Chapter 17:
Investments
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Investment in Marketable Equity
Securities - Overview

Equity investments represent ownership of
another company’s outstanding common stock.
 Marketable equity investments are actively traded
on a public stock exchange.
 By owning shares of common stock, the investor
“owns” a part of the company, represented by the
percentage ownership.
 There are different accounting rules for:
(1) less than 20 percent ownership (passive).
(2) between 20 and 50 percent ownership
(significant influence).
(3) greater than 50 percent ownership (control).
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(1) Less than 20 % ownership.
If marketable securities, use the mark-to
market method.
 Carries securities on balance sheet at
market value.
 Revaluation at the end of each period
based on new market price
 Unrealized gains (or losses) are recognized
as the investment is valued up (or down).
 Treatment of the Unrealized G/L depends
on classification of security:
– (a) Trading securities.
– (b) Available-for-sale securities.
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(a) Trading Securities
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Trading securities held for the short term, with
purpose of selling securities for profit.
At purchase - record at cost to acquire.
Activity during the year - record declaration of
cash dividends, and recognize “Dividend
Income” on the Income Statement:
Dividends Receivable/Cash
xx
Dividend Income
xx
For securities on hand at the end of the
accounting period - revalue to market value and
record “Unrealized Gain/Loss” on Income
Statement.
When sold - recognize “Gain/Loss on Sale” on
Income Statement for any balance since the last
revaluation.
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(b) Available-for-sale Securities
Available-for-sale (AFS) securities may be
held for the short term or for long term,
depending on management’s intentions.
 At purchase - record at cost to acquire.
 Activity during the year - record declaration
of cash dividends, and recognize
“Dividend Income” on the Income
Statement:
Dividends Receivable/Cash xx
Dividend Income
xx
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(b) Available-for-sale Securities
For securities on hand at the end of the
accounting period - revalue to market
value and record “Unrealized
Gain/Loss” on Balance Sheet (as part of
Other Comprehensive Income in
Stockholders’ Equity).
 When sold - recognize “Gain/Loss on
Sale” on Income Statement for total
difference between original cost and
selling price.
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(2) From 20% to 50% Investment
Because investment represents significant
influence of investor, we cannot account
for investments the same way as Trading
or AFS.
 Specifically, we cannot recognize
“Dividend Income” as dividends are
declared, because the investor can control
dividend payout, and therefore control the
creation of income.

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(2) From 20% to 50% Investment
The equity method increases the
investment account and recognizes
investor’s portion of income as investee
earns it (as investee reports income to
investor).
 The equity method decreases the
investment account as investee declares
dividends to the investor.
 Note: additional complications from equity
method from cost exceeding fair value of
investment (e.g., goodwill) are not
addressed here for unconsolidated
investments.
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Basic Equity Method Journal Entries
On investor’s books:
1. When investment purchased:
Equity Investment
xx
Cash, etc.
xx
2. When dividends declared to investor:
Dividends Receivable
xx
Equity Investment
xx
3. When income reported by investee to
investor (from investee’s I/S):
Equity Investment
xx
Income from Investment xx
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Illustration - Equity Method
Company P purchases 30% of the
outstanding common stock of Company S
on January 2, 2012 for $400,000 cash.
During 2012, Company S reported net
income of $300,000 to its shareholders, and
declared $100,000 dividends to its
shareholders.
Required:
Prepare all journal entries necessary (on
Company P’s books) to record this
investment using the equity method of
accounting.
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Journal Entries on P’s Books:
1.
Acquisition:
2.
Dividends declared (100,000 x 30%)
3.
Income reported (300,000 x 30%)
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Effects of Equity method
If the company had used the cost method and
recognized dividend income, the amount of
income would have been $30,000.
Under the equity method, Company P
recognized $90,000 income.
The equity method often yields higher income,
but the amount is less subject to manipulation.
The IRS recognizes income as the cash is
received (dividend income). This creates a
differential basis between tax and financial
accounting (more in Intermediate II).
Caution: It may conceal off-balance sheet
financing - one line on the balance sheet may
actually represent a percentage ownership in a
number of assets and liabilities (ex.: Enron).
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(3)Greater than 50% Investment
If an investor has majority control, the
investment is recorded using the equity
method, and a parent/subsidiary
relationship is established.
 At the end of the period, the financials of
the parent and subsidiary must be
combined, or consolidated, for external
financial reporting.
 Goodwill is recognized as a separate
asset in the consolidation.
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Comprehensive Problem
Prepare the following journal entries for Jackson
Company for 2012. Assume there were no other
investments prior to the following activities.
Feb. 17 - Purchased 500 shares of Medical Company
common stock for $20 per share (classified as trading
securities):
March 31 - Received a $1.20 per share dividend on
Medical Company stock:
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Comprehensive Problem
April 1 - Purchased 30,000 of the 100,000
outstanding shares of Olde Company common stock
at $10 per share.
Classification of Investment?
June 28 - Received a $1.00 share dividend on the
Olde Company stock:
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Comprehensive Problem
Oct. 1 - Purchased 2,000 of Alpha Company
common stock for $15 per share.
These shares are classified as available-for-sale.
Dec. 31 - Olde Company reported annual earnings
of $80,000 to its investors:
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Comprehensive Problem
Dec. 31 AJEs - At the end of the year, the following
market prices per share were reported:
Medical Co. (trading) $25 per share
Alpha Co. (AFS)
$12 per share
Olde Co. (equity)
$11 per share
AJE for Medical?
AJE for Alpha?
AJE for Olde?
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Comprehensive Problem
What total effect would the previous
transactions have on the income statement
for 2012?
What effect would the previous transactions
have on accumulated other comprehensive
income (AOCI) for 2012?
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Investment in Debt Securities Overview

Debt securities represent ownership of
corporate bonds, convertible debt,
government and municipal securities. Three
categories of classification:
(1) Held-to-maturity: company has the positive
intent and ability to hold to maturity.
(2) Trading: bought and held primarily for sale
in the near term
(3) Available-for-sale: not classified as held-tomaturity or trading.
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Debt Securities: Held-to-Maturity

Held to maturity securities carried at amortized
cost, not fair value. Treatment is similar to bonds
payable, with amortization of premiums and
discounts, and the recognition of periodic interest
revenue.
 Because debt investments are assets, they are
usually recorded in the investment account net of
the premium or discount. The investment account
is then amortized to face value over the life of the
debt investment.
 Held to maturity are not revalued, and have no
unrealized gains or losses, either to the income
statement or to other comprehensive income.
 (Equivalent topics of journalization and
amortization will be covered with bonds payable.) 20
Debt Securities: Trading and Available-for-Sale
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Debt investments classified as trading and
available-for-sale are treated in a similar fashion to
equity investments.
The debt investment in these categories are
carried at amortized cost during the year, so that
interest revenue is properly valued.
At the end of the year, the investments are
revalued to fair market value, and an unrealized
gain or loss is recognized.
A contra account “Fair Value Adjustment” is often
used for the valuation, so that the amortized cost
is maintained in the general ledger.
Revaluation of trading leads to Unrealized G/L on
I/S. Revaluation of AFS leads to Unrealized G/L in
Other Comprehensive Income.
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Rules on Reclassification
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Transfers between categories are recorded at fair
value at the date of transfer.
Transfer from trading to available-for-sale: the
unrealized gain or loss at the date of transfer is
recognized in income.
Transfer from available-for-sale to trading: the
unrealized gain or loss at the date of transfer is
recognized in income.
Transfer from held-to-maturity to available-forsale: the unrealized gain or loss at the date of
transfer is recognized in AOCI.
Transfer from available-for-sale to held-tomaturity: the unrealized gain or loss at the date of
transfer is recognized in AOCI.
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Fair Value Issues

Measurement is Based on Intent: arbitrary
classifications lead to differential effects in
financial statements.
 Cherry Picking: companies can choose held-tomaturity and available for sale classifications to
avoid potential losses in the income statement,
then enact “gains trading” to recognize gains at
the end of the year, and hold on to losing
investments with no income statement effect.
 Asymmetry between assets and liabilities – assets
fair value, but most liabilities not.
 Both FASB and the IASB believe that fair value is
more useful and relevant for financial statements,
but the expansion of fair value in US accounting is
proceeding cautiously.
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