald and Taza stock at year end is $21 and $17 respectively. Year-End Adjustment: Total Cost – Total Market Value = $325,000 – $295,000 = $30,000 Available-for-Sale Securities Illustrated (cont’d)

17. 15–17 Copyright © Houghton Mifflin Company. All rights reserved. April 1, 20x8: Change in policy required sale of 2,000 shares of Herald Corporation common stock at $23. Available-for-Sale Securities Illustrated (cont’d) 2,000 x $23 = $46,000 2,000 x $25 = 50,000 Loss $ 4,000

18. 15–18 Copyright © Houghton Mifflin Company. All rights reserved. July 1, 20x8: Received cash dividend from Taza Corporation equal to $0.20 per share. Available-for-Sale Securities Illustrated (cont’d)

19. 15–19 Copyright © Houghton Mifflin Company. All rights reserved. Dec. 31, 20x8: The market price at year end for Herald and Taza stock is $24 and $13, respectively. 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. Available-for-Sale Securities Illustrated (cont’d)

20. 15–20 Copyright © Houghton Mifflin Company. All rights reserved. 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 Method 1.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.

21. 15–21 Copyright © Houghton Mifflin Company. All rights reserved. On January 1, ITO Corporation acquired 40 percent of the voting stock of Quay Corporation for $180,000. Equity Method Illustrated During the year, Quay Corporation reported net income of $80,000 and paid cash dividends of $20,000.

22. 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.

23. 15–23 Copyright © Houghton Mifflin Company. All rights reserved. Consolidated Balance Sheet Purchase Method A way to prepare consolidated financial statements in which similar accounts from separate statements of the parent and subsidiaries are combined Subsidiary Parent 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.

24. 15–24 Copyright © Houghton Mifflin Company. All rights reserved. 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

25. 15–25 Copyright © Houghton Mifflin Company. All rights reserved. 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). 100 Percent Purchase at Book Value We will use this balance sheet information to prepare a consolidated balance sheet under the purchase method.

26. 15–26 Copyright © Houghton Mifflin Company. All rights reserved. Work Sheet for Preparing a Consolidated Balance Sheet

27. 15–27 Copyright © Houghton Mifflin Company. All rights reserved. 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.

28. 15–28 Copyright © Houghton Mifflin Company. All rights reserved. Purchase at More or Less Than Book Value Reasons to pay more than book value Parent wants to purchase a controlling interest in subsidiary Subsidiary has something parent wants Such as a new process, market, different product, etc. Reasons to pay less than book value Subsidiary’s assets are not worth their depreciated cost Subsidiary may have suffered heavy losses Causing its stock to sell at low prices

29. 15–29 Copyright © Houghton Mifflin Company. All rights reserved. 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)

30. 15–30 Copyright © Houghton Mifflin Company. All rights reserved. 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 subsidiary Other income and expense from intercompany transactions What kinds of intercompany transactions affect the consolidated income statement?

31. 15–31 Copyright © Houghton Mifflin Company. All rights reserved. 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)

32. 15–32 Copyright © Houghton Mifflin Company. All rights reserved. Worksheet for Preparing a Consolidated Income Statement

33. 15–33 Copyright © Houghton Mifflin Company. All rights reserved. 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.

34. 15–34 Copyright © Houghton Mifflin Company. All rights reserved. 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. On Dec. 31, accrue the interest earned as follows:

35. 15–35 Copyright © Houghton Mifflin Company. All rights reserved. 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:

36. 15–36 Copyright © Houghton Mifflin Company. All rights reserved. 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