Horngren’s Financial & Managerial
Accounting
Sixth Edition
Chapter 10
Investments
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Learning Objectives (1 of 2)
10.1 Identify why companies invest in debt and equity
securities and classify investments
10.2 Account for investments in debt securities
10.3 Account for investments in equity securities
10.4 Describe and illustrate how debt and equity
securities are reported
10.5 Use the rate of return on total assets to evaluate
business performance
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Learning Objective 10.1
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 are investments in notes or bonds
payable issued by another company.
– Equity securities are investments in stock ownership
in another company.
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Reasons to Invest
• There are two commons reasons a company would invest
in debt or equity securities:
– To invest excess cash in order to generate investment
income
– To invest in a debt or equity security of another
company as a business strategy, such as enhancing a
business relationship
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Classification and Reporting of
Investments (1 of 3)
• Investments are classified as:
– Short-term investments if the investor intends to sell
them in one year or less
– Long-term investments if the investor intends to hold
them for longer than one year
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Debt Securities
• Debt securities can be further classified into three
specific types, based on how long the investor intends to
hold the investment:
– A trading debt investment is a debt security that the
investor plans to sell in the very near future.
– A held-to-maturity (HTM) debt investment is a debt
security the investor intends to hold and has the ability
to hold until it matures.
– An available-for-sale (AFS) debt investment is a
debt security that isn’t a trading debt investment or a
held-to-maturity debt investment.
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Equity Securities
• Equity securities can also be classified into three specific
types, based on the investor’s level of influence over the
investee company:
– No significant influence equity investment―The
investor lacks the ability to participate in the decisions
of the investee company.
– Significant influence equity investment―The
investor has the ability to exert influence over operating
and financial decisions of the investee company.
– Controlling interest equity investment―The investor
owns more than 50% of the investee’s voting stock.
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Classification and Reporting of
Investments (2 of 3)
Exhibit 10-1 Types of Investments
Debt securities—Classified by how long the investor intends to hold
the investment
Types of Investments
Definition
Trading debt investment
A debt security that the investor plans to
sell in the very near future
Held-to-maturity (HTM) debt
investment
A debt security the investor intends to hold
and has the ability to hold until it matures.
Available-for-sale (AFS) debt
investment
A debt security that isn’t a trading debt
investment or a held-to-maturity debt
investment.
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Classification and Reporting of
Investments (3 of 3)
[Exhibit 10-1 continued]
Equity securities—Classified by the investor’s level of influence
over the investee company
Types of Investments
Definition
No significant influence
equity investment
An equity security in which the investor lacks the
ability to participate in the decisions of the
investee company.
Significant influence
equity investment
An equity security in which the investor has the
ability to exert influence over operating and
financial decisions of the investee company.
Controlling interest
equity investment
An equity security in which the investor
owns more than 50% of the investee’s voting
stock.
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Learning Objective 10.2
Account for investments in
debt securities
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How Are Investments in Debt Securities
Accounted For?
• Companies record an 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, 2018. Smart Touch Learning
plans to hold the bonds until maturity.
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Interest Revenue
On December 31, 2018, 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, 2023, it will receive the face value of
the bonds. Assuming that the last interest payment has been
recorded, the entry is:
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Learning Objective 10.3
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:
– The cost method is used for ownership less than 20%.
– The equity method is used for ownership between
20% and 50%.
– Consolidations are used for ownership greater than
50%.
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Purchase of Equity Securities
On March 1, 2018, 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.
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Dividend Revenue
Yellow Corporation declares and pays a cash dividend of
$0.16 per share on June 9, 2018. Smart Touch Learning
receives the cash dividend on June 9.
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Disposition (1 of 4)
On July 15, 2018, Smart Touch Learning sells 800 shares of
Yellow Stock for $25,000.
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Disposition (2 of 4)
On July 15, 2018, Smart Touch Learning sells 800 shares of
Yellow Stock for $25,000.
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Equity Securities with Significant Influence
(Equity Method)
Significant influence is assumed when a company has
20% to 50% ownership.
Accounted for using the equity method.
• Initial investment
− Record investment at cost when acquired
• Receipt of dividends
− Adjust the investment account balance for dividends
received
• Share of profits
− Adjust the investment account for the investor’s share
of investee’s net income or net loss
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Purchase
Smart Touch Learning pays $400,000 to purchase 40% of
the common stock of Kline, Inc.
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Dividends Received and Share of Net
Income (1 of 2)
Kline declares and pays a cash dividend of $50,000 on
June 30, 2018.
Error: $50,000 x 0.40 = 20,000
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Dividends Received and Share of Net
Income (2 of 2)
Kline reports net income of $125,000 for 2018.
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Disposition (3 of 4)
Smart Touch Learning sells 10% of the Kline common stock
for $40,000 on January 1, 2019.
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Disposition (4 of 4)
Smart Touch Learning records the sale of Kline common
stock as follows:
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Equity Securities with Control
(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 10.4
Describe and illustrate how
debt and equity securities
are reported
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How Are Debt and Equity Securities
Reported?
• Corporations’ debt and equity securities are reported on
the balance sheet in either the current or the long-term
asset section.
• How they are reported depends upon the type of
investment.
– Trading debt investments
– Available-for-sales (AFS) debt investments
– Held-to-maturity investments
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Trading Debt Investments (1 of 4)
• Trading debt investments are initially recorded at cost.
• They are adjusted for changes in fair value.
– Fair value is the price that would be used if the
investments were sold on the market.
– An adjustment is recorded as an unrealized holding
gain or loss and is reported in the Other Income and
(Expenses) section of the income statement.
• At disposal, the fair value adjustment is ignored in
determining the calculation of the gain or loss.
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Trading Debt Investments (2 of 4)
On December 31, 2018, Smart Touch Learning reports
trading debt investments of $26,160. The market value of
the trading debt investments is $24,000. The company has
an unrealized loss of $2,160 on the investments ($24,000 –
$26,160).
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Trading Debt Investments (3 of 4)
After the adjustment, the investment T-accounts appear as
follows:
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Trading Debt Investments (4 of 4)
Smart Touch Learning reports as follows:
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Available-For-Sale Debt Investments (1 of 6)
• AFS debt investments are recorded at current market
value.
• They are adjusted for changes in fair value.
– The adjustment is called unrealized holding gain/loss.
– AFS debt investments are included in Other
Comprehensive Income on the Statement of
Comprehensive Income and in the stockholders’ equity
section of the balance sheet.
• Disposition of available-for-sale debt investments is
handled in the same manner as trading debt investments.
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Available-For-Sale Debt Investments (2 of 6)
On December 31, 2018, Smart Touch Learning reports AFS
investments of $60,000. The market value of the investments
is $64,000.
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Available-For-Sale Debt Investments (3 of 6)
After Smart Touch learning posts the December 31, 2018,
adjustment, the investment T-accounts appear as follows:
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Available-For-Sale Debt Investments (4 of 6)
Smart Touch Learning reports as follows:
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Available-For-Sale Debt Investments (5 of 6)
• Comprehensive income is a company’s change in total
stockholders’ equity from all sources other than owners’
investments and dividends.
• Comprehensive income includes net income plus some
specific gains and losses, as follows:
– Unrealized holding gains or losses on available-for-sale
debt investments
– Foreign currency translation adjustments
– Gains or losses from post-retirement benefit plans
– Deferred gains or losses from derivatives
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Available-For-Sale Debt Investments (6 of 6)
Exhibit 10-2 Comprehensive Income
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Held-To-Maturity Debt Investments
• Held-to-maturity (HTM) investments are reported at
amortized cost.
• An HTM investment may be reported as a current asset
or a 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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Equity Investments with No Significant
Influence
• Equity investments with no significant influence must be
adjusted at the end of the year and reported at fair value.
• The company makes a year-end adjustment of the equity
investment to bring the account to market value.
• The adjustment is recorded as an unrealized holding gain
or loss and is reported in the Other Income and
(Expenses) section of the income statement.
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Exhibit 10-3 Debt and Equity Securities—Accounting
Methods and Financial Statement Effects (1 of 2)
Types of Investments
Accounting Methods
Financial Statement
Effects
Balance Sheet
Financial Statement
Effects
Income Statement
Trading Debt Investments
Fair Value: Unrealized
Holding Gain or Loss is
included in net income.
The investment is
reported as a current
asset on the balance
sheet.
Interest revenue is
reported on the income
statement.
Held-to-Maturity Investments
Amortized Cost
Depending on the
maturity date, the
investment is reported as
a current or long-term
asset on the balance
sheet.
Interest revenue is
reported on the income
statement.
Available-for-Sale Investments
Fair Value: Unrealized
Holding Gain or Loss is
included in Other
Comprehensive Income
and reported as a
separate component of
stockholders’ equity.
The investment is
reported as a current or
long-term asset on the
balance sheet depending
on management's intent.
Interest revenue is
reported on the income
statement.
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Exhibit 10-3 Debt and Equity Securities—Accounting
Methods and Financial Statement Effects (2 of 2)
Types of Investments
Accounting Methods
Financial Statement
Effects
Balance Sheet
Financial Statement
Effects
Income Statement
No Significant Influence
Equity Investments
Fair Value: Unrealized
Holding Gain or Loss
is included in net
income.
The investment is
reported as a current or
long-term asset on the
balance sheet depending
on management's
intent.
Dividend revenue is
reported on the income
statement.
Significant Influence Equity
Investments
Equity
The investment is
reported as a long-term
asset on the balance
sheet.
A percentage share of
investee’s net income is
reported on the income
statement.
Controlling Interest
Equity Investments
Consolidation
The balance sheets of
the parent and subsidiary
are combined.
The income statements of
the parent and subsidiary
are combined.
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Learning Objective 10.5
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? (1 of 2)
• 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? (2 of 2)
The rate of return on total assets for Kohl’s:
Rateof return of totalassets =
=
( Net income + Interest expense )
Average totalassets
($673 + $327 )
é æ $13,606 + $14,333 ö
êç
÷
êç
2
ø
ëè
= 0.07 = 7%
ù
ú
úû
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Revision Questions
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1. Which of the following is true of debt
securities?
• A) Debt securities entitle the holder to receipt of a share of
profit in the form of dividends.
• B) Debt securities typically pay interest for a fixed period.
• C) Debt securities include preferred stocks.
• D) Debt securities represent ownership interests of the
investors.
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Answer
• B) Debt securities typically pay interest for a fixed period.
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2. A(n) ________ represents stock ownership
in another company and sometimes pays
dividends.
• A) debt security
• B) Treasury bill
• C) corporate bond
• D) equity security
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Answer
• D) equity security
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3. Which type of debt security is always
categorized as a current asset?
• A) available-for-sale debt investments
• B) trading debt investments
• C) held-to-maturity debt investments
• D) Each of these choices can be categorized as long-term
if the investor intends to hold the investment for longer
than one year.
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Answer
• B) Trading debt investments are debt securities in which
the investor intends to sell in the very near future. Thus,
these are always categorized as current assets.
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4. Greene Corporation pays $500,000 to
acquire 40% of the voting stock of
Universal Technologies, Inc. on May 5,
2019. This investment will be classified as
a(n) ________.
• A) trading equity investment
• B) available-for-sale equity investment
• C) significant influence equity investment
• D) held-to-maturity equity investment
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Answer
• C) significant influence equity investment
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5. Dynamic Software, Inc. invests excess cash
of $100,000 in corporate bonds on March 30,
2019. The bonds mature 20 years from the date
of purchase. Dynamic plans to hold the bonds
until maturity and has the ability to do so. How
does the March 30, 2019 transaction affect the
accounting equation?
• A) liabilities will increase
• B) equity will decrease
• C) long-term assets will decrease
• D) total assets will remain unchanged
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Answer
• D) total assets will remain unchanged
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6. All State Services, Inc. acquired 100,000 shares of
Omega Metals, Inc. on January 1, 2018. Omega pays
a cash dividend of $0.25 per share on March 2, 2019.
With the current investment, All State Services, Inc.
holds 8% of Omega. In the journal entry on March 2,
2019, ________.
• A) Equity Investments is credited
• B) Dividend Revenue is credited
• C) Equity Investments is debited
• D) Cash Dividends is credited
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Answer
• B) Dividend Revenue is credited
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7. Sparklers Services, Inc. pays $1,350,000
to acquire 35% of voting stock of Global
Investments, Inc. on March 5, 2018. When
this transaction is recorded, the ________.
• A)
total equity will increase
• B) total assets will increase
• C) total assets will decrease
• D) total cash will decrease
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Answer
• D) total cash will decrease
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8. When a loss is recorded on the sale of a
significant influence equity investment,
________.
• A) total assets will increase
• B) equity will increase
• C) total assets will decrease
• D) equity will remain unchanged
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Answer
• C) total assets will decrease
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9. A parent company is a company that
________.
• A) is controlled by another corporation
• B) owns a controlling interest in another company
• C) is the first to begin operations in an industry
• D) has any level of investment in another company
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Answer
• B) owns a controlling interest in another company
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10. The fair value of an investment is the
price that ________.
• A) existed at the time of acquisition
• B) would be received if the company were to sell the
investment on the market
• C) is always equal to the weighted average cost of the
investment
• D) is not relevant for trading debt investments
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Answer
• B) would be received if the company were to sell the
investment on the market
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Thank You
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