Financial Accounting, 3e Weygandt, Kieso, & Kimmel Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee John Wiley & Sons, Inc. 1

CHAPTER 13 INVESTMENTS After studying this chapter, you should be able to: 1 Identify the reasons corporations invest in stocks and debt securities. 2 Explain the accounting for debt investments. 3 Explain the accounting for stock investments. 4 Describe the purpose and usefulness of consolidated financial statements. 5 Indicate how debt and stock investments are valued and reported on the financial statements. 6 Distinguish between temporary and long-term investments.

PREVIEW OF CHAPTER 13 INVESTMENTS Why Corporations Invest Accounting for Debt Investments Holdings of less than 20% Holdings between 20% and 50% Holdings of more than 50% Valuation and Reporting of investments Accounting for Stock Investments Accounting for Stock Investments Recording acquisition of bonds Recording bond interest Recording sale of bonds Categories of securities Balance sheet presentation Realized and unrealized gain or loss Balance sheet

ILLUSTRATION 13-1 TEMPORARY INVESTMENTS AND THE OPERATING CYCLE At the end of their operating cycles, many companies may have temporarily idle cash on hand pending the start of the next operating cycle. Until the cash is needed in operations, these companies may invest the excess funds to earn interest and dividends. The relationship of temporary investments to the operating cycle is depicted below. Cash Temporary Investments Accounts Receivable Inventory Invest Sell 2

ILLUSTRATION 13-2 WHY CORPORATIONS INVEST

TEMPORARY AND LONG-TERM INVESTMENTS Temporary 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. Investments that do not meet both criteria are classified as long-term investments. 3

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES AT ACQUISITION 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, and cost includes all expenditures necessary to acquire these investments. Kuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2001, for $54,000, including brokerage fees of $1,000. The entry to record the investment is: 54,000 54,000 4

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR 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: When the interest is received on January 1, the entry is: 3,000 3,000 5

ACCOUNTING FOR DEBT INVESTMENTS ENTRIES FOR SALE OF BONDS Any difference between the net proceeds (sales price less brokerage fees) from the sale of bonds 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, 2002, 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 6

ILLUSTRATION 13-3 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. 7

ACCOUNTING FOR 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, 2001, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock at $40 per share plus brokerage fees of $50. The entry for the purchase is: 40,500 40,500

ACCOUNTING FOR 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: 2,000 2,000 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. 9

ACCOUNTING FOR 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, 2002. Because the stock cost $40,500, a loss of $1,000 has been incurred. The entry to record the sale is: 39,500 1,000 40,500 17

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20% AND 50% When an investor owns between 20% and 50% of the common stock of a corporation, it is usually presumed that the investor has significant influence over the financial and operating activities of the investee. Subsequently, the investor should record its share of the net income of the investee in the year when it is earned. 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. Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2001. The entry to record this transaction is: 120,000 120,000

ACCOUNTING FOR STOCK INVESTMENTS HOLDINGS BETWEEN 20% AND 50% Beck reports 2001 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 30,000 12,000 12,000 27

ILLUSTRATION 13-4 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.

ACCOUNTING FOR 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.

ILLUSTRATION 13-5 VALUATION GUIDELINES 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. 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 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 10

VALUATION AND REPORTING OF INVESTMENTS For purposes of valuation and reporting at a financial statement date, debt and stock investments are classified into the following 3 categories of securities: 1 Trading securities are securities held with the intention of selling them in a short period of time (generally less than a month). 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.

ILLUSTRATION 13-6 VALUATION OF TRADING SECURITIES Trading securities are held with the intention of selling them in a short period of time (usually less than a month). Trading securities 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 the securities in the category and their total fair value. Pace Corporation has the following costs and fair values for its investments classified as trading securities:

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 7,000 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. 12

ILLUSTRATION 13-7 VALUATION OF AVAILABLE-FOR-SALE SECURITIES Available-for-sale securities are held with the intention of selling them in the near future. Available-for-sale securities 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 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:

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 9,537 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.

ILLUSTRATION 13-9 NONOPERATING ITEMS RELATED TO INVESTMENTS Temporary investments are listed immediately below cash in the current asset section of the balance sheet due to their liquidity. Temporary investments are reported at fair value. 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: 13

ILLUSTRATION 13-10 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. 14

ILLUSTRATION 13-11 COMPREHENSIVE BALANCE SHEET; INVESTMENT RELATED ITEMS IN RED PACE CORPORATION Balance Sheet December 31, 2001 The comprehensive balance sheet for Pace Corporation includes the following assets: 1 Temporary Investments, 2 Investments of less than 20%, and 3 Investments of 20% - 50%. Assets Current assets Cash $ 21,000 Temporary investments, at fair value 60,000 Accounts receivable $ 84,000 Less: Allowance for doubful accounts 4,000 80,000 Merchandise inventory, at FIFO cost 130,000 Prepaid insurance 23,000 Total current assets 314,000 Investments Investment in bonds 100,000 Investments in stock of less than 20% owned companies, at fair value 50,000 Investment in stock of 20% – 50% owned company, at equity 150,000 Total investments 300,000 Property, plant, and equipment Land 200,000 Buildings $ 800,000 Less: Accumulated depreciation 200,000 600,000 Equipment 180,000 Less: Accumulated depreciation 54,000 126,000 Total property, plant, and equipment 926,000 Intangible assets Goodwill (Note 1) 100,000 Patents 70,000 Total intangible assets 170,000 Total assets $ 1,710,000

ILLUSTRATION 13-11 COMPREHENSIVE BALANCE SHEET; INVESTMENT RELATED ITEMS IN RED The comprehensive balance sheet for Pace Corporation includes the following element of stockholders’ equity: Unrealized Gain on Available-for-Sale Securities. Reporting the unrealized gain or loss in the stockholders’ equity section: 1 reduces the volatility of net income due to fluctuations in fair value and 2 still informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value. 15

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