Study Study Objectives Objectives Reporting and Analyzing Investments Appendix D-1 Appendix D-2 1. Identify the reasons corporations invest in debt and stock securities. 2. Explain the accounting for debt investments. 3. Explain the accounting for stock investments. 4. Describe the purpose and usefulness of consolidated financial statements. 5. Indicate how debt and stock investments are valued and reported in financial statements. 6. Distinguish between short-term and long-term investments. Appendix D-3 Financial Accounting, Fifth Edition Why Why Corporations Corporations Invest Invest Why Why Corporations Corporations Invest Invest Accounting Accounting for for Debt Debt Instruments Instruments Corporations generally invest in debt or stock securities for one of three reasons. Question Recording Acquisition of Bonds 1. Pension funds and banks regularly invest in debt and stock securities to: Corporation may have excess cash. 2. To generate earnings from investment income. a. house excess cash until needed. 3. For strategic reasons. b. generate earnings. Illustration D-1 Appendix D-4 Recording Bond Interest c. meet strategic goals. Temporary investments and the operating cycle Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any. Calculate and record interest revenue based upon the carrying value of the bond times the interest rate times the portion of the year the bond is outstanding. d. avoid a takeover by disgruntled investors. SO 1 Identify the reasons corporations invest in debt and stock securities. Appendix D-5 SO 1 Identify the reasons corporations invest in debt and stock securities. Appendix D-6 SO 2 Explain the accounting for debt investments. Excel Accounting Accounting for for Debt Debt Instruments Instruments Accounting Accounting for for Debt Debt Instruments Instruments Accounting Accounting for for Debt Debt Instruments Instruments Sale of Bonds Illustration: Kuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2010, for $54,000, including brokerage fees of $1,000. The entry to record the investment is: Illustration: Kuhl Corporation acquires 50 Doan Inc. 12%, 10-year, $1,000 bonds on January 1, 2010, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is: Credit the investment account for the cost of the bonds and record as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds. Jan. 1 July 1 * Appendix D-7 SO 2 Explain the accounting for debt investments. Appendix D-8 SO 2 Explain the accounting for debt investments. Appendix D-9 ($50,000 x 12% x ½ = $3,000) SO 2 Explain the accounting for debt investments. Accounting Accounting for for Debt Debt Instruments Instruments Accounting Accounting for for Debt Debt Instruments Instruments Accounting Accounting for for Debt Debt Instruments Instruments Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1. Illustration: Assume that Kuhl corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2011, after receiving the interest due. Prepare the entry to record the sale of the bonds. Question Dec. 31 An event related to an investment in debt securities that does not require a journal entry is: a. acquisition of the debt investment. b. receipt of interest revenue from the debt investment. Jan. 1 Kuhl reports receipt of the interest on January 1 as follows. c. a change in the name of the firm issuing the debt securities. d. sale of the debt investment. Jan. 1 Appendix D-10 SO 2 Explain the accounting for debt investments. Accounting Accounting for for Debt Debt Instruments Instruments Appendix D-11 SO 2 Explain the accounting for debt investments. Accounting Accounting for for Stock Stock Investments Investments Ownership Ownership Percentages Percentages Question When bonds are sold, the gain or loss on sale is the difference between the: 0 --------------20% --------------20% ------------ 50% -------------- 100% a. sales price and the cost of the bonds. b. net proceeds and the cost of the bonds. c. sales price and the market value of the bonds. d. net proceeds and the market value of the bonds. No significant influence usually exists Significant influence usually exists Investment valued using Cost Method Investment valued using Equity Method Control usually exists Investment valued on parent’s books using Cost Method or Equity Method (investment eliminated in Consolidation) Appendix D-12 SO 2 Explain the accounting for debt investments. Holdings Holdings of of Less Less than than 20% 20% Companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions). The accounting depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation. Appendix D-13 SO 2 Explain the accounting for debt investments. Appendix D-14 SO 3 Explain the accounting for stock investments. Appendix D-15 SO 3 Explain the accounting for stock investments. Holdings Holdings of of Less Less than than 20% 20% Holdings Holdings of of Less Less than than 20% 20% Holdings Holdings of of Less Less than than 20% 20% Illustration: On July 1, 2010, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is: Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is: Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2011. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is: July 1 Appendix D-16 Dec. 31 Feb. 10 SO 3 Explain the accounting for stock investments. Appendix D-17 SO 3 Explain the accounting for stock investments. Appendix D-18 SO 3 Explain the accounting for stock investments. Holdings Holdings Between Between 20% 20% and and 50% 50% Equity Method Holdings Holdings Between Between 20% 20% and and 50% 50% Holdings Holdings Between Between 20% 20% and and 50% 50% Question Illustration: Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, 2010. For 2010, Beck reports net income of $100,000 and paid dividends of $40,000. Prepare the entries for these transactions. Under the equity method, the investor records dividends received by crediting: Record the investment at cost and subsequently adjust the amount each period for a. Dividend Revenue. ¾ the investor’s proportionate share of the earnings (losses) and b. Investment Income. c. Revenue from Investment. ¾ dividends received by the investor. d. Stock Investments. If investor’s share of investee’s losses exceeds the carrying amount of the investment, the investor ordinarily should discontinue applying the equity method. Appendix D-19 SO 3 Explain the accounting for stock investments. Holdings Holdings Between Between 20% 20% and and 50% 50% Appendix D-20 Debit 120,000 30,000 Credit ¾ Investor is referred to as the parent. ¾ Investee is referred to as the subsidiary. ¾ Investment in the subsidiary is reported on the parent’s books as a long-term investment. Revenue from Investments Debit Credit 30,000 ¾ Parent generally prepares consolidated financial statements. 12,000 138,000 Appendix D-22 SO 3 Explain the accounting for stock investments. Valuing Valuing and and Reporting Reporting Investments Investments Trading Securities Appendix D-23 Available-for-Sale Securities Appendix D-21 Categories of Securities Companies classify debt and stock investments into three categories: ¾ Trading securities ¾ Available-for-sale securities ¾ Held-to-maturity securities These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%. Appendix D-24 Question Marketable securities bought and held primarily for sale in the near term are classified as: a. available-for-sale securities. b. held-to-maturity securities. c. stock securities. d. trading securities Companies report securities at fair value, and report changes from cost as a component of the stockholders’ equity section. Appendix D-26 SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. Valuing Valuing and and Reporting Reporting Investments Investments These securities can be classified as current assets or as long-term assets, depending on the intent of management. Companies report trading securities at fair value, and report changes from cost as part of net income. SO 3 Explain the accounting for stock investments. Valuing Valuing and and Reporting Reporting Investments Investments Companies hold available-for-sale securities with the intent of selling these investments sometime in the future. Trading means frequent buying and selling. SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. SO 4 Describe the use of consolidated financial statements. Valuing Valuing and and Reporting Reporting Investments Investments Companies hold trading securities with the intention of selling them in a short period. Appendix D-25 SO 3 Explain the accounting for stock investments. Controlling Interest - When one corporation acquires a voting interest of more than 50 percent in another corporation After Milar posts the transactions for the year, its investment and revenue accounts will show the following. Stock Investments Dec. 31 Dec. 31 Holdings Holdings of of More More Than Than 50% 50% Illustration: Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, 2010. For 2010, Beck reports net income of $100,000 and paid dividends of $40,000. Prepare the entries for these transactions. Jan. 1 Appendix D-27 SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. Trading Trading Securities Securities Available-for-Sale Available-for-Sale Securities Securities Available-for-Sale Available-for-Sale Securities Securities Illustration: Investment of Pace classified as trading securities on December 31, 2010. Problem: How would the entries change if the securities were classified as available-for-sale? Illustration: Assume that Ingrao Corporation has two securities that it classifies as available-for-sale. Illustration 16-8 provides information on their valuation. Illustration D-6 Illustration D-7 The entries would be the same except that the Unrealized Gain or Loss—Equity account is used instead of Unrealized Gain or Loss—Income. The unrealized loss would be deducted from the stockholders’ equity section rather than charged to the income statement. The adjusting entry for Pace Corporation is: Dec. 31 Appendix D-28 SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. Available-for-Sale Available-for-Sale Securities Securities Appendix D-29 SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. ShortShort-Term Investments An unrealized loss on available-for-sale securities is: Nonoperating items related to investments (2) intended to be converted into cash within the next year or operating cycle, whichever is longer. c. reported as a separate component of stockholders' equity. d. deducted from the cost of the investment. Investments that do not meet both criteria are classified as long-term investments. Appendix D-32 SO 6 Distinguish between short-term and long-term investments. Illustration D-12 Illustration D-11 Appendix D-35 SO 6 Distinguish between short-term and long-term investments. Copyright Copyright Unrealized gain or loss on available-for-sale securities are reported as a separate component of stockholders’ equity. SO 6 Distinguish between short-term and long-term investments. Appendix D-33 Statement Statement of of Cash Cash Flows Flows Presentation Presentation Realized and Unrealized Gain or Loss Appendix D-34 Illustration D-10 (1) readily marketable and b. closed-out at the end of the accounting period. Presentation Presentation of of Realized Realized and and Unrealized Unrealized Gain Gain or or Loss Loss SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. Also called marketable securities, are securities held by a company that are a. reported under Other Expenses and Losses in the income statement. SO 5 Indicate how debt and stock investments are valued and reported reported in financial statements. Appendix D-30 Presentation Presentation of of Realized Realized and and Unrealized Unrealized Gain Gain or or Loss Loss Balance Balance Sheet Sheet Presentation Presentation Question Appendix D-31 The adjusting entry for Ingrao Corporation is: Dec. 31 SO 6 Distinguish between short-term and long-term investments. “Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” Appendix D-36