1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Winston Kwok, Ph.D., CPA Chapter 15 I NVESTMENTS AND I NTERNATIONAL O PERATIONS McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 15 - 2 B ASICS OF I NVESTMENTS 1.Companies transfer excess cash into investments to produce higher income. 2.Some companies are set up to produce income from investments. 3.Companies make investments for strategic reasons. 1.Companies transfer excess cash into investments to produce higher income. 2.Some companies are set up to produce income from investments. 3.Companies make investments for strategic reasons. Motivation for Investments C1

3. 15 - 3 S HORT -T ERM I NVESTMENTS C1 Short-term investments are securities that: Management intends to convert to cash within one year or the operating cycle, whichever is longer. Are readily convertible to cash. Short-term investments are securities that: Management intends to convert to cash within one year or the operating cycle, whichever is longer. Are readily convertible to cash. Short-term investments do not include cash equivalents. Cash equivalents are investments that are both readily converted to known amounts of cash and mature within three months.

4. 15 - 4 L ONG -T ERM I NVESTMENTS Long-term investments: are not readily convertible to cash. are not intended to be converted to cash in the short term. are reported in the noncurrent section of the balance sheet, often in its own category. Long-term investments: are not readily convertible to cash. are not intended to be converted to cash in the short term. are reported in the noncurrent section of the balance sheet, often in its own category. C1

5. 15 - 5 D EBT S ECURITIES VERSUS E QUITY S ECURITIES Debt Securities Reflect a creditor relationship Examples: Investments in notes, bonds, and CDs May be issued by governments, companies, or individuals Debt Securities Reflect a creditor relationship Examples: Investments in notes, bonds, and CDs May be issued by governments, companies, or individuals C1 Equity Securities Reflect an owner relationship Examples: Investments in ordinary shares Issued by other companies Equity Securities Reflect an owner relationship Examples: Investments in ordinary shares Issued by other companies

6. 15 - 6 C LASSIFICATION AND R EPORTING C1 Accounting for Investments depends on some or all of the following factors: 1. purpose, e.g. trading or long-term investment, the company’s intent to hold the security either short-term or long-term, 2. its contractual characteristics, e.g. debt or equity, 3. whether it is listed on an exchange, 4. the industry in which the reporting entity operates, and 5. the accounting policy choice of the reporting entity. Accounting for Investments depends on some or all of the following factors: 1. purpose, e.g. trading or long-term investment, the company’s intent to hold the security either short-term or long-term, 2. its contractual characteristics, e.g. debt or equity, 3. whether it is listed on an exchange, 4. the industry in which the reporting entity operates, and 5. the accounting policy choice of the reporting entity.

7. 15 - 7 H ELD - FOR -T RADING S ECURITIES  Acquired principally for the purpose of selling or repurchasing them in the near term, with a pattern of short-term profit-taking.  Such investments are accounted for by the fair value approach, in contrast to the historical cost approach generally used for other assets like land, buildings, and equipment. Fair value is the amount for which an asset could be exchanged between knowledgeable and willing parties, in an arm’s length transaction.  Acquired principally for the purpose of selling or repurchasing them in the near term, with a pattern of short-term profit-taking.  Such investments are accounted for by the fair value approach, in contrast to the historical cost approach generally used for other assets like land, buildings, and equipment. Fair value is the amount for which an asset could be exchanged between knowledgeable and willing parties, in an arm’s length transaction. P1

8. 15 - 8 Assume that Nestlé buys X Corp’s shares on October 1, with the intention to sell within a few months. The journal entry at purchase is as follows. H ELD - FOR -T RADING S ECURITIES P1

9. 15 - 9 When Nestlé’s fiscal year ends on December 31, 2010, the share price of X Corp has risen in value and the total market value is CHF 55,000. The CHF 5,000 value on top of the original cost is an unrealized gain on the investment. The year-end journal entry to record this gain is as follows. H ELD - FOR -T RADING S ECURITIES P1

10. 15 - 10 When Nestlé sells X Corp’s shares, it records a realized gain or loss. If Nestlé sells at CHF 60,000, which is higher than the carrying amount of CHF 55,000, then the journal entry is as follows. H ELD - FOR -T RADING S ECURITIES P1

11. 15 - 11 A VAILABLE - FOR -S ALE S ECURITIES  Purchased to yield dividends or increases in fair value.  Not actively managed like held-for-trading securities.  If the intent is to sell available-for-sale securities within the longer of one year or operating cycle, they are classified as short-term investments. Otherwise, they are classified as long-term.  Adjust the cost of available-for-sale securities to reflect changes in fair value. This is done with a fair value adjustment to its total portfolio cost.  Any unrealized gain or loss is not reported as part of profit or loss but as part of other comprehensive income.  Purchased to yield dividends or increases in fair value.  Not actively managed like held-for-trading securities.  If the intent is to sell available-for-sale securities within the longer of one year or operating cycle, they are classified as short-term investments. Otherwise, they are classified as long-term.  Adjust the cost of available-for-sale securities to reflect changes in fair value. This is done with a fair value adjustment to its total portfolio cost.  Any unrealized gain or loss is not reported as part of profit or loss but as part of other comprehensive income. P2

12. 15 - 12 A VAILABLE - FOR -S ALE S ECURITIES Assume that Nestlé buys Y Corp’s shares at CHF 100,000. Nestlé intends to hold this investment for longer than a year and decided to treat it as an available-for-sale (AFS) investment. P2

13. 15 - 13 A VAILABLE - FOR -S ALE S ECURITIES P2 Upon sale at CHF 10,000, the journal entry is: Assume that at year-end, the fair market value of Y Corp’s shares is CHF 120,000. The journal entry is as follows.

14. 15 - 14 H ELD - TO -M ATURITY D EBT Debt securities are recorded at cost when purchased. Interest revenue for investments in debt securities is recorded when earned. On September 1, 2010, Music City paid $29,500 plus a $500 brokerage fee to buy Dell’s 7%, 2-year bonds payable with a $30,000 par value. The bonds pay interest semiannually on August 31 st and February 28 th. Music City plans to hold the bonds until they mature (HTM securities). P3

15. 15 - 15 H ELD - TO -M ATURITY D EBT Interest earned but not received must be accrued on December 31, 2010. $30,000 par value × 7% × 4/12 = $700 interest earned. P3

16. 15 - 16 Significant influence is generally assumed with 20% to 50% ownership. 0%20%50%100% Cost or Fair Value Method Equity Method Consolidated Financial Statements P4 Investor Ownership of Investee Shares Outstanding I NVESTMENTS IN E QUITY WITH SIGNIFICANT INFLUENCE

17. 15 - 17  Original investment is recorded at cost.  The investment account is increased by a proportionate share of investee’s earnings.  The investment account is decreased by dividends received. P4 I NVESTMENTS IN E QUITY WITH SIGNIFICANT INFLUENCE

18. 15 - 18 On January 1, 2010, Micron Co. records the purchase of 3,000 shares (30%) of Star Co. ordinary shares at a total cost of $70,650 cash. P4 I NVESTMENTS IN E QUITY WITH SIGNIFICANT INFLUENCE

19. 15 - 19 For 2010, Star reports net income of $20,000, and pays total cash dividends of $10,000 on January 9, 2011. P4 $10,000 × 30% = $3,000 $20,000 × 30% = $6,000 I NVESTMENTS IN E QUITY WITH SIGNIFICANT INFLUENCE

20. 15 - 20 P4 I NVESTMENTS IN E QUITY WITH SIGNIFICANT INFLUENCE

21. 15 - 21 Required when investor’s ownership exceeds 50% of investee.  Equity Method is used.  Consolidated financial statements show the financial position, results of operations, and cash flows of all entities under the parent’s control. C2 INVESTMENTS IN EQUITY WITH CONTROL

22. 15 - 22 A CCOUNTING S UMMARY FOR I NVESTMENTS IN S ECURITIES C1

23. 15 - 23 C OMPREHENSIVE I NCOME C1 Comprehensive Income: all changes in equity during a period except those from owners’ investments and dividends. Example: Fair value adjustments on available-for-sale investments are shown in the statement of comprehensive income.

24. 15 - 24 C OMPONENTS OF R ETURN ON T OTAL A SSETS Return on total assets = Profit margin × Total asset turnover Net income Average total assets =× Net income Net sales Net sales Average total assets A1

25. 15 - 25 R ETURN ON T OTAL A SSETS Here are the returns on total assets and its components for Gap, Inc. for the years 2005 through 2009: All companies desire a high return on total assets. To improve the return, the company must meet any decline in profit margin or total asset turnover with an increase in the other. Companies consider these components in planning strategies. A1

26. 15 - 26 A PPENDIX 15A: I NVESTMENTS IN I NTERNATIONAL O PERATIONS Two major accounting challenges arise when companies have international operations: C3 Accounting for sales and purchases listed in a foreign currency. Preparing consolidated financial statements with international subsidiaries.

27. 15 - 27  Each country uses its own currency for internal economic transactions.  To make transactions in another country, units of that country’s currency must be acquired.  The cost of those currencies is called the exchange rate. E XCHANGE R ATES B ETWEEN C URRENCIES C3

28. 15 - 28 S ALES IN A F OREIGN C URRENCY Boston Company, a U.S.-based manufacturer makes a credit sale to London Outfitters, a British retail company. On December 12, 2010, Boston sells £10,000 with payment due on February 10, 2011. Boston keeps its record in U.S. dollars. At the date of sale, the British pound is valued at $1.80. £10,000 × $1.80 = $18,000 C3

29. 15 - 29 S ALES IN A F OREIGN C URRENCY Boston Company is a December 31, year-end company. On December 31, 2010, the British pound has an exchange rate of $1.84. The dollar value of the account receivable from London is $18,400 on this date. The receivable is to valued on the balance sheet at it current dollar amount. Accounts Receivable – London Outfitters DateExplanationDebitCreditBalance 12/12/10 Sale 18,000 12/31/10 Adjustment for foreign currency400 18,400 C3

30. 15 - 30 S ALES IN A F OREIGN C URRENCY On February 10, 2011, Boston receives London Outfitters’ payment of £10,000. Boston immediately exchanges the pounds for U.S. dollars. The exchange rate on this date is $1.78 per pound, so Boston receives $17,800 for the £10,000 received in settlement. Accounts Receivable – London Outfitters DateExplanationDebitCreditBalance 12/12/10 Sale 18,000 12/31/10 Adjustment for foreign currency400 18,400 2/10/11 Payment received 18,400-0- C3

31. 15 - 31 P URCHASES IN A F OREIGN C URRENCY NC Imports, a U.S. company, purchases products costing €20,000 from Hamburg Brewing on January 15, when the exchange rate is $1.20 per euro. €20,000 × $1.20 = $24,000 C3

32. 15 - 32 P URCHASES IN A F OREIGN C URRENCY NC Imports makes payment in full on February 14 when the exchange rate is $1.25 per euro. €20,000 × $1.25 = $25,000 C3

33. 15 - 33 C ONSOLIDATED S TATEMENTS WITH I NTERNATIONAL S UBSIDIARIES Consider a U.S.-based company that owns a controlling interest in a French company. The reporting currency of the U.S. company is the dollar. The French company maintains its books in Euros. Before preparing consolidated statements, the U.S. company must translate the French company’s statements into dollars. The process requires the parent company to select appropriate foreign exchange rates and to apply those rates to the foreign subsidiary’s account balances. Translate Account Balances C3

34. 15 - 34 E ND OF C HAPTER 15