Chapter 10
Investments
Learning Objectives
1. Identify why companies
invest in debt and
equity securities and
classify investments
2. Account for investments
in debt securities
3. Account for investments
in equity securities
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Learning Objectives
4. Describe and illustrate
how debt and equity
securities are reported
5. Use the rate of return
on total assets to
evaluate business
performance
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Learning Objective 1
Identify why companies
invest in debt and equity
securities and classify
investments
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Why Do Companies Invest?
• Businesses invest in a variety of companies’
stocks and bonds.
• An investor is the owner of a bond or share of
stock.
• The investee issues the bond or stock to the
investor.
• A security is a share or interest representing
financial value. There are two types of
securities:
– Debt securities
– Equity securities
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Reasons to Invest
• Why would a company invest in debt or
equity securities? There are two common
reasons:
• To invest excess cash in order to generate
investment income
• To invest in a debt or equity security of other
companies as a business strategy, such as
enhancing a business relationship
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Classification and Reporting of
Investments
• Investments are classified as short-term
investments or long-term investments.
• Types of investments:
–
–
–
–
–
Trading investments
Held-to-maturity investments (HTM)
Available-for-sale investments (AFS)
Significant interest investments
Controlling interest investments
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Classification and Reporting of
Investments
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Learning Objective 2
Account for investments in
debt securities
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How Are Investments in Debt
Securities Accounted For?
• Companies record the investment in debt
securities by first recording the purchase
of the investment.
• Companies record interest revenue.
• At the date of maturity, companies record
the disposition of the investment.
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Purchase of Debt Securities
• Smart Touch Learning has excess cash to
invest and pays $100,000 to buy
$100,000 face value, 9%, five-year Neon
Company bonds on July 1, 2016. Smart
Touch Learning plans to hold the bonds
until maturity.
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Interest Revenue
• On December 31, 2016, Smart Touch
Learning receives the first interest
payment on the bond investment.
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Disposition at Maturity
• When Smart Touch Learning disposes of
the bonds at maturity on June 30, 2021, it
will receive the face value of the bond.
Assuming the last interest payment has
been recorded, the entry is:
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Learning Objective 3
Account for investments in
equity securities
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How Are Investments in Equity
Securities Accounted For?
• The accounting for equity securities is
based on the percentage of ownership:
– Cost method for ownership less than 20%
– Equity method for ownership between 20%
and 50%
– Consolidations for ownership greater than 50%
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Equity Securities with Less Than 20%
Ownership (Cost Method)
• Accounted for as either:
– Trading securities
– Available-for-sale securities
• Recognize dividend revenue
• Adjust for changes in market value
• Recognize gain or loss on disposition
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Purchase of Equity Securities
• On March 1, 2016, Smart Touch Learning
acquires 1,000 shares of stock in Yellow
Corporation for $26.16 per share. Smart
Touch Learning owns less than 20% of
Yellow’s voting stock. Treat as availablefor-sale investment.
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Dividend Revenue
• Yellow Corporation declares and pays a
cash dividend of $0.16 per share on
June 9, 2016.
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Disposition
• On July 15, 2016, Smart Touch Learning
sells 800 shares of its Yellow Corporation
stock for $25,000. Smart Touch Learning
compares the cash received with the cost
of the stock disposed of and determines
the gain as follows:
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Disposition
• Smart Touch Learning will record the
following entry for the disposition of the
Yellow Stock:
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Equity Securities with 20% to 50%
Ownership (Equity Method)
• Significant
influence is
assumed
• Accounted for
using the
equity
method
Initial
investment
Receipt of
dividends
Share of
profits
• Record investment at cost when
acquired
• Adjust the investment account
balance for dividends received
• Adjust the investment account for
the investor’s share of investee’s
net income or net loss
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Purchase
• Investments accounted for by the equity
method are recorded at cost at the time of
purchase. Smart Touch Learning pays
$400,000 to acquire 40% of the common
stock of Kline, Inc., on January 6, 2016.
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Dividends Received (Equity Method)
• Kline declares and pays a cash dividend of
$50,000 on June 30, 2016. Because Smart
Touch Learning owns 40% of the stock, it
receives 40%, or $20,000, of the dividend.
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Share of Net Income (Equity Method)
• Kline, Inc., reported net income of
$125,000 for the 2016 year. Smart Touch
Learning must account for 40% of Kline’s
net income as an increase in the
investment account.
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Equity Securities with 20% to 50%
Ownership (Equity Method)
• After the preceding entries are posted,
Smart Touch Learning’s Long-term
Investments T-account shows its equity in
the net assets of Kline as follows:
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Disposition
• On January 1, 2017, Smart Touch
Learning sells 10% of the Kline common
stock for $40,000. Smart Touch Learning
will calculate the gain or loss as follows:
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Disposition
• The journal entry to record the disposition
of 10% of Smart Touch Learning’s interest
in Kline is as follows:
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Equity Securities with More Than 50%
Ownership (Consolidations)
• A controlling interest exists when the
investor owns more than 50% of the
investee’s voting stock.
• The parent company is the corporation that
controls the other company.
• The subsidiary company is the company
controlled by another corporation.
• The parent prepares consolidated statements
using consolidation accounting.
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Learning Objective 4
Describe and illustrate
how debt and equity
securities are reported
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How Are Debt and Equity Securities
Reported?
• Trading investments
• Available-for-sales (AFS) investments
• Held-to-maturity investments
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Trading Investments
• Record initial
investment at cost.
• Adjust for changes in
fair value.
• The fair value
adjustment is called
unrealized holding
gain/loss.
– Reported on the
income statement
Fair value is the
price that would be
used if the
company were to
sell the
investments on the
market.
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Trading Investments
• On December 31, 2016, Smart Touch
Learning reported trading investments of
$26,160. The market value of the
investments is $24,000.
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Available-for-Sale Investments
• Record initial
investment at cost.
• Adjust for changes in
fair value.
• The adjustment is
called unrealized
holding gain/loss.
– Reported in
stockholders’ equity
The adjustment is
recorded and shown
in the stockholders’
equity section of the
balance sheet as part
of comprehensive
income.
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Available-for-Sale Investments
• On December 31, 2016, Smart Touch
Learning reported AFS investments of
$60,000. The market value of the
investments is $64,000.
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Available-for-Sale Investments
• Comprehensive income includes net
income plus some specific gains and
losses, such as unrealized holding gains or
losses on available-for-sale investments.
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Held-to-Maturity Investments
• Held-to-maturity investments are reported
at amortized cost.
• The investment may be reported as a
current asset or long-term asset on the
balance sheet, depending on the maturity
date.
• Interest revenue is reported on the
income statement in the Other Revenues
and (Expenses) section.
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How Are Debt and Equity Securities
Reported?
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Learning Objective 5
Use the rate of return on
total assets to evaluate
business performance
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How Do We Use the Rate of Return on Total
Assets to Evaluate Business Performance?
• The rate of return on total assets
measures a company’s success in using
assets to earn a profit.
• Companies finance assets two ways:
– Debt: A company borrows from creditors to
purchase assets.
– Equity: A company receives cash or other
assets from stockholders.
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How Do We Use the Rate of Return on Total
Assets to Evaluate Business Performance?
• The rate of return on total assets is
calculated by adding interest expense to
net income and dividing by average total
assets. For Green Mountain:
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