Investments and Fair Value Accounting Chapter 15

Learning Objective 1 Describe why companies invest in debt and equity securities.

Investing Cash in Current Operations Cash may be used to replace worn-out equipment or to purchase new, more efficient, and productive equipment. Cash may be reinvested in the company to expand its current operations. Cash may be used to pay suppliers or other creditors.

Investing Cash in Temporary Investments Instead of letting excess cash remain idle in a checking account, most companies invest this cash in securities such as: Debt securities, which are notes and bonds that pay interest and have a fixed maturity date. Equity securities, which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

Investing Cash in Temporary Investments These debt securities and equity securities are termed Investments, or Temporary Investments, and are reported in the Current Assets section of the balance sheet.

Investing Cash in Temporary Investments The primary objective of investing in temporary investments is to: earn interest income receive dividends realize gains from increases in the market price of the securities.

Investing Cash in Long-Term Investments Long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments have a strategic purpose: Reduction of costs (e.g. reduce administrative expenses) Replacement of management (e.g. if the purchased company has been mismanaged) Expansion Integration (by acquiring a supplier or customer)

Learning Objective 2 Describe and illustrate the accounting for debt investments.

Purchase of Bonds Most companies invest excess cash in bonds as investments to earn interest revenue. Homer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March 17, 2014, plus accrued interest for 45 days. The bonds have an interest rate of 6%, payable on July 31 and January 31, 2015. $18,000 × 6% × (45/360)

Interest Revenue On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × 1½). The $540 interest includes $135 of accrued interest that Homer Company purchased with the bonds on March 17. ($540 – $135) or [$18,000 × 6% × (135/360)]

INTEREST REVENUE

Interest Revenue Homer Company’s accounting period ends on December 31. Thus, an adjusting entry must be made to accrue interest for five months. The following adjusting entry records the accrued interest: $18,000 × 6% × 5/12

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

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

Sale of Bonds If the proceeds from the sale > book value (cost) Gain If the proceeds from the sale < book value (cost) Loss On January 31, 2015, Homer Company sells the Treasury bonds at 98. The sale results in a loss of $360. Proceeds from sale ($18,000 × 98%) $17,640 Less book value (cost) of the bonds 18,000 Loss on sale of bonds $ (360)

Sale of Bonds There is no accrued interest upon the sale since the interest payment date is also January 31. The entry to record the sale is as follows: Reported as part of Other income (loss) on the income statement

Learning Objective 3 Describe and illustrate the accounting for equity investments.

Accounting for Equity Investments A company may invest in the preferred or common stock of another company. The company investing in another company’s stock is the investor. The company whose stock is purchased is the investee.

Less Than 20% Ownership Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method. Under the cost method, entries are recorded for the following transactions: Purchase of stock Receipt of dividends Sale of stock

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

Receipt of Dividends On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company. Dividend Revenue is reported as part of Other Income on Bart Company’s income statement.

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

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

H.W: PE 15-1A , PE 15-1B PE15-2A , PE15-2B

Investments and Fair Value Accounting The End