OLC SUPPLEMENT – CHAPTER 7
ACCOUNTING FOR PASSIVE INVESTMENTS IN SECURITIES
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Analyze and report bond investments held to maturity. p. 4
2. Analyze and report passive investments in securities using the market value method. p. 6
NATURE OF INVESTMENTS IN SECURITIES
Many strategic factors motivate managers to invest in securities. A company that has
extra cash and simply wants to earn a return on the idle funds can invest those funds
in shares or debt securities issued by other companies, either short-term or long-term.
These investments are passive because the managers have no intent to influence or
control other companies whose securities they have purchased.
Sometimes a company decides to invest in another company with the purpose of
influencing that company’s operating, investing, and financing activities. In other
situations, the investing company may wish to control the operating, investing, and
financing activities of another company. This can be accomplished by either
purchasing the target company outright or becoming its majority shareholder. In this
case, the two companies must report their financial positions and the results of their
operations in a single set of consolidated financial statements. For example, Dell Inc.
(the focus company of Chapter 8) prepares a set of consolidated financial statements
because it controls a number of companies that are listed in the notes to its financial
statements. The assets section of Dell’s balance sheet, shown in Exhibit 1, includes
both short-term and long-term investments.
EXIHBIT 1
DELL INC.
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (Partial)
(in millions of U.S. dollars)
February 1,February 2,
ASSETS
2008
2007
Current assets:
Cash and cash equivalents
$ 7,764
$ 9,546
Short-term investments
208
752
Receivable, net
7,693
6,152
Inventories
1,180
660
Other
3,035
2,829
Total current assets
19,880
19,939
Property, plant, and equipment, net
2,668
2,409
Investments
1,560
2,147
Goodwill and intangibles, net
2,428
155
Other non-current assets
618
662
Total assets
$27,561
$25,635
REAL WORLD EXCERPT
Dell Inc.
ANNUAL REPORT
This supplement discusses the measurement and reporting of passive
investments and uses relevant disclosures by Dell Inc. for illustrative
purposes. The accounting for active investments in equity securities that
provide the investing company with either significant influence or control over
another company is covered in Chapter 14, which is available as a supplement
on the Online Learning Centre (OLC).
PASSIVE INVESTMENTS IN DEBT AND EQUITY SECURITIES
Passive investments are made to earn a high rate of return on funds that may
be needed for future short-term or long-term purposes. The classification and
valuation of passive investments depend on the nature of the investment as
well as management’s intent. Investments are classified as cash equivalents if
they consist of highly liquid investments with original maturities of three
months or less at the date of purchase, such as treasury bills issued by the
Federal government and certificates of deposit. These are reported at cost plus
accrued interest, which approximates fair market value.
Passive investments include both investments in debt (treasury bills,
bonds1 and notes) and equity securities (shares). Debt securities are always
considered passive investments. If the company intends to hold the securities
until they reach their maturity dates, the investments are measured and
reported at amortized cost. If they are to be sold before maturity, they are
reported using the market value method. For investments in equity securities,
the investment is presumed passive if the investment company owns less than
20 percent of the outstanding voting shares of the other company. The market
value method is used to measure and report such investments.
The accounting methods used to record passive investments are directly
related to management intent from holding the investments. The various types
of passive investments and the appropriate measuring and reporting methods
can be summarized as follows:
Investments in Debt Securities
of Another Company
Level of
Ownership
Measuring and
Reporting Method
Held to
maturity
Amortized cost
method
Not held to
maturity
Investments in
Shares of Another
Company
< 20% of
outstanding
voting shares
Market value
method
The accounting for passive investments is covered in Section 3855, Financial
Instruments – Recognition and Measurement, of the CICA’s Accounting
Handbook. Publicly traded Canadian companies are expected to apply the
requirements of Section 3855 for fiscal years starting after September 30,
20062. Most Canadian companies will implement the requirements of Section
3855 for fiscal years 2007 and beyond. Similar recognition and measurement
requirements have been in effect in the United States since 1994. Hence, we
1
A bond is a long-term debt requiring repayment of principal at a specific date along with
periodic interest payments. Accounting for bonds is covered in Chapter 11.
2
use real world excerpts from the annual report of Dell Inc., which prepares its
financial statements in accordance with US GAAP, in order to illustrate
disclosures related to investments in debt and equity securities.
DEBT HELD TO MATURITY: AMORTIZED COST METHOD
When management plans to hold a bond (note) until its maturity date (when
the principal is due), it is reported in an account appropriately called Held-toMaturity Investments. Bonds should be classified as held-to-maturity
investments if management has the intent and the ability to hold them until
maturity. These investments in debt instruments are listed at cost adjusted for
the amortization of any bond discount or premium, not at their fair market
value.
Bond Purchases
On the date of purchase, a bond may be acquired at the maturity amount (at
par), for less than the maturity amount (at a discount), or for more than the
maturity amount (at a premium).3 The total cost of the bond, including all
incidental acquisition costs such as transfer fees and broker commissions, is
debited to the Held-to-Maturity Investments account.
To illustrate accounting for bond investments, assume that on August 1,
2008, Dell paid $100,000 for 8 percent bonds par-value4 bonds that mature on
July 31, 2013, with interest payable each July 31 and January 31. Management
plans to hold the bond for five years, until maturity.
The journal entry to record the purchase of the bonds follows:
Held-to-maturity investments (+A)……………………
Cash (-A)…………………………………………...
Assets
Cash
– 100,000
Held-to-maturity
investments
+100,000
=
Liabilities
+
100,000
100,000
Shareholders’ Equity
2
The accounting treatment of short-term investments was previously covered in Section 3010,
Temporary Investments, which was removed from the Handbook in April 2005.
3 The determination of the price of the bond is based on the present value techniques
discussed in Chapter 10. Many analysts refer to a bond price as a percentage of par. For
example, the financial section of a national newspaper might report that a Petro-Canada bond
with a par value of $1,000 is selling at 109.85. This means it would cost $1,098.50 (109.85%
of $1,000) to buy the bond.
4 When bond investors accept a rate of interest on a bond investment that is the same as
interest rate on the bonds, the bonds will sell at par (i.e., at 100 or 100% of face value).
3
Learning Objective 1
Analyze and report bond
investments held to maturity.
HELD-TO-MATURITY
INVESTMENTS are
investments in bonds that
management has the intent
and ability to hold until
maturity.
AMORTIZED COST METHOD
reports investments in debt
securities held to maturity at
cost, net of any discount or
premium.
Interest Earned
The bonds in the illustration were purchased at par, or face value. Since no
premium or discount needs to be amortized, the book value remains constant
over the life of the investment. In this situation, revenue earned from the
investment each period is measured as the amount of interest collected in cash
or accrued at year-end. The following journal entry records the receipt of
$4,000 ($100,000 x 8% x 6/12) in interest on January 315:
Cash (+A)……………………………………………….
Interest revenue (+R, +SE)…..…………………..
Assets
Cash
=
Liabilities
+
+4,000
4,000
4,000
Shareholders’ Equity
Interest revenue +4,000
The same entry is made on succeeding interest payment dates.
Principal at Maturity
When the bonds mature on July 31, 2013, the journal entry to record receipt of
the principal payment would be:
Cash (+A)…………………………………..……………
Held-to-maturity investments (–A)………………..
Assets
Cash
+100,000
Held-to-maturity
investments
–100,000
=
Liabilities
+
100,000
100,000
Shareholders’ Equity
If the bond investment must be sold before maturity, any difference between
market value (the proceeds from the sale) and net book value would be
reported as a gain or loss on sale. If management intends to sell the bonds
before the maturity date, they are treated in the same manner as investments in
shares classified as securities available for sale, as discussed in the next
section.
Learning Objective 2
Analyze and report passive
investments in securities
using the market value
method.
PASSIVE SHARE INVESTMENTS: THE MARKET VALUE METHOD
When the investing company owns less than 20 percent of the outstanding
voting shares of another company, the investment is considered passive.
Among the assets and liabilities on the balance sheet, only passive investments
in marketable securities are reported using the market value method on the
date of the balance sheet.6 This violates the historical cost principle.
Before we discuss the specific accounting for these investments, we
should consider the implications of using market value:
5
Dell’s fiscal year is the 52- or 53-week period ending on the Friday nearest January 31. For
2008, Dell’s fiscal year ends exactly on January 31, 2009.
6All nonvoting shares are accounted for under the market value method without regard to the
level of ownership.
4
1. Why are passive investments reported at fair market value on the
balance sheet? Two primary factors determine the answer to this question.
■ Relevance. Analysts who study financial statements often attempt to
forecast a company’s future cash flows. They want to know how a
company can generate cash for purposes such as expansion of the
business, payment of dividends, or survival during an economic
downturn. One source of cash is the sale of shares from the company’s
portfolio of passive investments. The best estimate of the cash that
could be generated by the sale of these securities is their current market
value.
■ Measurability. Accountants record only items that can be measured in
dollar terms with a high degree of reliability (an unbiased and verifiable
measurement). Determining the fair market value of most assets is very
difficult because they are not actively traded. For example, the head
office building of the Toronto Dominion Bank is an important part of the
Toronto skyline. The balance sheet of the Toronto Dominion Bank
reports the building in terms of its original cost less accumulated
amortization in part because of the difficulty in determining an objective
market value for it. Contrast the difficulty of determining the value of a
building with the ease of determining the value of securities that TD
Bank may own. A quick look at the National Post or an Internet
financial service is all that is necessary to determine the current price of
shares issues by many companies (e.g., Van Houtte, Gildan Activewear)
because these securities are traded each day on established stock
exchanges.
2. When an investment account is adjusted to reflect changes in fair
market value, what other account is affected when the asset account is
increased or decreased? Under the double-entry method of accounting,
every journal entry affects at least two accounts. The first account is a
valuation allowance that reflects changes in the fair market value of the
investment. The account balance is added to or subtracted from the
investment account, which is maintained at cost. The other account affected
is unrealized holding gains or losses that are recorded whenever the fair
market value of investments changes. There are unrealized because no
actual sale has taken place; the value of the investment has changed while
the shares are being held by the investing company. If the value of the
investments increased by $100,000 during the year, an adjusting journal
entry records the increase in the allowance account and an unrealized
holding gain for $100,000. If the value of the investments decreased by
$75,000 during the year, an adjusting journal entry records the decrease in
the valuation allowance account and an unrealized holding loss of $75,000.
Recording an unrealized holding gain is a departure from the revenue
principle which states that revenues and gains should be recorded when the
company has completed the earnings process that generated them. However,
recording an unrealized loss is consistent with the concept of conservatism.
The financial statement treatment of unrealized holding gains or losses
depends on the classification of the passive investments in shares.
5
UNREALIZED HOLDING
GAINS AND LOSSES are
amounts associated with
price changes of securities
that are currently held.
Classifying Passive Investments in Shares
Passive investments may be classified as securities held for trading or
securities available for sale, depending on management’s intent.
SECURITIES HELD FOR
TRADING are all investments in
shares or bonds held primarily
for the purpose of active trading
(buying and selling) in the near
future (classified as short term).
SECURITIES AVAILABLE
FOR SALE are all passive
investments other than
securities held for trading
(classified as short or long
term).
Securities Held for Trading
Securities held for trading are actively traded with the objective of
generating profits on short-term changes in the price of the securities. This
approach is similar to the one taken by many mutual funds. The portfolio
manager actively seeks opportunities to buy and sell securities. Securities held
for trading are classified as current assets on the balance sheet.
Securities Available for Sale
Most companies do not actively trade the securities of other companies.
Instead, they invest to earn a return on funds they may need for future
operating purposes. These investments are called securities available for
sale. They are classified as current or noncurrent assets on the balance sheet
depending on whether management intends to sell the securities during the
next year.
Securities held for trading (SHT for short) are most commonly reported by
financial institutions that actively buy and sell short-term investments to
maximize returns. Most corporations, however, invest in short- and long-term
securities available for sale (SAS for short). We will focus on this category in
the next section by analyzing Dell’s investing activities.
Securities Available for Sale
The notes to Dell’s annual report contain the following information
concerning its investment portfolio:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
REAL WORLD EXCERPT
NOTE 1 — Description of Business and Summary of Significant Accounting Policies
Dell Inc.
Investments — Dell’s investments in debt securities and publicly traded equity
securities are classified as available-for-sale and are reported at fair value (based on
quoted prices and market prices) using the specific identification method. Unrealized
gains and losses, net of taxes, are reported as a component of stockholders’ equity.
Realized gains and losses on investments are included in investment and other
income, net when realized. All other investments are initially recorded at cost. Any
impairment loss to reduce an investment’s carrying amount to its fair market value is
recognized in income when a decline in the fair market value of an individual security
below its cost or carrying value is determined to be other than temporary.
ANNUAL REPORT
For simplification, let us assume that Dell had no passive investments at
February 1, 2008. In the following illustration, we will apply the accounting
policy used by Dell.
Purchase of Shares
At the beginning of fiscal year 2008, Dell purchases 10,000 common shares of
Computer Components Corporation’s (CCC for short) for $60 per share7.
7
6
Computer Components Corporation is a fictitious company.
CCC has 100,000 outstanding shares, so Dell owns 10 percent (10,000 ÷
100,000) of CCC’s shares, which is treated as a passive investment. Such
investments are recorded initially at cost:
Investments in SAS (+A)………………....……………
Cash (–A)………………………….………………..
Assets
Investment in SAS +600,000
Cash
–600,000
= Liabilities
600,000
600,000
+ Shareholders’ Equity
This entry and those that follow are illustrated in Exhibit 3.
Dividends Earned
Investments in equity securities earn a return from two sources: (1) price
appreciation and (2) dividend income. Price increases (or decreases) are analyzed
both at year-end and when a security is sold. Dividends earned are reported as
investment income on the income statement and are included in the computation
of net income for the period. Assume that during the fourth quarter of fiscal 2008,
Dell received a cash dividend of $1 per share from CCC, which totals $10,000 ($1
x 10,000 shares). The journal entry and transaction effects are as follows:
Cash (+A)……………….………………....……………
Investment income (+R, +SE).............................
Assets
Cash
=
+10,000
Liabilities
+
10,000
10,000
Shareholders’ Equity
Investment income +10,000
This entry is the same for securities that are either held for trading or available
for sale.
Year-End Valuation
Passive investments are reported at fair market value on the balance sheet at
the end of the accounting period. Assume that CCC had a market value of $58
per share at the end of the year. That is, the investment has lost value of $2
($60 - $58) per share. However, the loss is not realized since the investment
has not been sold. It simply resulted from holding the shares while their
market value changed.
Reporting the investment in SAS at market value requires adjusting it to
market value at the end of each period. The adjusting entry recognizes the
unrealized holding gain or loss and creates a new contra asset account
Valuation Allowance – Investments in SAS that is similar to the Allowance
for Uncollectible Accounts. If the Valuation Allowance account has a debit
balance, it is added to the Investment in SAS account. If it has a credit
balance, it is subtracted.
The following chart is used to compute any unrealized gain or loss in the
investment in SAS portfolio:
7
Fiscal
Year
2008
Market
Value
–
Cost
Balance Needed
Unadjusted Balance
Amount for
= in Valuation Allowance – in Valuation Allowance = Adjusting Entry
$580,000
–
$600,000
=
($58 x 10,000)
($60 x 10,000)
$20,000
–
$0
=
(We assume there were
no passive investments at
the end of the prior year.)
($20,000)
An unrealized
loss for
the period
The adjusting entry at the end of fiscal 2008 is recorded as follows:
Net unrealized gains and losses–SAS (–SE)….….………
Valuation allowance – investments in SAS (–A)……..
Valuation allowance –
investments in SAS
0
20,000
20,000
Beg. Bal
AJE
Assets
= Liabilities
+
Valuation allowance –
Investments in SAS –20,000
End. Bal
20,000
20,000
Shareholders’ Equity
Net unrealized gains
and losses–SAS –20,000
Since the investment in SAS is expected to be held in the future, the
unrealized holding gain or loss is not reported as part of income. It is reported
in the shareholders’ equity section of the balance sheet as a component of
Other Comprehensive Income8.
If management of Dell intends to hold the investment in SAS for a long
term, it would be reported on the company’s balance sheet at January 31, 2006
under Investments at $580,000 ($600,000 cost less the credit balance of
$20,000 in the valuation allowance account). It would also report an
unrealized loss of $20,000 on securities available for sale under Other
Comprehensive Income. The only item reported on the income statement for
2005 would be investment income of $10,000 from the dividends earned,
classified under other non-operating items.
We assumed earlier, for illustrative purposes, that Dell did not have any
investments at February 1, 2008. In reality, Dell’s balance sheet (in Exhibit 1)
reports both short-term investments of $208 million, and long-term
investments of $1,560 million. Most of Dell’s investments are in debt
securities as disclosed in Note 2 to its financial statements (see Exhibit 2).
Let us assume that Dell held the CCC shares through the year 2006, and
that the price per share was $61 at year end. The year-end adjustment would
be computed as follows:
Fiscal
Year
2009
Market
Value
–
Cost
Balance Needed
Unadjusted Balance
Amount for
= in Valuation Allowance – in Valuation Allowance = Adjusting Entry
$610,000 –
$600,000 =
($61 x 10,000) ($60 x 10,000)
$10,000
–
($20,000)
=
($30,000)
An unrealized
gain for the period
The adjusting entry at the end of fiscal 2009 is recorded as follows:
8
A brief explanation of Comprehensive Income is available on the textbook’s Online
Learning Centre as a supplement to Chapter 6.
8
Valuation allowance – investment in SAS (+A)…..…….…
Net unrealized gains and losses–SAS (+SE).............
Assets
= Liabilities
Valuation allowance –
Investments in SAS +30,000
+
30,000
Valuation allowance –
investments in SAS
30,000
20,000 Beg. Bal
Shareholders’ Equity
30,000
Net unrealized gains
and losses–SAS +30,000
AJE
10,000 End. Bal
EXHIBIT 2
NOTE 2 — Financial Instruments
REAL WORLD EXCERPT
Dell Inc.
Disclosures About Fair Values of Financial Instruments
The fair value of investments and related interest rate derivative instruments has
been estimated based upon quoted rates and pricing models….
ANNUAL REPORT
Investments
The following table summarizes by major security type, the fair market value and cost
of Dell’s investments. All investments with remaining maturities in excess of one year
are recorded as long-term investments in the accompanying Consolidated
Statements of Financial Position.
February 1, 2008
Fair
Unrealized
Value
Cost
Gain (Loss)
(in millions)
Debt securities:
$1,013
$991
$22
U.S. government and agencies
571
569
2
U.S. corporate
68
67
1
International corporate
5
5
–
State and municipal governments
1,657
1,632
34
Total debt securities
111
111
–
Equity and other securities
$1,768
$1,743
$34
Investments
$ 208
$ 206
$2
Short-term
1,560
1,537
32
Long-term
$1,768
$1,743
$34
Total investments
Sale of Shares
When securities available for sale are sold, three accounts are affected, in
addition to Cash:
■ Investment in SAS
■ Valuation Allowance - Investment in SAS
■ Net Unrealized Gains and Losses
Let us assume that Dell sold its investment in CCC on November 15, 2008
for $62.50 per share. The company would receive $625,000 in cash ($62.50 x
10,000) for shares purchased for $600,000 in 2008. In entry (1), a gain on sale
of $25,000 ($625,000 – $600,000) would be recorded and the Investment in
SAS would be eliminated. In entry (2), the valuation allowance and related
net unrealized gains and losses would be eliminated.
9
(1) Cash (+A)………………………………………………… 625,000
Investment in SAS (–A)……………………………..
600,000
Gain on sale of investments (+Gain, +SE)………..
25,000
(2) Net unrealized gains and losses–SAS (–SE)............... 10,000
Valuation allowance – investment in SAS (–A)...…
Assets
Cash
Investment in SAS
= Liabilities
+625,000
–600,000
Valuation allowance–
Investments in SAS –10,000
10,000
Shareholders’ Equity
+
Gain on sale of
Investments
+25,000
Net unrealized gains
and losses–SAS +10,000
The effects of these transactions on the various accounts are illustrated in
Exhibit 3.
EXHIBIT 3 T-Accounts for the Illustrated Transactions
Balance Sheet Accounts
Investment in SAS (at cost) (A)
Beg. 2008
0
Purchase 600,000
End. 2008 600,000
End. 2009 600,000
600,000 2010 Sale
End. 2010
0
Valuation Allowance – Investment in SAS (A)
0 Beg. 2008
20,000
AJE 2008
20,000
End. 2008
2009 AJE
30,000
End. 2009 10,000
10,000
2010 Sale
0 End. 2010
Net Unrealized Gains and Losses (SE)
Beg. 2008
0
2008 AJE 20,000
End. 2008 20,000
30,000
2009 AJE
10,000 End. 2009
2010 Sale 10,000
0
Income Statement Accounts
Investment Income (R)
10,000
Earned
10,000 End. 2008
10
Gain on Sale of Investments (Gain)
25,000
2010 Sale
25,000 End. 2010
Comparing Trading and Available-for-Sale Securities
The reporting impact of unrealized holding gains or losses depends on the
classification of the investment.
Portfolio of securities available for sale. As we learned in the previous
section, the balance in net unrealized holding gains and losses is reported as
a separate component of shareholders’ equity (under other comprehensive
income). It is not reported on the income statement and does not affect net
income. At the time of sale, the difference between the proceeds from the
sale and the original cost of the investment is recorded as a gain or loss on
securities available for sale. At the same time the Net Unrealized Gains
and Losses – SAS and the Valuation Allowance – Investments in SAS are
eliminated.
Portfolio of securities held for trading. The amount of the adjustment to
net unrealized holding gains and losses is included in each period’s income
statement. Net holding gains increase net income and net holding losses
decrease it. This also means that the amount recorded as net unrealized
gains and losses on securities held for trading is closed to Retained
Earnings at the end of the period. Thus, when selling a security, Cash and
only two other balance sheet accounts are affected: Investment in SHT and
Valuation Allowance – Investments in SHT. The gain or loss on sale of
securities held for trading is the difference between the cash proceeds from
the sale and the cost of the investment, net of the valuation allowance.
Exhibit 4 provides comparative journal entries and financial statement
balances for the transactions illustrated for Dell Inc. from 2008 to 2010. Note
that the total income reported for the three years is the same $35,000 for
both types of securities. Only the allocation across the three periods
differs.
Income in
Securities Held for Trading
2008
$10,000 dividends
(20,000) unrealized loss
30,000 unrealized gain
15,000 realized gain
$35,000
2009
2010
Total
FINANCIAL
ANALYSIS
Securities Available for Sale
$10,000 dividends
–
–
25,000 realized gain
$35,000
Equity Securities and Earnings Management
Most managers prefer to treat their passive investments as securities available for
sale. This treatment generally reduces variations in reported earnings by avoiding
recognition of unrealized holding gains and losses resulting from quarter-to-quarter
changes in share prices. It also allows managers to smooth out earnings fluctuations
by selling securities with unrealized gains when earnings decline and by selling those
with unrealized losses when earnings increase. Diligent analysts can see through this
strategy, however, by examining the required note on investments in the financial
statements.
11
EXHIBIT 4 Comparison of Accounting for Securities Held for Trading and Securities Available for Sale
Part A: Entries
Securities Held for Trading
Securities Available for Sale
2008:
 Purchase
(for $600,000 cash)
Investment in SHT (+A)………..
Cash (–A)……………….........
 Receipt of dividends
($10,000 cash)
Cash (+A)………………………..
Investment income (+R, +SE)
 Year-end adjustment to
market
(market = $580,000)
Net unrealized gains/losses–
SHT (+Loss, –SE)…………….
Valuation allowance–
Investment in SHT (–A)……
600,000
Investment in SAS (+A)…...…...
Cash (–A)…………………......
600,000
600,000
Cash (+A)…………………………
Investment income (+R, +SE)
10,000
10,000
20,000
Net unrealized gains/losses–
SAS (+Loss, –SE)…………….
Valuation allowance–
Investment in SAS (–A)…..
30,000
Valuation allowance–
Investment in SAS (+A)….…..
Net unrealized gains/losses–
SAS (+Gain, +SE)…………
10,000
20,000
600,000
10,000
20,000
20,000
2009:
 Year-end adjustment to
market
(market = $610,000)
Valuation allowance–
Investment in SHT (+A)….…... 30,000
Net unrealized gains/losses–
SHT (+Gain, +SE)…………..
30,000
30,000
2010:
 Sale (for $600,000)
Part B: Financial Reporting
Balance Sheet Reporting:
Two balance sheet accounts are eliminated:
Three balance sheet accounts are eliminated:
Cash (+A)………..……………… 625,000
Valuation allowance–
Investment in SHT (–A)….
10,000
Investment in SHT (–A)...……
600,000
Gain on sale of investment
(+Gain, +SE)……………...
15,000
Cash (+A)………..……………….
Investment in SAS (–A)..…...
Gain on sale of investment
(+Gain, +SE)……………....
Net unrealized gains/losses–
SAS (+Loss, –SE)…………….
Valuation allowance–
Investment in SAS (–A)….
Securities Held for Trading
Assets
2010
625,000
600,000
25,000
10,000
10,000
Securities Available for Sale
2009
2008
Assets
2010
2009
2008
Investment in SHT
Valuation allowance – SHT
–
–
600,000 600,000
10,000 (20,000)
Investment in SAS
Valuation allowance – SAS
–
–
600,000
10,000
600,000
(20,000)
Net investment in SHT
–
610,000 580,000
Net investment in SAS
–
610,000
580,000
Shareholders’ Equity
Other comprehensive income:
Net unreal. gains/losses – SAS
Income Statement Reporting:
Investment income
Gain on sale
Net unrealized gains/
losses – SHT
12
2010
2009
2008
–
15,000
–
–
10,000
–
–
30,000
(20,000)
Investment income
Gain on sale
10,000
(20,000)
2010
2009
2008
–
25,000
–
–
10,000
–
SELF-STUDY QUIZ
Now let us reconstruct the activities that Dell Inc. undertook in a recent year with a few
transactions assumed. Answer the following questions using the T-accounts to help you
infer the amounts. Dollar amounts are in thousands.
Balance Sheet Accounts
(In Short-term Investments)
Investment in SAS
1/1
4,022
Purchase 19,000
?
12/31
8,875
Sale
(In Accumulated Other
Comprehensive Income)
1/1
AJE
12/31
Valuation Allowance –
Investment in SAS
1,565
? 1,092
Sale
5,683
Net Unrealized Gains and Losses – SAS
1,565
1/1
Sale
?
?
AJE
5,683
12/31
Income Statement Accounts
Investment Income
?
7,771
Earned
12/31
Gain on Sale of Investment
2,384
Sale
2,384
12/31
a. Purchased securities available for sale for
cash. Prepare the journal entry.
b. Received cash dividends on the investments.
Prepare the journal entry.
c. Sold SAS investments at a gain. Prepare the
journal entries.
d. At year-end, the SAS portfolio had a market
value of $14,558. Prepare the adjusting
entry.
e. What amounts would be reported on the
balance sheet at December 31 related to the
SAS investments? On the income statement
for the year?
f. How would year-end reporting change if the
investments were categorized as securities
held for trading instead of securities
available for sale?
After you have completed your answers, check them with the solutions on page16.
REAL WORLD EXCERPT
Dell Inc.
ANNUAL REPORT
DEMONSTRATION CASE A
(Try to resolve the requirements for Cases A and B before proceeding to the
suggested solutions that follow.)
Howell Equipment Corporation sells and services a major line of farm equipment.
Both sales and service operations have been profitable. The following transactions
affected the company during 2008:
Jan. 1
Dec. 28
Dec. 31
Purchased 2,000 common shares of Dear Company at $40 per share.
This purchase represented one percent of the shares outstanding.
Management intends to trade these shares actively.
Received $4,000 cash dividend on the Dear Company shares.
Determined that the market price of Dear’s common share was $39.
Required:
1. Prepare the journal entry for each of these transactions.
2. What accounts and amounts will be reported on the balance sheet at the end
of 2008? On the income statement for 2008?
SUGGESTED SOLUTION FOR CASE A
1. Jan. 1
Investment in SHT (+A) ……………………..…….
Cash (+A) (2,000 shares x $40)
……...……
Dec. 28 Cash (+A)
…………………………………….…..
Investment income (+R, +SE)
……….……
Dec. 31 Net unrealized gains/losses—SHT (+Loss, –SE)
Valuation Allowance—Investment in SHT (–A)
Fiscal
Year
2008
Market
Value –
$78,000
–
($39 x 2,000)
Cost
80,000
4,000
4,000
2,000
2,000
Balance Needed
Unadjusted Balance
Amount for
= in Valuation Allowance – in Valuation Allowance = Adjusting Entry
$80,000 =
$(2,000)
–
2. On the Balance Sheet:
Current Assets
Investment in SHT
$78,000
($80,000 cost – $2,000 allowance)
14
80,000
$0
=
$(2,000)
An unrealized
loss for the period
On the Income Statement:
Other Nonoperating Items
Investment income
$4,000
Net unrealized loss on trading securities (2,000)
DEMONSTRATION CASE B
Assume the same facts as in Case A except that the securities were purchased as
securities available for sale rather than as securities held for trading.
Required:
1. Prepare the journal entry for each of these transactions.
2. What accounts and amounts will be reported on the balance sheet at the end of
2008? On the income statement for 2008?
SUGGESTED SOLUTION FOR CASE B
Jan. 1
Investment in SAS (+A) …………………..…………..
Cash (+A) (2,000 shares x $40) ……...………….
Dec. 28 Cash (+A) …………………………………….………..
Investment income (+R, +SE) ……….………….
Dec. 31 Net unrealized gains/losses—SAS (+Loss, –SE) ….
Valuation Allowance—Investment in SAS (–A) …..
Fiscal
Year
2008
Market
Value
–
$78,000
–
($39 x 2,000)
Cost
80,000
80,000
4,000
4,000
2,000
2,000
Balance Needed
Unadjusted Balance
Amount for
= in Valuation Allowance – in Valuation Allowance = Adjusting Entry
$80,000 =
2. On the Balance Sheet:
Current Assets
Investment in SAS
$78,000
($80,000 cost – $2,000 allowance)
Shareholders’ Equity
Accumulated other comprehensive
Income:
Net unrealized loss on SAS
(2,000)
$(2,000)
–
$0
=
$(2,000)
An unrealized loss
for the period
On the Income Statement:
Other Nonoperating Items
Investment income
$4,000
15
Solution to Self-Study Quiz
a. Investment in SAS (+A) ………………………………. 19,000
Cash (–A) …………………………………………..
19,000
b. Cash (+A) …………………………………………….. 7,771
Investment income (+R, +SE) ……………………..
7,771
c. (1) Cash (+A) …………………………………………. 16,531
Gain on sale of investments (+Gain, +SE) ……..
2,384
Investment in SAS (–A) ………………………..
14,147
(2) Net unrealized gains/losses—SAS (–SE) …………. 1,092
Valuation Allowance—Investment in SAS (–A) …
1,092
d. Valuation Allowance—Investment in SAS (+A) ……. 5,210
Net unrealized gains/losses—SAS (+SE) ………….
5,210
Market
Value
–
Cost
$14,558
–
$8,875
Balance Needed
= in Valuation Allowance –
=
+$5,683
–
Unadjusted Balance
in Valuation Allowance
=
$473
=
($1,565 beg. bal. – $1,092 sale)
Amount for
Adjusting Entry
+$5,210
e. Balance Sheet
Income Statement
Assets
Nonoperating Items
Short-term investments $14,558
Gain on sale of investments
Shareholders’ Equity
Investment income
Net unrealized gains/losses 5,683
(in Accumulated Other Comprehensive Income)
$2,384
7,771
f. If the securities were held for trading, the net unrealized gain would not appear
on the balance sheet. Therefore, when the securities are sold in c, there would
be a gain on the sale of $1,292 [$16,531 cash – ($14,147 cost + $1,092
allowance)] reported on the income statement. Then at year-end, the net
unrealized gain of $5,210 would be reported on the income statement (not in
shareholders’ equity).
SUPPLEMENT TAKE-AWAYS
1. Analyze and report bond investments held to maturity. p. 2
When management intends to hold a bond investment until it matures, the
held-to-maturity bond is recorded at cost when acquired and reported at
amortized cost on the balance sheet. Any interest earned during the period
is reported on the income statement.
2. Analyze and report passive investments in securities using the
market value method. p. 4
• Acquiring less than 20 percent of the outstanding voting shares of an
investee’s common shares is presumed to be a passive investment in
shares. Passive investments may be classified as securities held for
training (actively traded to maximize return) or securities available for
sale (acquired to earn a return but are not as actively traded), depending
on management’s intent.
16
• The investments are recorded at cost and adjusted to market value at
year-end. A valuation allowance is increased or decreased to arrive at
market value with the resulting unrealized holding gain or loss that is
recorded and reported in net income for securities held for training, or as
a component of shareholders’ equity in other comprehensive income for
securities available for sale.
• Any dividends earned are reported as revenue, and any gains or losses on
sales of passive investments are reported on the income statement.
FINDING FINANCIAL INFORMATION
Balance Sheet
Current Assets
Investment in trading securities (net of
valuation allowance)
Investment in securities available for sale
(net of valuation allowance)
Noncurrent Assets
Investment in securities available for sale
(net of valuation allowance)
Investments held to maturity
Shareholders’ Equity
Accumulated other comprehensive
income:
Net unrealized gains and losses on
securities available for sale
Income Statement
Under “Other Items”
Investment income
Loss or gain on sale of investments
Net unrealized gains and losses on trading
securities
Cash Flow Statement
Operating Activities
Net income adjusted for:
Gains/losses on sale of investments
Net unrealized gains/losses on trading
Securities
Notes
In Various Notes
Accounting policies for investments
Details on securities held as trading and
available-for-sale securities
QUESTIONS
1. Explain the difference between a short-term investment and a long-term
investment.
2. Explain the difference in accounting methods used for passive investments,
investments in which the investor can exert significant influence, and
investments in which the investor has control over another entity.
3. Explain how bonds held to maturity are reported on the balance sheet.
4. Under the market value method, when and how does the investor company
measure revenue?
17
MULTIPLE-CHOICE QUESTIONS
1. Company A purchases 10 percent of Company B’s shares and Company A
intends to hold the shares for at least five years. At the end of the current year,
how would Company A’s investment in Company B’s shares be reported on
Company A’s December 31 (year-end) balance sheet?
a. at original cost in the current assets section
b. at market value on December 31, in the current assets section
c. at original cost in the long-term assets section
d. at market value on December 31, in the long-term assets section
2. Dividends received from an investment in shares that is reported as a security
available for sale in the long-term assets section of the balance sheet are
reported as
a. an increase to cash and a decrease to the investment in stock account
b. an increase to cash and an unrealized gain on the balance sheet
c. an increase to cash and an increase to revenue
d. an increase to cash and an unrealized gain on the income statement
3. Which of the following transactions results in recognizing gains and losses
that are recorded on the income statement for both securities held for trading
and securities available for sale?
a. when adjusting a security held for trading to its market value
b. when adjusting a security available for sale to its market value
c. only when recording the sale of a security held for trading
d. when recording the sale of either a security held for trading or a security
available for sale
4. Which of the following items is reported in the investing section of the cash
flow statement when an investment in shares is sold?
a. the subtraction of a resulting gain on the sale
b. the addition of a resulting loss on the sale
c. the addition of cash sales proceeds
d. all of the above
EXERCISES
Recording Bonds Held to Maturity
The Forzani Group Limited is Canada's largest retailer of sporting goods, offering a
comprehensive assortment of products, operating stores from coast to coast under the
names Sport Chek, Sports Experts, Coast Mountain Sports, Sport Mart and National
Sports. The company does more than $1 billion in sales each year.
Assume that as part of its cash management strategy, Forzani purchased $10 million
in bonds at par for cash on July 1, 2009. The bonds pay 10 percent interest each June 30
and December 31 and mature in 10 years. Forzani plans to hold the bonds until maturity.
Required:
1. Record the purchase of the bonds on July 1, 2009.
2. Record the receipt of interest on December 31, 2009.
18
Recording Transactions in the Portfolio of Securities Held for Trading
On June 30, 2008, MetroMedia, Inc. purchased 10,000 of Mitek’s common shares for $20 per
share. Management purchased the shares for speculative purposes and recorded them in the
portfolio of securities held for trading. The following information pertains to Mitek’s price
per share:
Date
Price
12/31/2008
$24
12/31/2009
31
12/31/2010
25
E-2
LO2
MetroMedia sold its investment in Mitek’s shares on February 14, 2011, at a price of $22
per share. Prepare any journal entries that are required by the facts presented in this case.
Recording Transactions in the Portfolio of Securities Available for Sale
Using the data in E-2, assume that MetroMedia management purchased Mitek’s
shares for the portfolio of securities available for sale instead of the portfolio of securities
held for trading. Prepare any journal entries that are required by the facts presented in the
case.
E-3
LO2
Reporting Gains and Losses in Passive Investments in Securities
On March 10, 2008, General Solutions, Inc. purchased 5,000 of MicroTech’s common shares
for $50 per share. Management purchased the shares for speculative purposes and
recorded it in the portfolio of securities held for trading. The following information
pertains to the MicroTech’s price per share:
E-4
LO2
Date
12/31/2008
12/31/2009
12/31/2010
Price
$55
40
42
General Solutions sold its investment in MicroTech’s shares on September 12, 2011, at a
price of $39 per share. Prepare any journal entries that are required by the facts presented
in this case.
Required:
1. Assume that management purchased the shares for speculative purposes and recorded
the investment in the portfolio of securities held for trading. Prepare any journal
entries that are required by the facts presented in this case.
2. Assume that management purchased the shares for speculative purposes and recorded
the investment in the portfolio of securities available for sale. Prepare any journal
entries that are required by the facts presented in this case.
19
PROBLEMS
Determining Financial Statement Effects for Bonds Held to Maturity (AP-1)
Starbucks is a rapidly expanding company that provides high-quality coffee products. Assume
that as part of its expansion strategy, Starbucks plans to open numerous new stores in Mexico
in five years. The company has $5 million to support the expansion and has decided to invest the
funds in corporate bonds until the money is needed. Assume that Starbucks purchased
bonds with $5 million face value at par for cash on July 1, 2008. The bonds pay 8 percent
interest each June 30 and December 31 and mature in five years. Starbucks plans to hold
the bonds until maturity.
P-1
LO1
Starbucks
Corporation
Required:
1. What accounts are affected when the bonds are purchased on July 1, 2008?
2. What accounts are affected when interest is received on December 31, 2008?
3. Should Starbucks prepare a journal entry if the market value of the bonds decreased to
$4,000,000 on December 31, 2008? Explain.
Recording Passive Investments (AP-2)
On March 1, 2007, HiTech Industries purchased 10,000 common shares of Integrated Services
Company for $20 per share. The following information applies to Integrated’s price per
share:
Date
12/31/2007
12/31/2008
12/31/2009
P–2
LO2
Price
$17
24
31
Required:
1. Prepare journal entries to record the facts in the case, assuming that HiTech purchased
the shares for the portfolio of securities held for trading.
2. Prepare journal entries to record the facts in the case, assuming that HiTech purchased
the shares for the portfolio of securities available for sale.
Recording Passive Investments (AP-3)
During January 2008, Ka-Shing Company purchased shares of the following companies as a
long-term investment:
Company and Type of Share
Q Corporation – Common
R Corporation – Preferred, nonvoting
20
Number of Shares
Outstanding
90,000
20,000
Purchase
12,600
12,000
Cost per
Share
$ 5
30
P–3
LO2
Subsequent to acquisition, the following data were available:
Net income reported at December 31:
Q Corporation
R Corporation
Dividends declared and paid during the year (per share):
Q Corporation – Common
R Corporation – Preferred
Market value per share at December 31:
Q Corporation – Common
R Corporation – Preferred
2008
2009
$30,000
40,000
$36,000
48,000
$0.85
1.00
$0.90
1.10
$ 4.00
29.00
$ 4.00
30.00
Required:
1. What accounting method should be used for the investment in Q Corporation’s common
shares? R Corporation’s preferred shares? Why?
2. Prepare the journal entries to record the following events for each year using parallel
columns (if none, explain why):
a. Purchase of the investments.
b. Income reported by Q and R Corporations.
c. Dividends received from Q and R Corporations.
d. Market value effects at year-end.
3. For each year, show how the following amounts should be reported on the financial
statements of Ka-Shing Company:
a. Long-term investment.
b. Shareholders’ equity—net unrealized gains and losses.
c. Revenues.
Recording Passive Investments
On August 4, 2007, Osaka Corporation purchased 1,000 common shares of Tremblay Ltée for
$45,000. The following information applies to the Tremblay’s shares:
Date
12/31/2007
12/31/2008
12/31/2009
Price
$52
47
38
Tremblay Ltée declares and pays cash dividends of $2 per share on June 1 of each year.
Required:
1. Prepare journal entries to record the facts in the case, assuming that Osaka purchased the
shares for the portfolio of securities held for trading.
2. Prepare journal entries to record the facts in the case, assuming that Osaka purchased the
shares for the portfolio of securities available for sale.
21
P–4
LO2
ALTERNATE PROBLEMS
Determining Financial Statement Effects for Bonds Held to Maturity (P-1)
AP–1
Krispy Kreme operates and franchises a worldwide chain of quick-service drive-in doughnut stores.
LO1
Customers drive up to a parking space and order doughnuts through an intercom speaker system.
Krispy Kreme
The ordered quantity is then delivered to the customer. Assume that Krispy Kreme has $10 million Doughnuts, Inc.
in cash to support future expansion and has decided to invest the funds in corporate bonds until
the money is needed. Krispy Kreme purchases bonds with $10 million face value for $10.3
million cash on January 1, 2009. The bonds pay 8 percent interest each June 30 and December 31
and mature in four years. Krispy Kreme plans to hold the bonds until maturity.
Required:
1. What accounts were affected when the bonds were purchased on January 1, 2009?
2. What accounts were affected when interest was received on June 30, 2009?
3. Should Krispy Kreme prepare a journal entry if the market value of the bonds decreased to
$9,700,000 on December 31, 2009? Explain.
Recording Passive Investments (P-2)
On September 15, 2008, MultiMedia Corporation purchased 10,000 common shares of Community
Broadcasting Company for $32per share. The following information applies to Community
Broadcasting’s price per share:
Date
12/31/2008
12/31/2009
12/31/2010
AP–2
LO2
Price
$34
24
21
Required:
1. Prepare journal entries to record the facts in the case, assuming that MultiMedia purchased
the shares for the portfolio of securities held for trading.
2. Prepare journal entries to record the facts in the case, assuming that MultiMedia purchased
the shares for the portfolio of securities available for sale.
Recording Passive Investments (P-3)
During January 2008, Hexagon Company purchased 12,000 of the 200,000 outstanding common
shares of Smiley Corporation at $30 per share. This block of shares was purchased as a long-term
investment. Assume that the accounting period for each company ends December 31. Subsequent
to acquisition, the following data were available:
2008
2009
Net income reported by Smiley Corporation at December
$40,000
$60,000
31
60,000
80,000
Cash dividends declared and paid by Smiley Corporation
during the year
28
29
Market price of Smiley Corporation’s share at December
31
Required:
1. What accounting method should Hexagon Company use to record the investment in Smiley
Corporation’s common shares? Why?
22
AP–3
LO2
2.
3.
Prepare the journal entries to record the following events for each
year using parallel columns (if none, explain why):
a Purchase of the investment.
b. Net income reported by Smiley Corporation.
c. Dividends received from Smiley Corporation.
d. Market value effects at year-end.
For each year, show how the following amounts should be reported on the
financial statements of Hexagon Company:
a. Long-term investment.
b. Shareholders’ equity—net unrealized gains and losses.
c. Revenues.
Critical Thinking Case
Evaluating an Ethical Dilemma: Using Inside Information
Assume that you are on the board of directors of a company that has decided to buy 80
percent of the outstanding shares of another company within the next three or four months.
The discussions have convinced you that this company is an excellent investment opportunity,
so you decide to buy $10,000 worth of the company’s shares for your personal portfolio. Is
there an ethical problem with your decision? Would your answer be different if you planned
to invest $500,000? Are there different ethical considerations if you don’t buy the shares but
recommend that your brother do so?
July 27, 2008
23
CP7-1