1. 13 Investments and Fair Value Accounting
C H A P T E R
Investments and Fair Value Accounting
Financial and Managerial Accounting
13e
Warren
Reeve
Duchac
human/iStock/360/Getty Images

2. Investing Cash in Current Operations
Cash may be used to replace worn-out equipment or to purchase new, more efficient and productive equipment.
In addition, cash may be reinvested in the company to expand its current operations.
Cash may be used to pay:
Expenses.
Suppliers of merchandise and other assets.
Interest to creditors.
Dividends to stockholders.
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3. Investing Cash in Temporary Investments
Instead of letting excess cash remain idle in a checking account, most companies invest their excess 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.
Investments in debt securities and equity securities, termed investments or temporary investments, are reported in the Current Assets section of the balance sheet.
The primary objective of investing in temporary investments is to earn interest revenue, receive dividends, or realize gains from increases in the market price of the securities.
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4. Investing Cash in Long-Term Investments
Long-term investments often involve the purchase of a significant portion of the stock of another company.
Such investments usually have a strategic purpose:
Reduction of costs.
Replacement of management.
Expansion.
Integration.
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5. Accounting for Debt Investments
Debt securities include notes and bonds issued by corporations and governmental organizations.
Most companies invest excess cash in bonds as investments to earn interest revenue.
The accounting for bond investments includes recording the following:
Purchase of bonds
Interest revenue
Sale of bonds
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6. Purchase of Bonds
The purchase of bonds is recorded by debiting an investments account for the purchase price of the bonds, including any brokerage commissions.
A brokerage commission is the fee charged by the agent who arranges the transaction between the buyer and seller.
If the bonds are purchased between interest dates, the purchase price includes accrued interest since the last interest payment.
This is because the seller has earned the accrued interest, but the buyer will receive the accrued interest when it is paid.
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7. The sale of a bond investment normally results in a gain or loss.
Sale of Bonds
The sale of a bond investment normally results in a gain or loss.
If the proceeds from the sale exceed the book value (cost) of the bonds, then a gain is recorded.
If the proceeds are less than the book value (cost) of the bonds, a loss is recorded.
The gain or loss on the sale of bond investments is reported as part of Other Income (Loss) on the income statement.
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8. Accounting for Equity Investments
A company may invest in the preferred or common stock of another company.
The company investing in another company’s stock is the investor.
The company whose stock is purchased is the investee.
The percent of the investee’s outstanding stock purchased by the investor determines the degree of control that the investor has over the investee. This, in turn, determines the accounting method used to record the stock investment.
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9. Cost Method: Less Than 20% Ownership
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
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10. Equity Method: Between 20%–50% Ownership
Investment of between 20% and 50% are accounted for using the equity method.
Under the equity method, the stock is recorded initially at its cost, including any brokerage commissions.
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: The investor records its share of the net income of the investee as an increase in the investment account. Its share of any net loss is recorded as a decrease in the investment account.
Dividends: The investor’s share of cash dividends received from the investee decreases the investment account.
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11. Consolidation: More Than 50% Ownership (slide 1 of 2)
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.
In this case, it is assumed that the investor purchased the stock of the investee primarily for strategic reasons, such as to produce more efficiently, diversify product lines, expand geographically, or acquire know-how.
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12. Consolidation: More Than 50% Ownership (slide 2 of 2)
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.
At the end of the year, the financial statements of the parent and subsidiary are combined and reported as a single company. These combined financial statements are called consolidated financial statements.
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13. Valuing and Reporting Investments
Debt and equity securities are financial assets that are often traded on public exchanges such as the New York Stock Exchange. As a result, their market value can be observed and, thus, objectively determined.
For this reason, generally accepted accounting principles (GAAP) allows some debt securities, and requires equity securities where there is less than a 20% ownership interest to be valued in the accounting records and financial statements at their fair market values.
These securities are classified as follows:
Trading securities
Available-for-sale securities
Held-to-maturity securities
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14. Trading Securities (slide 1 of 3)
Trading securities are debt and equity securities that are purchased and sold to earn short-term profits from changes in their market prices.
Trading securities are often held by banks, mutual funds, insurance companies, and other financial institutions.
Because trading securities are held as a short-term investment, they are reported as a current asset on the balance sheet.
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15. Trading Securities (slide 2 of 3)
Trading securities are valued as a portfolio (group) of securities using the securities’ fair values.
Fair value is the market price that the company would receive for a security if it were sold.
A change in the fair value of the portfolio (group) of trading securities is recognized as an unrealized gain or loss for the period.
If the fair value of the portfolio of trading securities was less than the cost:
The adjustment would debit Unrealized Loss on Trading Investments and credit Valuation Allowance for Trading Investments for the difference.
Unrealized Loss on Trading Investments would be reported on the income statement as Other Expenses.
Valuation Allowance for Trading Investments would be shown on the balance sheet as a deduction from Trading Investments (at cost).
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16. Trading Securities (slide 3 of 3)
Over time, the valuation allowance account is adjusted to reflect the difference between the cost and fair value of the portfolio.
Thus, increases in the valuation allowance account from the beginning of the period will result in an adjustment to record an unrealized gain.
Likewise, decreases in the valuation allowance account from the beginning of the period will result in an adjustment to record an unrealized loss.
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17. Available-for-Sale Securities (slide 1 of 4)
Available-for-sale securities are debt and equity securities that are neither held for trading, held to maturity, nor held for strategic reasons.
Changes in the fair values of available-for-sale securities are reported as part of stockholders’ equity and, thus, excluded from the income statement.
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18. Available-for-Sale Securities (slide 2 of 4)
The valuation allowance and unrealized gain are reported on the balance sheet as follows:
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19. Available-for-Sale Securities (slide 3 of 4)
If the fair value of the portfolio of available-for-sale securities was less than the cost:
The adjustment would debit Unrealized Gain (Loss) on Available-for-Sale Investments and credit Valuation Allowance for Available-for-Sale Investments for the difference.
Unrealized Gain (Loss) on Available-for-Sale Investments would be reported in the Stockholders’ Equity section as a negative item.
Valuation Allowance for Available-for-Sale Investments would be shown on the balance sheet as a deduction from Available-for-Sale Investments (at cost).
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20. Available-for-Sale Securities (slide 4 of 4)
Over time, the valuation allowance account is adjusted to reflect the difference between the cost and fair value of the portfolio.
Thus, increases in the valuation allowance from the beginning of the period will result in an adjustment to record an increase in the valuation and unrealized gain (loss) accounts.
Likewise, decreases in the valuation allowance from the beginning of the period will result in an adjustment to record decreases in the valuation and unrealized gain (loss) accounts.
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21. Held-To-Maturity Securities (slide 1 of 2)
Held-to-maturity securities are debt investments, such as notes or bonds, that a company intends to hold until their maturity date.
Held-to-maturity securities are primarily purchased to earn interest revenue.
If a held-to-maturity security will mature within a year, it is reported as a current asset on the balance sheet. Held-to-maturity securities maturing beyond a year are reported as noncurrent assets.
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22. Held-To-Maturity Securities (slide 2 of 2)
Only securities with maturity dates, such as corporate notes and bonds, are classified as held-to-maturity securities.
Equity securities are not held-to-maturity securities because they have no maturity date.
Held-to-maturity bond investments are recorded at their cost, including any brokerage commissions.
If the interest rate on the bonds differs from the market rate of interest, the bonds may be purchased at a premium or discount.
In such cases, the premium or discount is amortized over the life of the bonds.
Held-to-maturity bond investments are reported on the balance sheet at their amortized cost.
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23. Fair value is the price that would be received for selling an asset.
Fair Value Accounting
Fair value is the price that would be received for selling an asset.
Fair value assumes that the asset is sold under normal business conditions.
Generally accepted accounting principles require trading and available-for-sale investments to be recorded at their fair value.
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24. Effect of Fair Value Accounting on the Financial Statements: Balance Sheet
When an asset is reported at its fair value, any difference between the asset’s original cost or prior period’s fair value must be reported in a valuation allowance.
Changes in the fair value of available-for-sale securities are included as part of stockholders’ equity through the comprehensive income and accumulated other comprehensive income accounts.
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25. Effect of Fair Value Accounting on the Financial Statements: Income Statement
Although trading securities are reported at fair value in the balance sheet, changes in their fair values are not reported as part of stockholders’ equity; rather, the unrealized gains or losses are reported on the income statement.
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26. Financial Analysis and Interpretation: Dividend Yield
The dividend yield measures the rate of return to stockholders, based on cash dividends.
Dividend yield is most often computed for common stock because preferred stock has a stated dividend rate.
In contrast, the cash dividends paid on common stock normally vary with the profitability of the corporation.
The dividend yield is computed as follows:
Dividend Yield =
Dividends per Share of Common Stock
Market Price per Share of Common Stock
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27. Appendix: Comprehensive Income
Comprehensive income is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments.
Comprehensive income is computed by adding or subtracting other comprehensive income to (from) net income, as follows:
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.
The cumulative effect of other comprehensive income is reported on the balance sheet, as accumulated other comprehensive income.
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