Reporting and Analysing Investments CHAPTER 12

Reasons Companies Invest Illustration 12-1

Investments in money market instruments (short-term) and bonds (long-term)Investments in money market instruments (short-term) and bonds (long-term) In accounting for debt investments, entries are required to record:In accounting for debt investments, entries are required to record: –Acquisition –Interest revenue –Sale Are recorded at cost including brokerage feesAre recorded at cost including brokerage fees Debt Investments

Field Corporation acquires 50 Forbes, Inc. 12%, 10-year, $1,000 bonds on January 1 for $54,000. Acquisition of Bonds Jan. 1 Debt investments Cash Cash54,00054,000 To record purchase of 50 Forbes, Inc. bonds To record purchase of 50 Forbes, Inc. bonds

Bond Interest The bonds pay interest of $3,000 semi-annually on July 1 and January 1. The entry to record the receipt of interest on July 1 is: July 1 Cash Interest Revenue Interest Revenue3,0003,000 To record receipt of interest on Forbes bonds To record receipt of interest on Forbes bonds

Accrued Bond Interest If the buyer’s (Field) fiscal year ends on December 31, the following adjusting entry is needed to accrue interest of $3,000 earned since July 1: Dec. 31 Interest Receivable Interest Revenue Interest Revenue3,0003,000 To accrue interest on Forbes bonds To accrue interest on Forbes bonds

Sale of Bonds Field sells the bonds for $58,000 on January 1, 2005, after receiving the interest due. The bonds were purchased for $54,000. Field must record a gain of $4,000. The entry to record the sale of the bonds is as follows: Jan. 1 Cash Debt Investments Debt Investments Gain on sale of Debt Investments Gain on sale of Debt Investments58,00054,0004,000 To record sale of Forbes bonds

Equity Investments Investments in the share capital (preferred or common) of corporationsInvestments in the share capital (preferred or common) of corporations Accounting for investments in common shares is based on the extent of the investor's degree of influence over the operating and financial affairs of the issuing corporation (the investee)Accounting for investments in common shares is based on the extent of the investor's degree of influence over the operating and financial affairs of the issuing corporation (the investee)

Equity Investments Factors to consider in determining degree of influence are whether:Factors to consider in determining degree of influence are whether: –Investor has representation on the investee's board of directors –Investor participates in the investee's policy-making process –Material transactions exist between the investor and the investee –Common shares that are held by other shareholders are concentrated or dispersed

Accounting Guidelines – Equity Investments Illustration 12-3

Cost Method (Less than 20%) Record investment at costRecord investment at cost Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if anyCost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any Recognize revenue when cash dividends are declaredRecognize revenue when cash dividends are declared

Acquisition of Shares On July 1, 2004, Passera Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common shares at $40 per share, plus brokerage fees of $500. July 1 Equity Investments Cash Cash40,50040,500 To record purchase of 1,000 Beal common shares To record purchase of 1,000 Beal common shares

Dividends Passera Corporation receives $2 per share dividend on December 31. Dec. 31 Cash (1,000 x $2) Dividend Revenue Dividend Revenue2,0002,000 To record receipt of cash dividend To record receipt of cash dividend

Sale of Shares Net Proceeds from the Sale (sales price less brokerage fees) Net Proceeds from the Sale (sales price less brokerage fees) - Cost of the Shares = Gain (Loss)

Sale of Shares Passera Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation shares on February 10, Feb. 10 Cash Loss on Sale of Equity Investments Loss on Sale of Equity Investments Equity Investments Equity Investments 39,5001,000 40,500 To record sale of Beal common shares To record sale of Beal common shares

Equity Method (More than 20%) Investment in common shares is initially recorded at costInvestment in common shares is initially recorded at cost Investment account adjusted annually to show the investor’s equity in the investeeInvestment account adjusted annually to show the investor’s equity in the investee Investor has significant influence over investeeInvestor has significant influence over investee

Acquisition of Shares Milar Corporation acquires 30% of the common shares of Beck Inc. for $120,000 on January 1, Jan. 1 Equity Investments Cash Cash 120, ,000 To record purchase of Beck common shares To record purchase of Beck common shares

Net Earnings (Loss) and Dividends For 2004, Beck reports net earnings of $100,000 and declares and pays a $40,000 cash dividendFor 2004, Beck reports net earnings of $100,000 and declares and pays a $40,000 cash dividend Milar is required to record:Milar is required to record: –Its share of Beck's earnings, $30,000 (100,000 x 30%) –The reduction in the investment account for the dividends received, $12,000 ($40,000 x 30%)

Revenue and Dividends Dec. 31 Equity Investments Revenue from Investment in Beck Company Revenue from Investment in Beck Company 30,000 30,000 To record 30% equity in Beck's 2004 net earnings Dec. 31 Cash Equity Investments Equity Investments 12,000 12,000 To record dividends received During the year the investment account increased by $18,000 ($30,000 - $12,000)

Cost and Equity Methods Compared

Controlling Interest Controlling interest is usually granted when one company holds more than 50% of the common shares of another companyControlling interest is usually granted when one company holds more than 50% of the common shares of another company Investor and investee are, in some sense, one companyInvestor and investee are, in some sense, one company –Investor: parent company –Investee: subsidiary company

Consolidated Financial Statements Inform creditors, investors, and others of the magnitude and scope of operations of companies under common controlInform creditors, investors, and others of the magnitude and scope of operations of companies under common control Present assets and liabilities controlled by parent and the aggregate profitability of subsidiary companiesPresent assets and liabilities controlled by parent and the aggregate profitability of subsidiary companies Prepared in addition to financial statements for individual parent and subsidiary companiesPrepared in addition to financial statements for individual parent and subsidiary companies

Short- and Long-Term Investments Investments include:Investments include: –Short-term paper (certificates of deposit, treasury bills, commercial paper) –Debt securities (government and corporate bonds) –Equity securities (preferred and common shares) These can be classified as either short-term or long-termThese can be classified as either short-term or long-term

Short- and Long-Term Investments Short-term investments are debt or equity securities, held by a company, that areShort-term investments are debt or equity securities, held by a company, that are –Readily marketable –Intended to be converted into cash in the near future Investments that do not meet both of the above criteria are classified as long-term investmentsInvestments that do not meet both of the above criteria are classified as long-term investments

Valuation of Investments Value of debt and equity investments may fluctuate greatly during the time they are heldValue of debt and equity investments may fluctuate greatly during the time they are held Conservatism requires accountants to use the lower of cost and market (LCM) ruleConservatism requires accountants to use the lower of cost and market (LCM) rule Application of the LCM rule varies depending on whether the investment is short- or long- termApplication of the LCM rule varies depending on whether the investment is short- or long- term

Valuation of Short-Term Investments LCM normally applied to total portfolioLCM normally applied to total portfolio Allowance to Reduce Cost to Market Value used to record the difference between cost and market valueAllowance to Reduce Cost to Market Value used to record the difference between cost and market value Allowance account is a contra asset account deducted from the cost of the investments to arrive at the LCM valuationAllowance account is a contra asset account deducted from the cost of the investments to arrive at the LCM valuation

Reporting of Short-Term Investments Current Assets Cash Cash Short-term investments, at cost Short-term investments, at cost Less: Allowance to reduce cost to market value Less: Allowance to reduce cost to market value Short-term investments, at market Short-term investments, at market$140,000 2,000 2,000$xxxxxx138,000

Valuation of Long-Term Investments LCM applied to individual investmentsLCM applied to individual investments Carrying values not adjusted to reflect temporary fluctuations in market valueCarrying values not adjusted to reflect temporary fluctuations in market value When market falls below cost and the decline is not temporary, reduce investment to market valueWhen market falls below cost and the decline is not temporary, reduce investment to market value Investment is credited directly; no allowance account is usedInvestment is credited directly; no allowance account is used

Evaluating Investment Portfolio Performance Time sale of investments before year-endTime sale of investments before year-end Misclassification of investments as short- and long-termMisclassification of investments as short- and long-term

Short-term investmentsShort-term investments –Report at LCM in current asset section of balance sheet –Disclose market value –Present after Cash or combined with Cash as a cash equivalent if highly liquid Long-term investmentsLong-term investments –Separate section of the balance sheet immediately below Current Assets –Report at cost or at equity (if significant influence) Balance Sheet Presentation

Statement of Earnings Presentation Gains and losses on investments, interest and dividend revenue are reported in the non-operating section of the Statement of EarningsGains and losses on investments, interest and dividend revenue are reported in the non-operating section of the Statement of Earnings

Cash Flow Statement Presentation Information on the cash inflows and outflows that resulted from investment transactions are reported in the investing activities section of the Cash Flow StatementInformation on the cash inflows and outflows that resulted from investment transactions are reported in the investing activities section of the Cash Flow Statement