Chapter 10 Investments

Learning Objectives 1.Identify why companies invest in debt and equity securities and classify investments 2.Account for investments in debt securities 3.Account for investments in equity securities 10-2

Learning Objectives 4.Describe and illustrate how debt and equity securities are reported 5.Use the rate of return on total assets to evaluate business performance 10-3

Learning Objective 1 Identify why companies invest in debt and equity securities and classify investments 10-4

Why Do Companies Invest? 10-5 Businesses invest in a variety of companies’ stocks and bonds. An investor is the owner of a bond or share of stock. The investee issues the bond or stock to the investor. A security is a share or interest representing financial value. There are two types of securities: – Debt securities – Equity securities

Reasons to Invest Why would a company invest in debt or equity securities? There are two common reasons: To invest excess cash in order to generate investment income To invest in a debt or equity security of other companies as a business strategy, such as enhancing a business relationship 10-6

Classification and Reporting of Investments 10-7 Investments are classified as short-term investments or long-term investments. Types of investments: – Trading investments – Held-to-maturity investments (HTM) – Available-for-sale investments (AFS) – Significant interest investments – Controlling interest investments

10-8 Classification and Reporting of Investments

Learning Objective 2 Account for investments in debt securities 10-9

How Are Investments in Debt Securities Accounted For? Companies record the investment in debt securities by first recording the purchase of the investment. Companies record interest revenue. At the date of maturity, companies record the disposition of the investment

Purchase of Debt Securities Smart Touch Learning has excess cash to invest and pays $100,000 to buy $100,000 face value, 9%, five-year Neon Company bonds on July 1, Smart Touch Learning plans to hold the bonds until maturity

Interest Revenue On December 31, 2016, Smart Touch Learning receives the first interest payment on the bond investment

Disposition at Maturity When Smart Touch Learning disposes of the bonds at maturity on June 30, 2021, it will receive the face value of the bond. Assuming the last interest payment has been recorded, the entry is: 10-13

Learning Objective 3 Account for investments in equity securities 10-14

How Are Investments in Equity Securities Accounted For? The accounting for equity securities is based on the percentage of ownership: – Cost method for ownership less than 20% – Equity method for ownership between 20% and 50% – Consolidations for ownership greater than 50% 10-15

Equity Securities with Less Than 20% Ownership (Cost Method) Accounted for as either: – Trading securities – Available-for-sale securities Recognize dividend revenue Adjust for changes in market value Recognize gain or loss on disposition 10-16

Purchase of Equity Securities On March 1, 2016, Smart Touch Learning acquires 1,000 shares of stock in Yellow Corporation for $26.16 per share. Smart Touch Learning owns less than 20% of Yellow’s voting stock. Treat as available- for-sale investment

Dividend Revenue Yellow Corporation declares and pays a cash dividend of $0.16 per share on June 9,

Disposition On July 15, 2016, Smart Touch Learning sells 800 shares of its Yellow Corporation stock for $25,000. Smart Touch Learning compares the cash received with the cost of the stock disposed of and determines the gain as follows: 10-19

Disposition Smart Touch Learning will record the following entry for the disposition of the Yellow Stock: 10-20

Equity Securities with 20% to 50% Ownership (Equity Method) Significant influence is assumed Accounted for using the equity method Initial investment Record investment at cost when acquired Receipt of dividends Adjust the investment account balance for dividends received Share of profits Adjust the investment account for the investor’s share of investee’s net income or net loss

Purchase Investments accounted for by the equity method are recorded at cost at the time of purchase. Smart Touch Learning pays $400,000 to acquire 40% of the common stock of Kline, Inc., on January 6,

Dividends Received (Equity Method) Kline declares and pays a cash dividend of $50,000 on June 30, Because Smart Touch Learning owns 40% of the stock, it receives 40%, or $20,000, of the dividend

Share of Net Income (Equity Method) Kline, Inc., reported net income of $125,000 for the 2016 year. Smart Touch Learning must account for 40% of Kline’s net income as an increase in the investment account

Equity Securities with 20% to 50% Ownership (Equity Method) After the preceding entries are posted, Smart Touch Learning’s Long-term Investments T-account shows its equity in the net assets of Kline as follows: 10-25

Disposition On January 1, 2017, Smart Touch Learning sells 10% of the Kline common stock for $40,000. Smart Touch Learning will calculate the gain or loss as follows: 10-26

Disposition The journal entry to record the disposition of 10% of Smart Touch Learning’s interest in Kline is as follows: 10-27

Equity Securities with More Than 50% Ownership (Consolidations) A controlling interest exists when the investor owns more than 50% of the investee’s voting stock. The parent company is the corporation that controls the other company. The subsidiary company is the company controlled by another corporation. The parent prepares consolidated statements using consolidation accounting

Learning Objective 4 Describe and illustrate how debt and equity securities are reported 10-29

How Are Debt and Equity Securities Reported? Trading investments Available-for-sales (AFS) investments Held-to-maturity investments 10-30

Trading Investments Record initial investment at cost. Adjust for changes in fair value. The fair value adjustment is called unrealized holding gain/loss. – Reported on the income statement Fair value is the price that would be used if the company were to sell the investments on the market.

Trading Investments On December 31, 2016, Smart Touch Learning reported trading investments of $26,160. The market value of the investments is $24,

Available-for-Sale Investments Record initial investment at cost. Adjust for changes in fair value. The adjustment is called unrealized holding gain/loss. – Reported in stockholders’ equity The adjustment is recorded and shown in the stockholders’ equity section of the balance sheet as part of comprehensive income.

Available-for-Sale Investments On December 31, 2016, Smart Touch Learning reported AFS investments of $60,000. The market value of the investments is $64,

Available-for-Sale Investments Comprehensive income includes net income plus some specific gains and losses, such as unrealized holding gains or losses on available-for-sale investments

Held-to-Maturity Investments Held-to-maturity investments are reported at amortized cost. The investment may be reported as a current asset or long-term asset on the balance sheet, depending on the maturity date. Interest revenue is reported on the income statement in the Other Revenues and (Expenses) section

How Are Debt and Equity Securities Reported? 10-37

Learning Objective 5 Use the rate of return on total assets to evaluate business performance 10-38

How Do We Use the Rate of Return on Total Assets to Evaluate Business Performance? The rate of return on total assets measures a company’s success in using assets to earn a profit. Companies finance assets two ways: – Debt: A company borrows from creditors to purchase assets. – Equity: A company receives cash or other assets from stockholders

The rate of return on total assets is calculated by adding interest expense to net income and dividing by average total assets. For Green Mountain: How Do We Use the Rate of Return on Total Assets to Evaluate Business Performance?

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