Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Appendix D Investments in Other Corporations PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

App D-2 Why Do Companies Invest? 1.Companies transfer excess cash into investments to produce higher income. Some companies are set up to produce income from investments. 2.Companies use investments to even out seasonal fluctuations in cash. Such investments in securities are referred to as passive investment. 3.Some companies invest with the purpose of influencing, but not controlling another company’s policies and activities. 4.Managers may want to control another company, either by purchasing it directly or by becoming a majority shareholder. 1.Companies transfer excess cash into investments to produce higher income. Some companies are set up to produce income from investments. 2.Companies use investments to even out seasonal fluctuations in cash. Such investments in securities are referred to as passive investment. 3.Some companies invest with the purpose of influencing, but not controlling another company’s policies and activities. 4.Managers may want to control another company, either by purchasing it directly or by becoming a majority shareholder.

App D-3 Passive investments are made to earn a high rate of return on funds that may be needed in the future. This category includes debt securities (bonds and notes) and equity securities (stock). Passive Equity Investments Presumed to be passive if the investing company owns less than 20% of the other company’s outstanding voting shares. Passive Debt Investments Investments in debt securities are always considered to be passive. Measure and report using the Fair Value Method Hold to Maturity? Measure and report at Amortized Cost Yes No Passive Investments in Debt and Equity Securities

App D-4 Active investments are those in which a company owns enough stock in another business to influence or control that business. Significant influence is presumed to exist if the investing company owns from 20 to 50% of the outstanding voting shares. The equity method is used to measure and report this type of active investment. Investments in Stock for Significant Influence

App D-5 Investments in Stock for Control Control is the ability to determine the operating and financial policies of another company through ownership of its voting stock. For all practical purposes, control is presumed when the investing company owns more that 50% of the outstanding voting stock. These investments are accounted for by combining the two companies using the acquisition method and preparing consolidated financial statements.

App D-6 Summary of Investment Types

App D-7 Debt Investments Held to Maturity: Amortized Cost Method Assume that on October 1, 2013, Washington Post Company paid the face value of $100 million for 8% bonds due to mature on October 1, The 8% interest is paid each September 30 th. Management plans and has the ability to hold the bonds for five years, until they mature. 1 Analyze Liabilities Assets = Stockholders’ Equity + Held-to-Maturity Investments +100 Cash Record dr Held-to-Maturity Investments (+A) cr Cash (-A)100

App D-8 Debt Investments Held to Maturity: Amortized Cost Method On December 31, 2013, Washington Post Company will prepare an adjusting entry to accrue interest for three months (since the October 1 purchase) ($100 million × 8% × 3/12 = $2 million). 1 Analyze Liabilities Assets = Stockholders’ Equity + Interest Receivable +2Interest Revenue (+R) +2 2 Record dr Interest Receivable (+A) cr Interest Revenue (+R, +SE)2 2

App D-9 Debt Investments Held to Maturity: Amortized Cost Method On September 30, 2014, Washington Post Company will receive a full year of interest. Revenue recognized in 2014 is ($100,000,000 × 8% × 9/12). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash +8 Interest Receivable -2 Interest Revenue (+R) +6 2 Record dr Cash (+A) cr Interest Receivable (-A) cr Interest Revenue (+R, +SE)

App D-10 Debt Investments Held to Maturity: Amortized Cost Method On October 1, 2018, Washington Post Company will receive the principal amount of the investment as the bonds mature. If the bond investment were sold before maturity, any difference between the fair value and the net book value is reported as a gain or loss on sale in the income statement. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash +100 Held-to-Maturity Investments Record dr Cash (+A) cr Held-to-Maturity Investments (-A)100

App D-11 Securities Available for Sale: Fair Value Method Classifying Passive Investments Trading Securities Trading securities are traded actively, with the objective of generating short-term profits on changes in the securities price. They are classified as current assets on the balance sheet. Trading Securities Trading securities are traded actively, with the objective of generating short-term profits on changes in the securities price. They are classified as current assets on the balance sheet. Available-for-Sale Securities Most companies do not actively trade the securities of other companies. They invest to earn a return on funds they may need in the near future. These securities may be classified as either current assets or noncurrent assets depending on the intent of management to sell them within one year.

App D-12 Recording and Reporting Available-for-Sale Securities On January 2, 2013, Washington Post purchased 1,000,000 shares of Internet Financial News (IFN) common stock for $60 per share paying $60,000,000. The 1,000,000 shares represents 10% of the outstanding shares. This investment would be treated as a passive investment. 1 Analyze Liabilities Assets = Stockholders’ Equity + Available-for-Sale Securities +60 Cash Record dr Available-for-Sale Securities (+A) cr Cash (-A)60

App D-13 Recording and Reporting Available-for-Sale Securities Investments in equity securities earn a return from two sources: (1) increase in the market price and (2) dividend income. On December 15, 2013, Washington Post received a $1 per share cash dividend from IFN totaling $1,000, Analyze Liabilities Assets = Stockholders’ Equity + Cash +1Dividend Revenue (+R) +1 2 Record dr Cash (+A) cr Dividend Revenue (+R, +SE)1 1

App D-14 Recording and Reporting Available-for-Sale Securities At the end of the accounting period, passive investments are reported on the balance sheet at their fair value. On December 31, 2013, IFN stock was trading at $58 per share in the open market. 2 Record dr Net Unrealized Losses/Gains (-SE) cr Available-for-Sale Securities (-A)2 2 1 Analyze Liabilities Assets = Stockholders’ Equity + Available-for-Sale Securities -2 Net Unrealized Losses/Gains -2

App D-15 Recording and Reporting Available-for-Sale Securities Now let’s assume that Washington Post held the IFN securities through the year At the end of 2014, the stock had a market value of $61 per share. On December 31, 2014, we must make an adjusting entry to state the investment at fair value. 1 Analyze Liabilities Assets = Stockholders’ Equity + Available-for-Sale Securities +3 Net Unrealized Losses/Gains +3 2 Record dr Available-for-Sale Securities (+A) cr Net Unrealized Losses/Gains (+SE)3 3

App D-16 Recording and Reporting Available-for-Sale Securities Now let’s assume that on March 17, 2015,Washington Post sold all of its investment in IFN for $64 per share. The company receives $64 million in cash ($64 x 1,000,000 shares) for stock purchased at $60 million in 2013 ($60 x 1,000,000 shares). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash +64 Available-for-Sale Securities -61 Net Unrealized Losses/Gains -1 Gain on Sale of Investments (+R) +4 2 Record dr Cash (+A) dr Net Unrealized Losses/Gains (-SE) cr Available-for-Sale Securities (-A) cr Gain on Sale of Investments(+R, +SE)

App D-17 Comparing Available-For-Sale and Trading Securities The impact of unrealized holding gains or losses on the financial statements depends on whether an investment is a trading security or a security available-for-sale. Available-for-Sale Securities The unrealized gain (loss) on investments account is reported as a separate component of stockholders’ equity, under Accumulated Other Comprehensive Income. It is not reported on the income statement and does not affect net income. Available-for-Sale Securities The unrealized gain (loss) on investments account is reported as a separate component of stockholders’ equity, under Accumulated Other Comprehensive Income. It is not reported on the income statement and does not affect net income. Trading Securities The unrealized gain (loss) is included in each period’s income statement. Holding gains increase income and holding losses decrease net income. The unrealized gain (loss) account is closed to retained earnings at the end of the period. Trading Securities The unrealized gain (loss) is included in each period’s income statement. Holding gains increase income and holding losses decrease net income. The unrealized gain (loss) account is closed to retained earnings at the end of the period.

App D-18 { In some cases, influence or control may exist with less than 20% ownership. Investor Ownership of Investee Shares Outstanding 0%20%50%100% Cost or Fair Value Method Equity Method Consolidated Financial Statements Accounting for Influential Investments

App D-19 { Significant influence is generally assumed with 20% to 50% ownership. Investor Ownership of Investee Shares Outstanding 0%20%50%100% Equity Method Consolidated Financial Statements Accounting for Influential Investments Cost or Market Value Method

App D-20 Recording Investments Under the Equity Method

App D-21 Recording Investments Under the Equity Method In 2013, Washington Post purchased 4,000,000 shares of the outstanding voting stock of Internet Financial News (IFN) for $240 million cash. Washington Post purchased 40% of the voting stock of IFN and was presumed to have significant influence over the affiliate. 1 Analyze Liabilities Assets = Stockholders’ Equity + Investments in Affiliates +240 Cash -240 Net Unrealized Losses/Gains +3 2 Record dr Investments in Affiliates (+A) cr Cash (-A)240

App D-22 Recording Investments Under the Equity Method In 2013, IFN reported net income of $50,000,000. Washington Post’s share of net income is $20,000,000 (40% × $50,000,000). The journal entry is: 1 Analyze Liabilities Assets = Stockholders’ Equity + Investments in Affiliates +20 Equity In Affiliate Earnings (+R) Record dr Investments in Affiliates (+A) cr Equity in Affiliate Earnings (+R, +SE)20

App D-23 Investments with Controlling Interests: Consolidated Statements Required when investor’s ownership exceeds 50% of investee. 1. Vertical integration. One company acquires another company that operates on a different level in the distribution channel. 2. Horizontal growth. Companies operate on the same level of the distribution channel. 3. Synergy. Two companies operating together may be more profitable than two companies operating separately.

App D-24 What are Consolidated Statements? When one company purchases all the assets and liabilities of another company and the acquired company goes out of existence, the acquisition is called a merger. When the acquired company remains in business, the company that gains control over it by acquiring all or a majority of the voting stock is called the parent company. The other company is called a subsidiary company. When one company acquires another, results of their operations must be reported together, in consolidated statements. Consolidated financial statements combine the operations of two or more companies into a single set of statements usually identified by the term “consolidated” in the statement title.

App D-25 End of Appendix D