Accounting for Debt and Equity Investments

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Investments and
Investments and
Fair Value
Fair Value
Accounting
Accounting
Chapter 15
Chapter 15

Learning ObjectivesLearning Objectives
1.1. Describe why companies invest in debt and equityDescribe why companies invest in debt and equity
securities.securities.
2.2. Describe and illustrate the accounting for debtDescribe and illustrate the accounting for debt
investments.investments.
3.3. Describe and illustrate the accounting for equityDescribe and illustrate the accounting for equity
investments.investments.
4.4. Describe and illustrate valuing and reportingDescribe and illustrate valuing and reporting
investments in the financial statements.investments in the financial statements.
5.5. Describe fair value accounting and its implicationsDescribe fair value accounting and its implications
for the future.for the future.
6.6. Describe and illustrate the computation of dividendDescribe and illustrate the computation of dividend
yield.yield.

Learning Objective
Learning ObjectiveDescribe why companies invest in
Describe why companies invest in
debt and equity securities.
debt and equity securities.
11

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

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

o These debt securities and equity securities areThese debt securities and equity securities are
termedtermed InvestmentsInvestments, or, or Temporary InvestmentsTemporary Investments,,
and are reported in the Current Assets sectionand are reported in the Current Assets section
of the balance sheet.of the balance sheet.

o The primary objective of investing inThe primary objective of investing in
temporary investments is to:temporary investments is to:
 earn interest incomeearn interest income
 receive dividendsreceive dividends
 realize gains from increases in the market price ofrealize gains from increases in the market price of
the securities.the securities.

Investing Cash in Long-Term InvestmentsInvesting Cash in Long-Term Investments
o Long-term investments often involve theLong-term investments often involve the
purchase of a significant portion of the stockpurchase of a significant portion of the stock
of another company. Such investments have aof another company. Such investments have a
strategic purpose:strategic purpose:
 Reduction of costsReduction of costs
 Replacement of managementReplacement of management
 ExpansionExpansion
 IntegrationIntegration

Learning Objective
Learning ObjectiveDescribe and illustrate the
Describe and illustrate the
accounting for debt investments.
accounting for debt investments.
22

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

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

(continued)
INTERESTINTEREST
REVENUEREVENUE

INTERESTINTEREST
REVENUEREVENUE

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

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

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

Sale of BondsSale of Bonds
o On January 31, 2015, Homer Company sells theOn January 31, 2015, Homer Company sells the
Treasury bonds at 98.The sale results in a lossTreasury bonds at 98.The sale results in a loss
of $360.of $360.
Proceeds from saleProceeds from sale
($18,000 × 98%)($18,000 × 98%) $17,640$17,640
Less book value (cost)Less book value (cost)
of the bondsof the bonds 18,00018,000
Loss on sale of bondsLoss on sale of bonds $ (360)$ (360)

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

Learning Objective
accounting for equity investments.
accounting for equity investments.
33

Accounting for Equity InvestmentsAccounting for Equity Investments
o A company may invest in the preferred orA company may invest in the preferred or
common stock of another company.Thecommon stock of another company.The
company investing in another company’s stockcompany investing in another company’s stock
is theis the investorinvestor..
o The company whose stock is purchased is theThe company whose stock is purchased is the
investee.investee.

ACCOUNTINGACCOUNTING
FOR EQUITYFOR EQUITY
INVESTMENTSINVESTMENTS

Less Than 20% OwnershipLess Than 20% Ownership
o Investments of less than 20% of the investee’sInvestments of less than 20% of the investee’s
outstanding stock are accounted for by usingoutstanding stock are accounted for by using
thethe cost methodcost method. Under the cost method,. Under the cost method,
entries are recorded for the followingentries are recorded for the following
transactions:transactions:
 Purchase of stockPurchase of stock
 Receipt of dividendsReceipt of dividends
 Sale of stockSale of stock

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

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

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

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

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

Purchase of StockPurchase of Stock
Simpson Inc. purchased a 40% interest inSimpson Inc. purchased a 40% interest in
Flanders Corporation’s common stock on JanuaryFlanders Corporation’s common stock on January
2, 2014 for $350,000.2, 2014 for $350,000.

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

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

RECORDINGRECORDING
INVESTEEINVESTEE
DIVIDENDSDIVIDENDS

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

More Than 50% OwnershipMore Than 50% Ownership
o If the investor purchases more than 50% of theIf the investor purchases more than 50% of the
outstanding stock of the investee, the investoroutstanding stock of the investee, the investor
is considered to have control over the investee.is considered to have control over the investee.
The purchase is termed aThe purchase is termed a businessbusiness
combinationcombination..

More Than 50% OwnershipMore Than 50% Ownership
o A corporation owning all or a majority of theA corporation owning all or a majority of the
voting stock of another corporation is called avoting stock of another corporation is called a
parent companyparent company.The corporation that is.The corporation that is
controlled is called thecontrolled is called the subsidiary companysubsidiary company..
o At the end of the year, the financial statementsAt the end of the year, the financial statements
of the parent and subsidiary are combined,of the parent and subsidiary are combined,
andand consolidated financialconsolidated financial statementsstatements areare
issued.issued.

Learning Objective
Learning ObjectiveDescribe and illustrate valuing and
Describe and illustrate valuing and
reporting investments in the
reporting investments in the
financial statements.
financial statements.
44

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

o Trading securities are reported as currentTrading securities are reported as current
assets on the balance sheet.assets on the balance sheet.
o Trading securities are valued as a portfolioTrading securities are valued as a portfolio
(group) of securities using their fair values.(group) of securities using their fair values.
Fair valueFair value is the market price that would beis the market price that would be
received for a security if it were sold.received for a security if it were sold.
o Changes in fair value of the portfolio areChanges in fair value of the portfolio are
recognized as anrecognized as an unrealizedunrealized gaingain oror lossloss for thefor the
period.period.

o Maggie Company purchased a portfolio ofMaggie Company purchased a portfolio of
trading securities during 2014. On Decembertrading securities during 2014. On December
31, 2014, the cost and fair values of the31, 2014, the cost and fair values of the
securities were as follows:securities were as follows:

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

TRADINGTRADING
SECURITIESSECURITIES

Available-for-Sale SecuritiesAvailable-for-Sale Securities
o Available-for-sale securitiesAvailable-for-sale securities are debt andare debt and
equity securities that are neither held forequity securities that are neither held for
trading, held to maturity, nor held for strategictrading, held to maturity, nor held for strategic
reasons.reasons.

o Maggie Company purchased three securitiesMaggie Company purchased three securities
during 2014 as available-for-sale securities. Onduring 2014 as available-for-sale securities. On
December 31, 2014, the cost and fair values ofDecember 31, 2014, the cost and fair values of
the securities were as follows:the securities were as follows:

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

AVAILABLE-FOR-AVAILABLE-FOR-
SALE SECURITIESSALE SECURITIES
Equal

Held-To-Maturity SecuritiesHeld-To-Maturity Securities
o Held-to-maturityHeld-to-maturity securitiessecurities are debtare debt
investments, such as notes or bonds, that ainvestments, such as notes or bonds, that a
company intends to hold until their maturitycompany intends to hold until their maturity
date.date.

Learning Objective
Learning ObjectiveDescribe fair value accounting and
Describe fair value accounting and
its implications for the future.
its implications for the future.
55

Fair Value AccountingFair Value Accounting
o Fair valueFair value is the price that would be receivedis the price that would be received
for selling an asset or paying off a liability.for selling an asset or paying off a liability.
o Fair value assumes that the asset is sold or theFair value assumes that the asset is sold or the
liability is paid off underliability is paid off under normalnormal rather thanrather than
distressed conditions.distressed conditions.

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

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

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

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

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

Learning Objective
computation of dividend yield.
computation of dividend yield.
66

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

Appendix
Appendix
Comprehensive
Comprehensive
Income
Income

Comprehensive IncomeComprehensive Income
o Comprehensive incomeComprehensive income is defined as allis defined as all
changes in stockholders’ equity during achanges in stockholders’ equity during a
period, except those resulting from dividendsperiod, except those resulting from dividends
and stockholders’ investments.and stockholders’ investments.

o Other comprehensive incomeOther comprehensive income items includeitems include
unrealized gains and losses on available-for-unrealized gains and losses on available-for-
sale securities as well as other items such assale securities as well as other items such as
foreign currency and pension liabilityforeign currency and pension liability
adjustments.adjustments.
o The cumulative effect of other comprehensiveThe cumulative effect of other comprehensive
income is reported on the balance sheet, asincome is reported on the balance sheet, as
accumulated other comprehensive incomeaccumulated other comprehensive income..

o Companies may report comprehensive incomeCompanies may report comprehensive income
in the financial statements as follows:in the financial statements as follows:
 On the income statementOn the income statement
 In a separate statement of comprehensive incomeIn a separate statement of comprehensive income
 In the statement of stockholders’ equityIn the statement of stockholders’ equity

COMPREHENSIVCOMPREHENSIV
E INCOMEE INCOME

Investments and
Investments and
Fair Value
Fair Value
Accounting
Accounting
The End
The End

Accounting for Debt and Equity Investments

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