CHAPTER 17

INVESTMENTS In accounting for investments, entries are required to record the: –Acquisition –Interest/dividends –Disposal

TYPES OF INVESTMENTS 1.DEBT –Bonds, GICs, T-Bills, Commercial Paper –Typically: Come with no ownership or decision-making rights Priority claim on the assets of a debtor when insolvent Are interest bearing securities that pay a stated annual interest rate on a “face value” or “principal” Interest fully taxable 2.EQUITY –Stocks, real assets –Typically: Come with ownership and voting rights in a business Last to be paid off in a bankruptcy Value is linked to expectation of future cash flows of the business Some may pay dividends (return of profits to owner) but don’t have to Tax favoured status for lower tax brackets NOTE: Capital gains can be earned on Debt or Equity investments and are only 50% taxable in Canada. Do you know the difference between Profit, Interest, Dividends, and Capital gains?

ACCOUNTING FOR INVESTMENTS Accounting for DEBT investments differs depending on whether investments are 1.Temporary, or 2.Long-term Accounting for EQUITY differs depending on how much of the company’s stock you own.

TEMPORARY VS. LONG-TERM INVESTMENTS Temporary investments are securities, held by a company, that are 1.Readily marketable (can be sold easily), and 2.Intended to be converted into cash in the near future (<12mths). Investments that do not meet both criteria are classified as long-term investments.

TEMPORARY INVESTMENTS AND THE OPERATING CYCLE At the end of their operating cycles, many companies may have idle cash on hand (temporarily) Until the cash is needed, these companies may invest the excess funds to earn interest and dividends. Cash Temporary Investments Accounts Receivable Inventory Invest Sell

TEMPORARY INVESTMENTS AND THE OPERATING CYCLE Why would you bother with temporary investments? Does it make that much of a difference in revenues? Reasons: –Opportunity cost – Will invest only if no superior opportunities for money –Time value of money – avoids inflationary erosion of purchasing power –Profitability – MUST understand the cost structure of a business; observe…

Assume Company A and B are identical, and both have an extra $1 million available for three months this year. Company A lets it sit in the business’s regular bank account, earning no interest. Company B invests in a 90-day Bond which pays 8% per annum.

TEMPORARY DEBT INVESTMENTS NOTE: I recommend you start a fresh page and make a chart in your notes like this one (leave enough space for a journal entry in each section): TemporaryLong-Term 1. Acquiring Bonds 2. Recording Interest Earned 3. Disposing of (selling) Bonds

TEMPORARY DEBT INVESTMENTS 1. Acquisition TEMPORARY DEBT INVESTMENTS 1. Acquisition Kuhl Corporation acquires 50 Doan Inc. 6%, 10-year, $1,000 bonds on January 1 for $54,000. The bonds pay interest on December 31. The entry to record the temporary investment is: DateParticularsDebitCredit Jan. 1 Bonds54,000 Cash

Interest receipts are calculated using the bond’s face or principal value, which is $50,000 (50 x $1,000). The interest for December 31 will be $3,000 ($50,000 x 6%). The entry on December 31 is: TEMPORARY DEBT INVESTMENTS 2. Interest TEMPORARY DEBT INVESTMENTS 2. Interest DateParticularsDebitCredit Dec 31 Cash3,000 Interest Revenue

TEMPORARY DEBT INVESTMENTS 3. Disposal TEMPORARY DEBT INVESTMENTS 3. Disposal DateParticularsDebitCredit April 30 Year 2 Cash49,000 54,000Bonds DateParticularsDebitCredit April 30 Year 2 Interest Receivable1,000 Interest Receivable Loss on Sale of Bond6,000 Step 1: Record interest up to the date of disposal. Step 2: Dispose of the Bond. Assume the Bond is sold for $49,000 on April 30 of year 2. 1,000Interest Revenue (4/12 of $3,000)

LONG-TERM DEBT INVESTMENTS 1. Acquisition LONG-TERM DEBT INVESTMENTS 1. Acquisition Market forces determine the price of a bond; this is almost NEVER the same as the face value When you hold bonds for the long-term, you must recognize the difference in price paid and the face value. DateParticularsDebitCredit Jan. 1 Year 1 Bonds50,000 4,000Premium on bonds 54,000Cash

LONG-TERM DEBT INVESTMENTS 2. Interest LONG-TERM DEBT INVESTMENTS 2. Interest As interest accrues, a bond premium (or discount) must be amortized over the life of the bond, since nothing will be received for the premium when the bond matures (only the face value will be paid by the issuer of the bond). This corresponds with the Matching Principle. The straight-line method is used to amortize bond premiums and discounts. Why? DateParticularsDebitCredit Dec 31 Year 1 Cash3, Premium on bonds ($4,000 / 10 years) 2,600Interest Revenue (6% x $50,000) - $400 ACHTUNG!

LONG-TERM DEBT INVESTMENTS 3. Disposal LONG-TERM DEBT INVESTMENTS 3. Disposal Disposal resembles the process for long-term assets When we sell the bond, we must ensure that any discount or premium is amortized up to the date of disposal Then remove any remaining premium/discount and record any gain or loss on the sale. Just like disposing of assets, there are two steps to the process. Say on April 30 of year 2, the bond is sold for $49,000

LONG-TERM DEBT INVESTMENTS 3. Disposal LONG-TERM DEBT INVESTMENTS 3. Disposal DateParticularsDebitCredit April 30 Year 2 Cash49,000 3,466.67Premium on bonds ($4,000 – 400 – ) 50,000Bonds DateParticularsDebitCredit April 30 Interest Receivable1, Premium on bonds (4/12 of $400) Interest Revenue Loss on Sale of Bond5, Step 1: Amortize premium up to the date of disposal. Step 2: Dispose of the Bond. 1,000Interest Receivable

Do Problems: BE17-2 P17-1A

ACCOUNTING GUIDELINES FOR EQUITY INVESTMENTS Investor’s Ownership Presumed Interest in Investee’s Influence Accounting Common Shares on Subsidiary Guidelines Less than 20% Insignificant Cost method Between 20% and 50% Significant Equity method More than50% Controlling Equity method for accounting; Consolidated financial statements for financial reporting NOTE: I recommend you start a fresh page and make a chart in your notes like this one (leave enough space for a journal entry in each section): 50% Cost Equity Consol. 1. Acquiring Equity 2. Recording Dividends earned 3. Divesting of Equity (selling)

RECORDING EQUITY INVESTMENTS HOLDINGS LESS THAN 20% The Cost Method RECORDING EQUITY INVESTMENTS HOLDINGS LESS THAN 20% The Cost Method Investment is recorded at cost and revenue is recognized only when cash dividends are received. (Same as cost method for Bonds really…) Unrealized gains and losses are reported in net income

LESS THAN 20% 1. Acquisition LESS THAN 20% 1. Acquisition On July 1, 2003, we acquire 1,000 shares (10 percent ownership) of Beal Corporation at $40 per share plus brokerage fees of $500. The entry for the purchase is: DateParticularsDebitCredit July 1 Equity Investment – Beal Common Shares40,500 Cash

LESS THAN 20% 2. Dividends LESS THAN 20% 2. Dividends Entries are required for any cash dividends received during the time the shares are held. If we receive a $2 per share dividend on December 1, 2003, the entry is: DateParticularsDebitCredit Dec. 1 Cash2,000 Dividend Revenue

LESS THAN 20% 3. Disposal LESS THAN 20% 3. Disposal When shares are sold, the difference between the net proceeds from the sale and the cost of the shares is recognized as a gain or loss. Assume we receive $39,500 on the sale of our investment of Beal common shares on February 10, Because the shares cost $40,500, a loss of $1,000 has been incurred. The entry to record the sale is: DateParticularsDebitCredit Feb. 10 Cash39,500 1,000Loss on Sale of Investment 40,500Equity Investment

BETWEEN 20% AND 50% The Equity Method BETWEEN 20% AND 50% The Equity Method The equity method: The investment in common shares 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. Why?

What is significant influence? –Representation on the board of directors –Participation in the policy-making process –Material inter-company transactions –Interchange of managerial personnel –Provision of technical information BETWEEN 20% AND 50% The Equity Method BETWEEN 20% AND 50% The Equity Method

We acquire 30% of the common shares of Beck Company for $120,000 on January 1, The entry to record this transaction is: BETWEEN 20% AND 50% 1. Acquisition BETWEEN 20% AND 50% 1. Acquisition DateParticularsDebitCredit Jan. 1 Equity Investment120,000 Cash

Beck reports 2003 net income of $100,000 and declares and pays a $40,000 cash dividend. We are required to record: 1) Our share of Beck’s net income, $30,000 (30% x $100,000) BETWEEN 20% AND 50% 2. Dividends and Net Income BETWEEN 20% AND 50% 2. Dividends and Net Income 2) The reduction in the investment account for the dividends received, $12,000 ($40,000 x 30%). The entries are: DateParticularsDebitCredit Dec. 31 Equity Investment30,000 Revenue from Investment DateParticularsDebitCredit Dec. 31 Cash12,000 Equity Investment ACHTUNG!

BETWEEN 20% AND 50% 3. Disposal BETWEEN 20% AND 50% 3. Disposal Same as the Cost Method (i.e. same as when holdings are less than 20%)

MORE THAN 50% A company that controls (e.g., owns more than 50 %) of the common shares of another entity is known as a parent company. The company it owns is the subsidiary. For this, the equity method of accounting is used to account for the investment, and consolidated financial statements are prepared.

Consolidated financial statements present the assets and liabilities controlled by the parent company and the combined profitability of any subsidiaries. They are prepared in addition to the financial statements for each individual company. MORE THAN 50%

VALUATION AND REPORTING OF INVESTMENTS The value of debt and equity investments may fluctuate greatly during the time they are held. Conservatism principle requires accountants to use the lower of cost and market rule. (When else is this used?) Application of the LCM rule varies depending upon whether the investment is temporary or long- term.

VALUATION AND REPORTING OF TEMPORARY INVESTMENTS The decline in value from cost to market is reported as a loss. An Allowance to Reduce Cost to Market Value account is used to record the difference between the cost and market value. The Allowance account is a contra asset and is deducted from the cost of the investments Don’t Panic! This technique operates just like Allowance for Doubtful Accounts and Accumulated Depreciation, both of which YOU ALREADY KNOW!

VALUATION AND REPORTING OF LONG-TERM INVESTMENTS Long-term investments should not be adjusted to reflect temporary fluctuations in market value. Only when a drop is NOT due to temporary fluctuations should lower of cost and market be used for long term investments. Any write-down to market value is accounted for on the income statement as a permanent loss. No allowance account is used.

COMPREHENSIVE BALANCE SHEET

Do Problems: P17-7A Homework: P17-9A Submit word processed (use excel)