Financial Accounting chapter 12

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Chapter 12

InvestmentsInvestments

Financial Accounting, IFRS Edition

Weygandt Kimmel Kieso

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1. Discuss why corporations invest in debt and share securities.

2. Explain the accounting for debt investments.3. Explain the accounting for share investments.4. Describe the use of consolidated financial

statements.5. Indicate how debt and share investments are

reported in financial statements.6. Distinguish between short-term and long-term

investments.

Study ObjectivesStudy Objectives

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Why Why Corporations Corporations

InvestInvest

Cash Cash managementmanagementInvestment Investment incomeincomeStrategic Strategic reasonsreasons

Accounting Accounting for Debt for Debt


Accounting Accounting for Share for Share


Valuing and Valuing and Reporting Reporting


Categories Categories of of securitiessecuritiesStatement of Statement of financial financial positionpositionRealized and Realized and unrealized unrealized gain or lossgain or lossClassified Classified statement of statement of financial financial positionposition

Holdings of Holdings of less than less than 20%20%Holdings Holdings between 20% between 20% and 50%and 50%Holdings of Holdings of more than more than 50%50%

Recording Recording acquisition acquisition of bondsof bondsRecording Recording bond bond interestinterestRecording Recording sale of sale of bondsbonds


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Corporations generally invest in debt or share securities for one of three reasons.

Why Corporations InvestWhy Corporations Invest

SO 1 Discuss why corporations invest in debt and share securities.SO 1 Discuss why corporations invest in debt and share securities.

1. Corporation may have excess cash.2. To generate earnings from investment

income.3. For strategic reasons. Illustration 12-1

Temporary investments and the operating

cycle

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Pension funds and banks regularly invest in debt and share securities to: a. house excess cash until needed. b. generate earnings. c. meet strategic goals. d. avoid a takeover by disgruntled

investors.

QuestionQuestion

Why Corporations InvestWhy Corporations Invest

SO 1 Discuss why corporations invest in debt and share securities.SO 1 Discuss why corporations invest in debt and share securities.

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Accounting for Debt InstrumentsAccounting for Debt Instruments

SO 2 Explain the accounting for debt investments.SO 2 Explain the accounting for debt investments.

Recording Acquisition of BondsCost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

Recording Bond InterestCalculate and record interest revenue based upon the carrying value of the bond times the interest rate times the portion of the year the bond is outstanding.

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Sale of BondsCredit the investment account for the cost of the bonds and record as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds.

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Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is:

Debt investments 54,000Cash 54,000



Jan. 1

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Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The bonds pay interest semiannually on July 1 and January 1. The entry for the receipt of interest on July 1 is:



Cash 2,000Interest revenue 2,000

* ($50,000 x 8% x ½ = $2,000)

*July 1

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Illustration: If Kuhl Corporation’s fiscal year ends on December 31, prepare the entry to accrue interest since July 1.


SO 2SO 2

Interest receivable 2,000Interest revenue 2,000

Kuhl reports receipt of the interest on January 1 as follows.Cash 2,000

Interest receivable 2,000

Dec. 31

Jan. 1

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Illustration: Assume that Kuhl corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2011, after receiving the interest due. Prepare the entry to record the sale of the bonds.



Cash 58,000Debt investments 54,000Gain on sale of debt investments

4,000

Jan. 1

Recording Sale of Bonds

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An event related to an investment in debt securities that does not require a journal entry is: a. acquisition of the debt investment. b. receipt of interest revenue from the

debt investment. c. a change in the name of the firm

issuing the debt securities. d. sale of the debt investment.

Question



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When bonds are sold, the gain or loss on sale is the difference between the: a. sales price and the cost of the

bonds. b. net proceeds and the cost of the

bonds. c. sales price and the market value of

the bonds. d. net proceeds and the market value of

the bonds.

Question



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0 --------------20% ------------ 50% -------------- 100%0 --------------20% ------------ 50% -------------- 100%No

significant influence usually exists

Significant influence usually exists

Control usually exists

Investment valued

using Cost Method

Investment valued using Equity Method

Investment valued on parent’s books using Cost Method or Equity Method (investment

eliminated in Consolidation)

Ownership Percentages

Accounting for Share InvestmentsAccounting for Share Investments

SO 3 Explain the accounting for share investments.SO 3 Explain the accounting for share investments.

The accounting depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation.

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Companies record the investment at cost, and recognize revenue only when cash

dividends are received.


Holdings of Less than 20% (Cost Method)


Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions).

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July 1


Holdings of Less than 20%Holdings of Less than 20%

Illustration: On July 1, 2011, Sanchez Corporation acquires 1,000 ordinary shares (10% ownership) of Beal Corporation. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is:

Share investments 40,500Cash 40,500

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Dec. 31



Illustration: During the time Sanchez owns the shares, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:

Cash 2,000Dividend revenue 2,000

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Feb. 10



Illustration: Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal shares on February 10, 2012. Because the shares cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is:Cash 39,500

Loss on sale of share1,000Share investments 40,500

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Holdings Between 20% and 50% (Equity Method)Record the investment at cost and subsequently adjust the amount each period for the investor’s proportionate share of

the earnings (losses) and dividends received by the investor.

If investor’s share of investee’s losses exceeds the carrying amount of the investment, the investor ordinarily should discontinue applying the equity method.



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Under the equity method, the investor records dividends received by crediting: a. Dividend Revenue. b. Investment Income. c. Revenue from Investment. d. Share Investments.

Question

Holdings Between 20% and 50%Holdings Between 20% and 50%


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Illustration: Illustration: Milar Corporation acquires 30% of the ordinary shares of Beck Company for $120,000 on January 1, 2011. For 2011, Beck reports net income of $100,000 and paid dividends of $40,000. Prepare the entries for these transactions.Share investments 120,000

Cash

120,000

Cash 12,000 Share investments

12,000

Share investments 30,000 Revenue from investments

30,000


($40,000 x 30%)

($100,000 x 30%)


Jan. 1

Dec. 31

Dec. 31

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After Milar posts the transactions for the year, its investment and revenue accounts will show the following.

Debit CreditShare Investments

120,000120,000 30,00030,000Debit CreditRevenue from Investments



30,00030,000 12,00012,000138,000138,000

Illustration: Illustration: Milar Corporation acquires 30% of the ordinary shares of Beck Company for $120,000 on January 1, 2011. For 2011, Beck reports net income of $100,000 and paid dividends of $40,000. Prepare the entries for these transactions.

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Controlling Interest - When one corporation acquires a voting interest of more than 50 percent in another corporation

Investor is referred to as the parent. Investee is referred to as the subsidiary. Investment in the subsidiary is reported on the

parent’s books as a long-term investment. Parent generally prepares consolidated

financial statements.

SO 4 Describe the use of consolidated financial statements.SO 4 Describe the use of consolidated financial statements.

Holdings of More Than 50%


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Consolidated statements indicate the magnitude and scope of operations of the companies under common control.

SO 4 Describe the use of consolidated financial statements.SO 4 Describe the use of consolidated financial statements.

Holdings of More Than 50%


Illustration 12-5Examples of consolidated companies and their subsidiaries

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Answer on

notes page

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Valuing and Reporting InvestmentsValuing and Reporting Investments

Categories of SecuritiesCompanies classify debt and share investments into three categories: Fair value through profit or loss (FVPL)

securities Available-for-sale (AFS) securities Held-to-maturity securities

These guidelines apply to all debt securities and all share investments in which the holdings are less than 20%.

SO 5 Indicate how debt and share investments are SO 5 Indicate how debt and share investments are reported in financial statements.reported in financial statements.

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Fair Value Through Profit or Loss (FVPL)Companies hold securities with the

intention of selling them in a short period (< month).

Frequent buying and selling.

Companies report securities at fair value, and report changes from cost as part of net income.

Changes are reported as unrealized gains or losses.


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Illustration: Investment of Pace classified as fair value through profit or loss securities on December 31, 2011.

Fair Value Through Profit or Loss (FVPL)Fair Value Through Profit or Loss (FVPL)

The adjusting entry for Pace Corporation is:


Dec. 31 Market adjustment—FVPL 7,000Unrealized gain—income 7,000

Illustration 12-7

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Available-for-Sale (AFS) SecuritiesHeld with the intent of selling these

investments sometime in the future. Classified as current assets or as non-current assets, depending on the intent of management.Report securities at fair valueReport changes from cost as a component of the equity


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Marketable securities bought and held primarily for sale in the near term are classified as: a. Available-for-sale securities. b. Held-to-maturity securities. c. Share securities. d. Fair value through profit or loss

Question



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Problem: How would the entries for fair value through profit or loss securities change if the securities were classified as available-for-sale?The entries would be the same except that the

Unrealized Gain or Loss—Equity account is used instead of Unrealized Gain or Loss—Income.

The unrealized loss would be deducted from equity rather than charged to income.

Available-for-Sale SecuritiesAvailable-for-Sale Securities


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Illustration: Assume that Ingrao Corporation has two securities that it classifies as available-for-sale.

The adjusting entry for Ingrao Corporation is:


Dec. 31 Unrealized gain or loss—equity9,537Market adjustment—AFS 9,537

Illustration 12-8


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An unrealized loss on available-for-sale securities is: a. reported under other revenue and

expenses in the income statement. b. closed-out at the end of the

accounting period. c. reported as a separate component of

equity. d. deducted from the cost of the

investment.

Question



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Securities held by a company that are (1)readily marketable and (2)intended to be converted into cash

within the next year or operating cycle, whichever is longer.

Short-Term Investments

SO 6 Distinguish between short-term and long-term investments.

Investments that do not meet both criteria are classified as long-term investments.

Statement of Financial Position Presentation


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Nonoperating items related to investments

Presentation of Realized and Unrealized Gain or Loss

Statement of Financial Position PresentationStatement of Financial Position Presentation


Illustration 12-10

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Realized and Unrealized Gain or Loss


Unrealized gain or loss on available-for-sale securities is reported as a separate component of equity. Illustration 12-

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39 SO 6 Distinguish between short-term and long-term investments.

Classified Statement of Financial Position (partial)

Illustration 12-12

40 SO 6 Distinguish between short-term and long-term investments.

Classified Statement of Financial Position (partial)

Illustration 12-12

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Identify where each of the following items would be reported in the financial statements.

SO 6 Distinguish between short-term and long-term investments.Answers on notes page

Use the following possible categories:Intangible assets EquityProperty, plant, and equipment Non-current liabilitiesInvestments Current liabilitiesCurrent assets Other income and expenses


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Both IFRS and GAAP use the same criteria to determine whether the equity method of accounting should be used—that is, significant influence with a general guide of over 20% ownership. GAAP uses the term equity investment whereas IFRS uses the term associate investment to describe investments under the equity method.

Under IFRS, both the investor and an associate company should follow the same accounting policies. As a result, in order to prepare financial information, adjustments are made to the associate’s policies to conform to the investor’s books. GAAP does not have that requirement.

Understanding U.S. GAAPUnderstanding U.S. GAAP

Key Key DifferencesDifferences

Investments

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The basis for consolidation under IFRS is control. Under GAAP, a bipolar approach is used, which is a risk-and reward model (often referred to as a variable-entity approach) and a voting interest approach. However, under both systems, for consolidation to occur, the investor company must generally own 50% of another company.

IFRS specifies the following four types of financial assets:1. Financial assets at fair value through profit or loss.2. Held-to-maturity investments.3. Loans and receivables.4. Available-for-sale financial assets.The loans and receivables category does not exist under GAAP.



Investments

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The category of financial asset at fair value through profit or loss is similar to the trading securities discussed in GAAP. As noted in the chapter, this category also includes investments that the company has decided to report at fair value. GAAP also gives the company the option to report investments at fair value.

Unrealized gains and losses related to available-for-sale securities are reported in other comprehensive income under GAAP and IFRS. These gains and losses that accumulate are then reported in the equity section. Under IFRS, they are frequently reported in a line item labeled “Reserves” whereas under GAAP, they are reported in accumulated other comprehensive income.



Investments

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Looking to the Looking to the FutureFuture


As indicated earlier, both the FASB and IASB have indicated that they believe that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. It seems likely, as more companies choose the fair value option for financial instruments, that we will eventually arrive at fair value measurement for all financial instruments.

Investments

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Consolidated Statement of Financial Position

Preparing Consolidated Financial StatementsPreparing Consolidated Financial Statements

Companies prepare consolidated statements of financial position from the individual statements of their affiliated companies.

Transactions between the affiliated companies are eliminated.

Appendix

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Illustration: Assume that on January 1, 2011, Powers Construction Company pays $150,000 in cash for 100% of Serto Brick Company’s ordinary shares. Powers Company records the investment at cost, as required by the cost principle.The combined totals do not represent a consolidated statement of financial position, because there has been a double counting of assets and equity in the amount of $150,000.


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Illustration 12A-1

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Use of a Worksheet—Cost Equal to Book Value


Illustration 12A-2

SO 7

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Use of a Worksheet—Cost Above Book Value


SO 7 Describe the content of a worksheet for a consolidated statement of financial position.

Illustration: Assume the same data used above, except that Powers Company pays $165,000 in cash for 100% of Serto’s ordinary shares. The excess of cost over book value is $15,000 ($165,000 - $150,000).

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Illustration 12A-3

SO 7

Use of a Worksheet—Cost Above Book Value

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SO 8 Explain the form and content of consolidated financial statements.

Illustration: The prior worksheet shows an excess of cost over book value of $15,000. In the consolidated statement of financial position, Powers first allocates this amount to specific assets, such as inventory and plant equipment, if their fair market values on the acquisition date exceed their book values. Any remainder is considered to be goodwill. For Serto Company, assume that the fair market value of property and equipment is $155,000.Thus, Powers allocates $10,000 of the excess of cost over book value to property and equipment, and the remainder, $5,000, to goodwill.

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Illustration 12A-4


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Consolidated Income Statement


Statement shows the results of operations of affiliated companies as though they are one economic unit.

All intercompany revenue and expense transactions must be eliminated.

A worksheet facilitates the preparation of consolidated income statements in the same manner as it does for the statement of financial position.

Appendix


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