INVESTMENTS
Chapter 12 covers the accounting for investments in
another entity. Graphic 12-1 on page 522 outlines the types
of investments and their accounting treatment.
Type
Characteristics
Accounting
Loan
Intend to hold to
Amortized Cost
maturity
Trading Held in an active Fair Value (holding gains
security trading account
and losses included in
earnings)
Availabl
Fair Value (holding gains
e
and losses excluded from
For Sale
earnings)
Equity
Fair value is not
Cost
determinable
Equity
Investor can
Cost adjusted for growth
significantly alter
investee's policies
Equity
Investor controls Consolidation
investee
In this course we will focus primarily on the first three
types of securities and briefly introduce the accounting
issues involved when the investor can exercise some
control over the investee.
Accounting For Marketable Securities
The key problem is how to account for unrealized holding
gains and losses on the securities. These are changes in
value that are unrealized because the securities have not
been sold.
There are two issues involved:
Should the changes in value be reflected in the balance
sheet?
Should the changes in value be included in current period's
earnings?
Debt Securities Held to Maturity
Examples: Loans, Long-Term Note Receivables, LeaseReceivables
Characteristics: Fixed Maturity, Fixed Interest Rate (if the
interest rate floats then the fair value stays constant)
The firm's intent is to hold the security until maturity, i.e.,
to receive interest and principal payments.
The value of the security fluctuates with changes in interest
rates. For example, if I have a loan receivable at 8%, and
interest rates increase to 10%, the value of receiving 8%
interest declines. However, because the firm does not
intend to sell the security, the change in value may not be
relevant. As a result, changes in value are not recorded.
The fair value is reported in the footnotes.
Dow Chemical
Fair Value of Financial Instruments at December 31, 1999
Cost
Marketable securities:
Debt securities
$ 1,771
Equity securities
1,043
Other
138
Total
$ 2,952
Gain
$ 20
580
2
$602
Loss
Fair
Value
$ (31) $1,760
(47) 1,576
-140
$ (78) $3,476
Securities Available for Sale
Most marketable securities (short-term investments) held
by firms (except for financial institutions) are included in
this category.
• Securities are recorded at fair value on the balance sheet
• Unrealized holding gains and losses appear in a separate
section of stockholders equity. Temporary changes in
value do not appear in the income statement.
• Impairment (non-temporary) losses are recorded in the
income statement. These are permanent declines in
value due to bankruptcy, etc.
Example: E 12-5
2000
March 2 Purchased 1 million PG common shares for $31
million
April 12 Purchased $20 million of 10% bonds at face
value.
July 18 Received cash dividends of $2 million from PG
Oct 15 Received $1 million in interest
Oct 16 Sold the bonds for $21 million
Nov 1
Purchased 500,000 LTD preferred shares for $40
million
Dec 31 Market prices are $32 per share for PG and $74
per share for LTD.
2001
Jan 23
Mar 1
Sold half of PG shares for $32
Sold LTD shares for $76
Date
Account
Dr
Cr
Trading Securities
The entity intends to actively buy and sell these securities
with the intention of making a profit on short-term
fluctuations in price. Primarily used by financial
institutions.
• Securities are reported on the balance sheet at fair value.
• Unrealized holding gains and losses are included in net
income.
Example: E 12-5, assuming that the investments in PG and
LTD are considered to be trading securities. Record the
appropriate entries for 12/31/00, 1/23/01, 3/1/01.
Date
Account
Dr
Cr
Example: Microsoft
Balance Sheet
June 30
1999
2000
$ 4,975
12,261
2,245
1,469
752
21,702
1,611
14,372
940
$38,625
$ 4,846
18,952
3,250
1,708
1,552
30,308
1,903
17,726
2,213
$52,150
Retained earnings, including other comprehensive
income of $1,787 and $1,527
13,614
18,173
Current assets:
Cash and equivalents
Short-term investments
Accounts receivable
Deferred income taxes
Other
Total current assets
Property and equipment, net
Equity and other investments
Other assets
Total assets
Income Statement
Operating income
Investment income
Gain on sales
1998
6,414
703
--
1999
9,928
1,803
160
2000
10,937
3,182
156
Income before income taxes
7,117
11,891
14,275
Statement of Cash Flows
Investing
Additions to property and equipment (656)
Cash portion of WebTV purchase price (190)
Cash proceeds from sale of Softimage, Inc.
-Purchases of investments
(19,114)
Maturities of investments
1,890
Sales of investments
10,798
(36,441) (43,158)
4,674
4,025
21,080 28,085
Net cash used for investing
(11,191) (11,927)
(7,272)
(583)
---
(879)
-79
Footnotes
Financial Instruments
The Company considers all liquid interest-earning investments
with a maturity of three months or less at the date of purchase to be
cash equivalents. Short-term investments generally mature
between three months and six years from the purchase date. All
cash and short-term investments are classified as available for sale
and are recorded at market using the specific identification
method; unrealized gains and losses are reflected in other
comprehensive income. Cost approximates market for all
classifications of cash and short-term investments; realized and
unrealized gains and losses were not material.
Equity and other investments include debt and equity instruments.
Debt securities and publicly traded equity securities are classified
as available for sale and are recorded at market using the specific
identification method. Unrealized gains and losses are reflected in
other comprehensive income. All other investments, excluding
joint venture arrangements, are recorded at cost.
June 30, 2000
Cost
Basis
Debt securities
recorded at market
6,406
Common stock and
Warrants
Preferred stock
Other investments
Equity and
other investments
Unrealized
Recorded
Gains/(Losses) Basis
(977)
5,429
5,815
2,319
205
3,958
---
9,773
2,319
205
$14,745
$2,981
$17,726
Other Comprehensive Income
The changes in the components of other comprehensive income are
as follows:
Year Ended June 30
Net unrealized investment
gains/(losses)
Translation adjustments
and other
Other comprehensive
income/(loss)
1998
627
(124)
$ 503
1999
1,052
69
$1,121
2000
(283)
23
$(260)
Equity Method
Includes investments in which the investor can exert
significant influence, but cannot control the investee.
Generally investor holds 20-50% of the investee.
• Investment is recorded at historical cost
• Investment is increased by share of the investee's net
income (investor record's its share of investee's income
in the investor's earnings)
• Dividends received reduce the value of the investment.
Example: Illustration 12-4, On 1/2/00, ACC purchases 25%
of EM common stock for $200 million.
EM has $100 net income and pays $24 in dividends.
ACC Entries:
Dr. Investment
$200
Cr. Cash
$200
Dr. Investment
$25
Cr. Investment revenue $25
Dr. Cash
$6
Cr. Investment
$6
Required for Thursday, November 2
Financial Statements:
• Determine the value of the marketable securities
• Determine the amount of the unrealized holding gain and
loss as of the end of the year.
• Compute marketable securities as a proportion of current
assets.
• Compute the unrealized holding gain and loss as a
proportion of net income.
Chapter problems:
E12-6, E12-7, E12-8, E12-12, P12-3