Investments in Other Corporations
Appendix D
© 2009 The McGraw-Hill Companies, Inc.
Why Do Companies Invest?
1. Companies transfer excess cash into investments to
produce higher income. Some companies are set up to
produce income from investments.
2. Companies us investments to even out seasonal
fluctuations in cash. Such investments in securities are
referred to as passive investment.
3. Some companies invest with the purpose of influencing,
but not controlling the company’s policies and activities.
4. Managers may want to control another company, either by
purchasing it directly or by becoming a majority
shareholder.
McGraw-Hill/Irwin
Slide 2
Passive Investments in Debt and Equity
Securities
Passive investments are made to earn a high rate of
return on funds that may be needed in the future. This
category includes debt securities (bonds and notes) and
equity securities (stock).
Passive Equity Investments
Presumed to be passive if the
investing company owns less
than 20% of the other
company’s outstanding voting
shares.
Reporting Using Market Value
Method
Passive Debt Investments
Investments in debt securities
are always considered to be
passive.
No
Hold to
Maturity?
Yes
Reporting at Amortized Cost
Investments in Stock for Significant
Influence
Active investments are those in which a company owns
enough stock in another business to influence or control
that business. Significant influence is presumed to exist
if the investing company owns from 20 to 50% of the
outstanding voting shares.
The equity method is
used to measure and
report this type of active
investment.
McGraw-Hill/Irwin
Slide 4
Investments in Stock for Control
Control is the ability to determine the operating and
financial policies of another company through
ownership of its voting stock. For all practical purposes,
control is presumed when the investing company owns
more that 50% of the outstanding voting stock.
These investments are accounted for by
combining the two companies using the
consolidated statement method.
McGraw-Hill/Irwin
Slide 5
Debt Investments Held to Maturity:
Amortized Cost Method
Assume that on October 1, 2010, Washington Post paid the
par value of $100,000,000 for 8% bonds due to mature on
October 1, 2015. The 8% interest is paid each September
30th. Management plans to hold the bonds for five years,
until they mature.
Debit
100,000,000
Investments Held-to-Maturity (+A)
Cash (-A)
ASSETS
Cash
Investments – Held-to-Maturity (-A)
McGraw-Hill/Irwin
Credit
100,000,000
=
LIABILITIES
+
STOCKHOLDERS' EQUITY
-100,000,000
+100,000,000
Slide 6
Debt Investments Held to Maturity:
Amortized Cost Method
On December 31, 2010, Washington Post will prepare an
adjusting entry to accrue interest for three months
($100,000,000 × 8% × 3/12).
Interest Receivable (+A)
Interest Revenue (+R, +OE)
ASSETS
Interest Receivable
McGraw-Hill/Irwin
= LIABILITIES +
+2,000,000
Debit
2,000,000
Credit
2,000,000
STOCKHOLDERS' EQUITY
Interest Revenue
+2,000,000
Slide 7
Debt Investments Held to Maturity:
Amortized Cost Method
On September 30, 2011, Washington Post will receive a full
year of interest. Revenue recognized in 2011 is
($100,000,000 × 8% × 9/12).
Cash (+A)
Interest Revenue (+R, +OE)
Interest Receivable (-A)
ASSETS
Cash
Interest Receivable
McGraw-Hill/Irwin
Debit
8,000,000
= LIABILITIES +
+8,000,000
-2,000,000
Credit
6,000,000
2,000,000
STOCKHOLDERS' EQUITY
Interest Revenue
+6,000,000
Slide 8
Debt Investments Held to Maturity:
Amortized Cost Method
On October 1, 2015, Washington Post will receive the
principal amount of the investment as the bonds mature.
Cash (+A)
Investment Held-to-Maturity (-A)
ASSETS
Cash
Investment Held-to-Maturity
=
Debit
100,000,000
LIABILITIES
Credit
100,000,000
+
STOCKHOLDERS' EQUITY
+100,000,000
-100,000,000
If the bond investment were sold before maturity, any difference between
market value and book value would be reported as a gain or loss on sale.
McGraw-Hill/Irwin
Slide 9
Securities Available for Sale: Market Value
Method
Classified Passive Investments
Trading Securities
Trading securities are traded
actively, with the objective of
generating short-term profits
on changes in the securities
price. They are classified as
current assets on the balance
sheet.
McGraw-Hill/Irwin
Securities Available for Sale
Most companies do not
actively trade the securities of
other companies. They invest
to earn a return on funds they
may need in the near future.
These securities may be
classified as either current
assets or noncurrent assets
depending on the intent of
management to sell them
within one year.
Slide 10
Recording and Reporting
Securities Available for Sale
On January 2, 2010, Washington Post purchased
1,000,000 shares of Internet Financial News (IFN)
common stock for $60 per share. The 1,000,000 shares
represents 10% of the outstanding shares. These
securities are classified by management as available for
sale and are considered a passive investment.
Debit
60,000,000
Securities Available for Sale (+A)
Cash (-A)
ASSETS
Cash
Securities Available for Sale
McGraw-Hill/Irwin
Credit
60,000,000
=
LIABILITIES
+
STOCKHOLDERS' EQUITY
-60,000,000
+60,000,000
Slide 11
Recording and Reporting
Securities Available for Sale
Investments in equity securities earn a return fro two
sources: (1) increase in the market price and (2)
dividend income. On December 15, 2010, Washington
Post received a $1 per share cash dividend from IFN.
Debit
Cash (+A) 1,000,000 shares × $1 per
share
Investment Income (+R, +OE)
ASSETS
Cash
McGraw-Hill/Irwin
= LIABILITIES
+1,000,000
Credit
1,000,000
1,000,000
+
STOCKHOLDERS' EQUITY
Investment Income
+1,000,000
Slide 12
Recording and Reporting
Securities Available for Sale
At the end of the accounting period, passive investments
are reported on the balance sheet at their market value.
On December 31, 2010, IFN stock was trading at $58 per
share in the open market.
Unrealized Gain (Loss) on Investment (-OE)
Market Value Allowance (-A)
McGraw-Hill/Irwin
Debit
2,000,000
Credit
2,000,000
Slide 13
Recording and Reporting
Securities Available for Sale
Market Value Allowance
12/31/09
0
AJE 2,000,000
12/31/10 2,000,000
McGraw-Hill/Irwin
Slide 14
Recording and Reporting
Securities Available for Sale
Now let’s assume that Washington Post held the IFN
securities through the year 2011. At the end of 2011, the
stock had a market value of $61 per share. On December
31, 2011, we must make an adjusting entry to state the
investment at market value.
December 31, 2011
Shares
Market value
1,000,000
Cost
1,000,000
Balance Needed in Allowance
Current Balance in Allowance
Amount of Adjusting Entry
Per Share
$
61
$
60
Market Value Allowance (+A)
Unrealized Gain (Loss) on Investment (+OE)
McGraw-Hill/Irwin
Total
$ 61,000,000
60,000,000
$ 1,000,000
(2,000,000)
$ 3,000,000
Debit
3,000,000
Credit
3,000,000
Slide 15
Recording and Reporting
Securities Available for Sale
Market Value Allowance
AJE
3,000,000
12/31/11 1,000,000
12/31/09
0
AJE 2,000,000
12/31/10 2,000,000
Washington Post
Partial Balance Sheet
December 31, 2011
McGraw-Hill/Irwin
Assets
Investment in marketable securities
Market value allowance
Net investment
$ 60,000,000
1,000,000
$ 61,000,000
Stockholders' Equity
Other comprehensive income
Unrealized gain on investments
$ 1,000,000
Slide 16
Recording and Reporting
Securities Available for Sale
Now let’s assume that on March 17, 2012,Washington
Post sold all of its investment in IFN for $64 per share.
Cash (+A)
Securities Available for Sale (-A)
Gain on Sale of Investment (+R, +OE)
McGraw-Hill/Irwin
Debit
64,000,000
Credit
60,000,000
4,000,000
Slide 17
Comparing Available-For-Sale and Trading
Securities
The impact of unrealized holding gains or losses on the
financial statements depends on whether an investment is a
trading security or a security available for sale.
Available-for-Sale Securities
The unrealized gain (loss)
account is reported as a
separate component of
stockholders’ equity, under
Other Comprehensive Income. It
is not reported on the income
statement.
McGraw-Hill/Irwin
Trading Securities
The unrealized gain (loss) is
included in each period’s income
statement. Holding gains
increase income and holding
losses decrease net income. The
unrealized gain (loss) account is
closed to retained earnings at
the end of the period.
Slide 18
Accounting for Influential Investments
Investor Ownership of
Investee Shares
Outstanding
0%
{
Cost or
Market
Value
Method
Equity
Method
20%
Consolidated Financial
Statements
50%
100%
In some cases, influence or control may exist
with less than 20% ownership.
McGraw-Hill/Irwin
Slide 19
Accounting for Influential Investments
Investor Ownership of
Investee Shares
Outstanding
Cost or
Market
Value
Method
20%
{
0%
Equity
Method
Consolidated Financial
Statements
50%
100%
Significant influence is generally assumed with
20% to 50% ownership.
McGraw-Hill/Irwin
Slide 20
Recording Investments Under the Equity
Method
 Original investment is recorded at cost.
 The investment account is increased by a
proportionate share of investee’s net
income, or decreased by proportionate
share of investee’s net loss.
 The investment account is decreased by
dividends declared for the period.
McGraw-Hill/Irwin
Slide 21
Recording Investments Under the Equity
Method
In 2010, Washington Post purchased 4,000,000
shares of the outstanding voting stock of Internet
Financial News (IFN) for $60 per share. Washington
Post purchased 40% of the voting stock of IFN and
was presumed to have significant influence over the
investee.
Debit
240,000,000
Investment in Affiliates (+A)
Cash (-A)
ASSETS
Cash
Investment in Affiliates
McGraw-Hill/Irwin
Credit
240,000,000
=
LIABILITIES
+
STOCKHOLDERS' EQUITY
-240,000,000
+240,000,000
Slide 22
Recording Investments Under the Equity
Method
During 2010, IFN reported net income of
$50,000,000. Washington Post’s share of net
income is $20,000,000 (40% × $50,000,000). The
journal entry is:
Debit
20,000,000
Investment in Affiliates (+A)
Equity in Investee Earnings (+R, +OE)
ASSETS
Investment in Affiliates
McGraw-Hill/Irwin
=
+20,000,000
LIABILITIES
Credit
20,000,000
+
STOCKHOLDERS' EQUITY
Equity in Earnings
+20,000,000
Slide 23
Investments with Controlling Interests:
Consolidated Statements
Required when investor’s ownership exceeds 50%
of investee.
1. Vertical integration. One company acquires another
company that operates on a different level in the
distribution channel.
2. Horizontal growth. Companies operate on the same
level of the distribution channel.
3. Synergy. Two companies operating together may be
more profitable than two companies operating
separately.
McGraw-Hill/Irwin
Slide 24
What are Consolidated Statements?
When one company purchases all the assets and liabilities of another
company and the acquired company goes out of existence, the
acquisition is called a merger. When the acquired company remains
in business, the company that gains control over it by acquiring all or a
majority of the voting stock is called the parent company. The other
company is called a subsidiary company. When one company
acquires another, results of their operations must be reported together,
in consolidated statements. Consolidated financial statements
combine the operations of two or more companies into a single set of
statements usually identified by the term “consolidated” in the
statement title.
McGraw-Hill/Irwin
Slide 25
End of Appendix D
© 2009 The McGraw-Hill Companies, Inc.