1. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Investments and Fair Value Accounting Chapter 15

2. Learning Objectives 1. Describe why companies invest in debt and equity securities. 2. Describe and illustrate the accounting for debt investments. 3. Describe and illustrate the accounting for equity investments. 4. Describe and illustrate valuing and reporting investments in the financial statements. 5. Describe fair value accounting and its implications for the future. 6. Describe and illustrate the computation of dividend yield.

3. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe why companies invest in debt and equity securities. 1

4. Investing Cash in Current Operations o Cash may be used to replace worn-out equipment or to purchase new, more efficient, and productive equipment. o Cash may be reinvested in the company to expand its current operations. o Cash may be used to pay suppliers or other creditors.

5. Investing Cash in Temporary Investments o Instead of letting excess cash remain idle in a checking account, most companies invest this cash in securities such as:  Debt securities, which are notes and bonds that pay interest and have a fixed maturity date.  Equity securities, which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

6. Investing Cash in Temporary Investments o These debt securities and equity securities are termed Investments, or Temporary Investments, and are reported in the Current Assets section of the balance sheet.

7. Investing Cash in Temporary Investments o The primary objective of investing in temporary investments is to:  earn interest income  receive dividends  realize gains from increases in the market price of the securities.

8. Investing Cash in Long-Term Investments o Long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments have a strategic purpose:  Reduction of costs  Replacement of management  Expansion  Integration

9. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the accounting for debt investments. 2

10. Purchase of Bonds o Homer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March 17, 2014, plus accrued interest for 45 days. The bonds have an interest rate of 6%, payable on July 31 and January 31, 2015. $18,000 × 6% × (45/360)

11. Interest Revenue o On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × 1½). The $540 interest includes $135 of accrued interest that Homer Company purchased with the bonds on March 17. ($540 – $135) or [$18,000 × 6% × (135/360)]

12. (continued) I NTEREST R EVENUE

14. Interest Revenue o Homer Company’s accounting period ends on December 31. Thus, an adjusting entry must be made to accrue interest for five months. The following adjusting entry records the accrued interest: $18,000 × 6% × 5/12

15. Interest Revenue o For the year ended December 31, 2014, Homer Company would report Interest revenue of $855 ($405 + $450) as part of Other income on the income statement.

16. Interest Revenue o Homer Company receives interest of $540 on January 31, 2015. Notice that Interest Receivable is credited for $450 to reflect that this amount is a receivable from 2014. Interest Revenue of $90 is the interest earned from January 1 through January 31, 2015.

17. Sale of Bonds o On January 31, 2015, Homer Company sells the Treasury bonds at 98. The sale results in a loss of $360. Proceeds from sale ($18,000 × 98%)$17,640 Less book value (cost) of the bonds 18,000 Loss on sale of bonds$ (360)

18. Reported as part of Other income (loss) on the income statement Sale of Bonds o There is no accrued interest upon the sale since the interest payment date is also January 31. The entry to record the sale is as follows:

19. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the accounting for equity investments. 3

20. Accounting for Equity Investments o A company may invest in the preferred or common stock of another company. The company investing in another company’s stock is the investor. o The company whose stock is purchased is the investee.

21. A CCOUNTING FOR E QUITY I NVESTMENTS

22. Less Than 20% Ownership o Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method. Under the cost method, entries are recorded for the following transactions:  Purchase of stock  Receipt of dividends  Sale of stock

23. Purchase of Stock o On May 1, Bart Company purchases 2,000 shares of Lisa Company common stock at $49.90 per share plus a brokerage fee of $200.

24. Receipt of Dividends o On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company. o Dividend Revenue is reported as part of Other Income on Bart Company’s income statement.

25. Sale of Stock o On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission. The gain is reported as part of Other income on Bart Company’s income statement.

26. Between 20% ─ 50% Ownership o If the investor purchases between 20% and 50% of the outstanding stock of the investee, the investor is considered to have significant influence over the investee, and the investment is accounted for using the equity method.

27. Between 20% ─ 50% Ownership o Under the equity method, the investment account is adjusted for the investor’s share of the net income and dividends of the investee. These adjustments are as follows:  Net income: Recorded as an increase in the investment account.  Dividends: Decrease the investment account.

28. Purchase of Stock Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2014 for $350,000.

29. Recording Investee Net Income For the year ended December 31, 2014, Flanders Corporation reported net income of $105,000. Income of Flanders Corporation may be reported separately or as part of Other Income on Simpson Inc.’s income statement.

30. Recording Investee Dividends During the year, Flanders declared and paid cash dividends of $45,000.

31. R ECORDING I NVESTEE D IVIDENDS

32. Sale of Stock On January 1, 2015, Simpson Inc. sold Flanders Corporation’s stock for $400,000, a gain of $26,000, calculated as follows:

33. More Than 50% Ownership o If the investor purchases more than 50% of the outstanding stock of the investee, the investor is considered to have control over the investee. The purchase is termed a business combination.

34. More Than 50% Ownership o A corporation owning all or a majority of the voting stock of another corporation is called a parent company. The corporation that is controlled is called the subsidiary company. o At the end of the year, the financial statements of the parent and subsidiary are combined, and consolidated financial statements are issued.

35. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate valuing and reporting investments in the financial statements. 4

36. Trading Securities o Trading securities are debt and equity securities that are purchased and sold to earn short-term profits from changes in their market prices.

37. Trading Securities o Trading securities are reported as current assets on the balance sheet. o Trading securities are valued as a portfolio (group) of securities using their fair values. Fair value is the market price that would be received for a security if it were sold. o Changes in fair value of the portfolio are recognized as an unrealized gain or loss for the period.

38. Trading Securities o Maggie Company purchased a portfolio of trading securities during 2014. On December 31, 2014, the cost and fair values of the securities were as follows:

39. Trading Securities o The adjusting entry on December 31, 2014, to record the fair value of the securities ($25,300) is as follows: : Unrealized Gain on Trading Investments is reported on the income statement.

40. T RADING S ECURITIES

41. Available-for-Sale Securities o Available-for-sale securities are debt and equity securities that are neither held for trading, held to maturity, nor held for strategic reasons.

42. Available-for-Sale Securities o Maggie Company purchased three securities during 2014 as available-for-sale securities. On December 31, 2014, the cost and fair values of the securities were as follows:

43. Available-for-Sale Securities o On December 31, the adjusting entry credits a stockholders’ equity account instead of an income statement account. The $1,300 increase in fair value is credited to Unrealized Gain (Loss) on Available-for-Sale Investments. Added to current assets Added to stockholders’ equity

44. A VAILABLE - FOR - S ALE S ECURITIES Equal

45. Held-To-Maturity Securities o Held-to-maturity securities are debt investments, such as notes or bonds, that a company intends to hold until their maturity date.

46. S UMMARY

49. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe fair value accounting and its implications for the future. 5

50. Fair Value Accounting o Fair value is the price that would be received for selling an asset or paying off a liability. o Fair value assumes that the asset is sold or the liability is paid off under normal rather than distressed conditions.

51. Trends to Fair Value Accounting o A current trend for the FASB and other accounting regulators is to adopt accounting principles using fair values for valuing and reporting assets and liabilities.

52. Trends to Fair Value Accounting o Factors contributing to this trend include the following:  Current generally accepted accounting principles are a hybrid of varying measurement methods that often conflict with one other.  A greater percentage of the total assets of many companies consists of financial assets such as receivables and securities.  The world economy has created pressure on accounting regulators to adopt a worldwide set of accounting principles and standards.

53. Trend to Fair Value Accounting o Potential disadvantages of using fair values:  Fair values may not be readily obtainable for some assets or liabilities.  Fair values make it more difficult to compare companies if companies use different methods of measuring fair values.  Using fair values could result in more fluctuations in accounting reports because fair values change from year to year.

54. Statement Effect of Fair Value Accounting  Balance Sheet. When an asset or liability is reported at its fair value, any difference between the asset’s original cost or prior period’s fair value must be recorded.  Balance Sheet. The unrealized gain or loss on changes in fair value must also be recorded. One method reports these as part of stockholders’ equity on the balance sheet. (continued)

55. Statement Effect of Fair Value Accounting o Income Statement. Instead of recording the unrealized gain or loss on changes in fair values as part of stockholders’ equity, the unrealized gains or losses may be reported on the income statement.

56. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the computation of dividend yield. 6

57. Dividend Yield = Dividends per Share of Common Stock Market Price per Share of Common Stock News Corporation News Corporation : Dividend Yield = $0.19 $16.98 = 1.1% Dividend Yield o The dividend yield measures the rate of return to stockholders based on cash dividends distributed. Dividend yield is calculated as follows:

58. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix Comprehensive Income

59. o Comprehensive income is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments.

60. Comprehensive Income o Other comprehensive income items include unrealized gains and losses on available-for- sale securities as well as other items such as foreign currency and pension liability adjustments. o The cumulative effect of other comprehensive income is reported on the balance sheet, as accumulated other comprehensive income.

61. Comprehensive Income o Companies may report comprehensive income in the financial statements as follows:  On the income statement  In a separate statement of comprehensive income  In the statement of stockholders’ equity

62. C OMPREHENSIVE I NCOME

64. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Investments and Fair Value Accounting The End