1. A ccounting Principles, 6e Weygandt, Kieso, & Kimmel Prepared by Marianne Bradford, Ph.D. Bryant College John Wiley & Sons, Inc.

2. After studying this chapter, you should be able to: 1 Discuss why corporations invest in debt and stock securities. 2 Explain the accounting for debt investments. 3 Explain the accounting for stock investments. 4 Describe the use of consolidated financial statements. 5 Indicate how debt and stock investments are valued and reported on the financial statements. 6 Distinguish between short-term and long-term investments. CHAPTER 17 INVESTMENTS

3. PREVIEW OF CHAPTER 17 Investments Why Corporations Invest Accounting for Debt Investments Recording acquisition of bonds Recording bond interest Recording sale of bonds   

4. PREVIEW OF CHAPTER 17 Investments Accounting for Stock Investments Holdings less than 20% Holdings between 20% and 50% Holdings of more than 50%    Valuation and Reporting of Investments Categories of securities Balance sheet presentation Realized and unrealized gain or loss Comprehensive balance sheet    

5. STUDY OBJECTIVE 1 Discuss why corporations invest in debt and stock securities.

6. ILLUSTRATION 17-1 TEMPORARY INVESTMENTS AND THE OPERATING CYCLE Cash Temporary Investments Accounts Receivable Inventory Invest Sell  At the end of their operating cycles, many companies may have temporarily idle cash on hand until the start of the next operating cycle.  These companies may invest the excess funds to earn a greater return.  The relationship of temporary investments to the operating cycle is depicted below.

7. ILLUSTRATION 17-2 WHY CORPORATIONS INVEST ReasonTypical Investment To house excess cash until needed Low-risk, high-liquidity, short- term securities such as government-issued securities To generate earnings I need 1,000 Treasury bills by tonight! Debt securities (banks and other financial institutions); and stock securities (mutual funds and pension funds) To meet strategic goals Stocks of companies in a related industry or in an unrelated industry that the company wishes to enter

8. STUDY OBJECTIVE 2 Explain the accounting for debt investments.

9. ACCOUNTING FOR DEBT INVESTMENTS RECORDING AQUISITION OF BONDS Debt investments are investments in government and corporation bonds. In accounting for debt investments, entries are required to record the 1 acquisition, 2 interest revenue, and 3 sale. At acquisition – the cost principle applies. Cost includes all expenditures necessary to acquire these investments. Kuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2002, for $54,000, including brokerage fees of $1,000. The entry to record the investment is: 54,000

10. ACCOUNTING FOR DEBT INVESTMENTS RECORDING BOND INTEREST The bonds pay $3,000 interest on July 1 and January 1 ($50,000 x 12% x ½). The July 1 entry is: It is necessary to accrue $3,000 interest earned since July 1 at year-end. The December 31 entry is: 3,000 DateAccount Titles and ExplanationDebitCredit Dec. 31Interest Receivable Interest Revenue (To accrue interest on Doan Inc. bonds) 3,000

11. ACCOUNTING FOR DEBT INVESTMENTS RECORDING BOND INTEREST When the interest is received on January 1, the entry is: 3,000

12. ACCOUNTING FOR DEBT INVESTMENTS RECORDING SALE OF BONDS Any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds is recorded as a gain or loss. Kuhl Corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2003, after receiving the interest due. Since the securities cost $54,000, a gain of $4,000 has been realized. The entry to record the sale is: 58,000 54,000 4,000

13. STUDY OBJECTIVE 3 Explain the accounting for stock investments.

14. ILLUSTRATION 17-3 ACCOUNTING GUIDELINES FOR STOCK INVESTMENTS Stock investments are investments in the capital stock of corporations. When a company holds stock or debt of various corporations, the group of securities is identified as an investment portfolio.

15. RECORDING STOCK INVESTMENTS HOLDINGS LESS THAN 20% In accounting for stock investments of less than 20%, the cost method is used. Under the cost method, the investment is recorded at cost, and revenue is recognized only when cash dividends are received. On July 1, 2002, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is: 40,500

16. RECORDING STOCK INVESTMENTS HOLDINGS LESS THAN 20% Entries are required for any cash dividends received during the time the stock is held. If a $2 per share dividend is received by Sanchez Corporation on December 31, the entry is: Dividend Revenue is reported under Other Revenue and Gains in the income statement. Since dividends do not accrue, adjusting entries are not made to accrue dividends. 2,000

17. RECORDING STOCK INVESTMENTS HOLDINGS LESS THAN 20% When stock is sold, the difference between the net proceeds from the sale and the cost of the stock is recognized as a gain or loss. Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation common stock on February 10, 2003. Because the stock cost $40,500, a loss of $1,000 has been incurred. The entry to record the sale is: DateAccount Titles and ExplanationDebit Credit Feb. 10Cash Loss on Sale of Stock Investments Stock Investments (To record sale of Beal common stock) 39,500 1,000 40,500

18. ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20% AND 50% When an investor owns between 20% and 50% of the common stock of a corporation, the investor has significant influence over the financial and operating activities of the investee. Under the equity method, the investment in common stock is initially recorded at cost, and the investment account is adjusted annually to show the investor’s equity in the investee. Each year, the investor 1) debits the investment account and credits revenue for its share of the investee’s net income and 2) credits dividends received to the investment account.

19. ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20% AND 50% Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2002. The entry to record this transaction is: 120,000

20. ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20% AND 50% Beck reports 2002 net income of $100,000 and declares and pays a $40,000 cash dividend. Milar is required to record 1) its share of Beck’s net income, $30,000 (30% X $100,000) and 2) the reduction in the investment account for the dividends received, $12,000 ($40,000 X 30%). The entries are: 30,000 12,000

21. ILLUSTRATION 17-4 INVESTMENT AND REVENUE ACCOUNTS AFTER POSTING After posting the transactions for the year, the investment and revenue accounts will show the above results. During the year, the investment account has increased by $18,000 which represents Milar’s 30% equity in the $60,000 increase in Beck’s retained earnings ($100,000 - $40,000). Milar will also report $30,000 of revenue from its investment, which is 30% of Beck’s net income of $100,000. Milar would report only $12,000 (30% X $40,000) of dividend revenue if the cost method were used.

22. RECORDING STOCK INVESTMENTS HOLDINGS OF MORE THAN 50%  A company that owns more than 50% of the common stock of another entity is known as a parent company.  The entity whose stock is owned by the parent company is called the subsidiary (affiliated) company.  The parent company is perceived to have a controlling interest in the subsidiary due to its stock ownership.  When one company owns more than 50% of the common stock of another company, consolidated financial statements are usually prepared.

23. RECORDING STOCK INVESTMENTS MANAGEMENT PERSPECTIVE Controlling Group Home Box Office Board of Directors Time Warner, Inc. Board of Directors Home Box Office Corporation Time Warner, Inc. Control Separate Legal Entities Single Economic Entity Time Warner, Inc. own 100% of the common stock of Home Box Office (HBO). The common stockholders of Time Warner elect the board of directors of the company, who, in turn, select the officers and managers of the company. The Board of Directors controls the property owned by the corporation, which includes the common stock of HBO.

24. STUDY OBJECTIVE 4 Indicate how debt and stock investments are valued and reported on the financial statements.

25. ILLUSTRATION 17-5 VALUATION GUIDELINES Trading We’ll sell within ten days. Available-for-Sale We’ll hold the stock for a while to see how it performs. Held-to-Maturity We intend to hold these bonds until maturity. At fair value with changes reported in net income At fair value with changes reported in the stockholders’ equity section At amortized cost Fair value is the amount for which a security could be sold in a normal market and offers the best approach at investment valuation since it represents the expected cash realizable value of the securities.

26. CATEGORIES OF SECURITIES For purposes of valuation and reporting at a financial statement date, debt and stock investments are classified into the following THREE categories of securities: 1) Trading securities are securities bought and held primarily for sale in the near term to generate income on short-term price differences. 2) Available-for-sale securities are securities that may be sold in the future. 3) Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.

27. ILLUSTRATION 17-6 VALUATION OF TRADING SECURITIES  Trading securities are 1) held with the intention of selling them in a short period (generally less than a month), and 2) are reported at fair value, and changes from cost are reported as part of net income.  The changes are reported as unrealized gains or losses since the securities have not been sold. The unrealized gain or loss is the difference between the total cost of trading securities and their total fair value.  Pace Corporation has the following costs and fair values for its investments classified as trading securities:

28. VALUATION AND REPORTING OF INVESTMENTS — TRADING SECURITIES Pace Corporation has an unrealized gain of $7,000 because total fair value ($147,000) is $7,000 greater than total cost ($140,000). Fair value and the unrealized gain or loss are recorded through an adjusting entry at the time financial statements are prepared. A valuation allowance account, Market Adjustment - Trading, is used to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Pace Corporation is: 7,000

29. 1 The fair value of the securities is the amount reported on the balance sheet. 2 The unrealized gain is reported on the income statement in the Other Revenues and Gains section. 3 The unrealized loss is reported on the income statement in the Other Expenses and Losses section. VALUATION AND REPORTING OF INVESTMENTS — TRADING SECURITIES

30. ILLUSTRATION 17-7 VALUATION OF AVAILABLE- FOR-SALE SECURITIES  Available-for-sale securities are 1) held with the intention of selling them in the near future, and 2) are reported at fair value, and changes from cost are reported as a component of stockholders equity.  The changes are reported as unrealized gains or losses since the securities have not been sold.  The unrealized gain or loss is the difference between the total cost of the securities in the category and their total fair value.  Elbert Corporation has the following costs and fair values for its investments classified as available-for-sale securities:

31. VALUATION AND REPORTING OF INVESTMENTS AVAILABLE-FOR-SALE SECURITIES Elbert Corporation has an unrealized loss of $9,537 because total fair value ($284,000) is $9,537 less than total cost ($293,537). Fair value and the unrealized gain or loss are recorded through an adjusting entry at the time financial statements are prepared. A valuation allowance account, Market Adjustment - Available-for-Sale, is used to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Elbert Corporation is: 9,537

32. VALUATION AND REPORTING OF INVESTMENTS AVAILABLE-FOR-SALE SECURITIES 1 The fair value of the securities is the amount reported on the balance sheet. 2 The unrealized gain or loss is reported as a separate component of stockholders’ equity.

33. STUDY OBJECTIVE 5 Distinguish between short-term and long-term investments.

34. SHORT-TERM INVESTMENTS  Short-term investments 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.  An investment is readily marketable when it can be sold easily whenever the need for cash arises.  Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer.

35. ILLUSTRATION 17-8 PRESENTATION OF SHORT- TERM INVESTMENTS  Short Term investments are listed immediately below cash in the current asset section of the balance sheet due to their liquidity.They are reported at fair value.

36. ILLUSTRATION 17-9 NONOPERATING ITEMS RELATED TO INVESTMENTS  Long-term investments are typically reported in a separate section of the balance sheet immediately below current assets.  In the income statement, the items below are reported in the nonoperating section:  Long-term investments are typically reported in a separate section of the balance sheet immediately below current assets.  In the income statement, the items below are reported in the nonoperating section:

37. ILLUSTRATION 17-10 UNREALIZED LOSS IN STOCKHOLDERS’ EQUITY SECTION  An unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders’ equity.  Dawson Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000.  The statement presentation of the unrealized loss is shown below.  An unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders’ equity.  Dawson Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000.  The statement presentation of the unrealized loss is shown below.

38. ILLUSTRATION 17-11 COMPREHENSIVE BALANCE SHEET The comprehensive balance sheet for Pace Corporation includes the following assets: 1 Short-term Investments, 2 Investments of less than 20%, and 3 Investments of 20% - 50%. The comprehensive balance sheet for Pace Corporation includes the following assets: 1 Short-term Investments, 2 Investments of less than 20%, and 3 Investments of 20% - 50%. Total property, plant, and equipment 926,000 Intangible assets Goodwill (Note 1) 170,000 Total intangible assets 170,000 Total assets $ 1,710,000

39. The comprehensive balance sheet for Pace Corporation includes the following element of stockholders’ equity: Unrealized Gain on Available-for-Sale Securities. ILLUSTRATION 17-11 COMPREHENSIVE BALANCE SHEET

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41. CHAPTER 17 INVESTMENTS