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15
Investments and Fair
Value Accounting
Principles of Financial Accounting, 11e
Reeve • Warren • Duchac
15-1
11-1
1
Describe why
companies invest in
debt and equity
securities.
15-4
15-2
11-2
1
Investing Cash in Current Operations
Cash may be used to replace worn out
equipment or to purchase new, more efficient,
and productive equipment. Cash may be
reinvested in the company to expand its current
operations. Cash may be used to pay suppliers or
other creditors.
15-3
11-3
1
Investing Cash in Temporary
Investments
Debt securities are notes and bonds that
pay interest and have a fixed maturity
date. Equity securities are preferred and
common stock that represent ownership
in a company and do not have a fixed
maturity date.
15-4
11-4
1
Investing Cash in Temporary
Investments
These debt securities and equity
securities are termed Investments, or
Temporary Investments, and are
reported in the Current Assets section
of the balance sheet.
15-5
11-5
1
Investing Cash in Long-Term
Investments
Long-term investments often involve the
purchase of a significant portion of the stock
of another company. Such investments have a
strategic purpose:
1. Reduction of costs
2. Replacement of management
3. Expansion
4. Integration
15-6
11-6
2
Describe and illustrate
the accounting for debt
investments.
15-9
15-7
11-7
2
Purchase of Bonds
Homer Company purchases $18,000 of U.S. Treasury
bonds direct from a Federal Reserve Bank at their par value
on March 17, 2010 (45 days after the last interest payment
date). The bonds have an interest rate of 6%, payable on
July 31 and January 31.
$18,000 × 6% × (45/360)
15-8
11-8
2
Interest Revenue
On July 31, Homer Company receives a semiannual
interest payment of $540 ($18,000 × 6% × ½).
($540 – $135) or [$18,000 × 6% ×
(135/360)]
15-9
11-9
2
Accrued Interest
Homer Company’s accounting period ends on December
31. The following adjusted entry is required to record the
accrued interest:
Homer Company would report Interest Revenue on its
2010 income statement at $855 ($405 + $450).
15-10
11-10
2
Semiannual Receipt of Interest
Homer Company receives interest of $540 on
January 31, 2011. Notice that Interest Receivable is
credited for $450 to reflect this is a receivable from
2010. Interest Revenue of $90 is the interest earned
from January 1 through January 31, 2011.
15-11
11-11
2
Sale of Bonds
On January 31, 2011, Homer Company sells Treasury
bonds at 98. The sale results in a loss of $360.
Proceeds from sale ($18,000 × 98%)
Less book value (cost) of the bonds
Loss on sale of bonds
15-12
11-12
$17,640
18,000
$(360)
Reported as part of Other Income
(Loss) on the income statement
2
Example Exercise 15-1
Bond Transactions
Journalize the entries to record the following selected
bond investment transactions for Tyler Company:
1. Purchased for cash $40,000 of Tyler Company 10%
bonds at 100 plus accrued interest of $320.
2. Received the first semiannual interest.
3. Sold $30,000 of the bonds at 102 plus accrued
interest of $110.
15-15
15-13
11-13
Example Exercise 15-1 (continued)
2
Follow My Example 15-1
1. Investments—Tyler Company Bonds……………………
Interest Receivable………………………………………….
Cash……………………………………………………..
40,000
320
40,320
2. Cash ($40,000 × 10% × ½)………………………………….. 2,000
Interest Receivable……………………………………
Interest Revenue………………………………………
320
1,680
3. Cash [($30,000 × 102%) + $110 accrued interest]………. 30,710
Interest Revenue………………………………………
Gain on Sale of Investments………………………...
Investments—Tyler Company Bonds……………...
110
600
30,000
For Practice: PE 15-1A, PE 15-1B
15-16
15-14
11-14
3
Describe and illustrate
the accounting for
equity investments.
15-17
11-15
15-15
3
Accounting for Equity
Investments
A company may invest in the preferred or
common stock of another company. The
company investing in another company’s
stock is the investor. The company whose
stock is purchased is the investee.
15-16
11-16
3
Exhibit 1
15-17
11-17
Stock Investments
3
Less Than 20% Ownership
Investments of less than 20%
of the investee’s outstanding
stock are accounted for by
using the cost method.
15-18
11-18
3
Purchase of Stock (Cost Method)
On May 1, Bart Company purchases 2,000 shares of Lisa
Company common stock at $49.90 per share plus a
brokerage fee of $200.
15-19
11-19
3
Receipt of Dividends (Cost Method)
On July 31, Bart Company receives a dividend of $0.40
per share from Lisa Company.
Dividend Revenue is reported as part of Other Income on
Bart Company’s income statement.
15-20
11-20
3
Sale of Stock (Cost Method)
On September 1, Bart Company sells 1,500 shares of Lisa
Company stock for $54.50 per share, less a $160
commission.
Proceeds from sale [(54.50 × 1,500 shares) – $160
Book value (cost) of the stock ($100,000/2,000 shares) × 1,500
Gain on sale of investments
15-21
11-21
$81,590
75,000
$ 6,590
3
Example Exercise 15-2
Stock Transactions
On September 1, 1,500 shares of Monroe Company
are acquired at a price of $24 per share plus a $40
brokerage fee. On October 14, a $0.60 per share
dividend was received on the Monroe Company
stock. On November 11, 750 shares (half) of Monroe
Company’s stock were sold for $20 per share, less a
$45 brokerage fee. Prepare the journal entries for the
original purchase, dividends, and sale.
15-24
15-22
11-22
Example Exercise 15-2 (continued)
3
Follow My Example 15-2
Sept. 1 Investments—Monroe Company Stock…………….
Cash………………………………………………….
36,040
36,040*
*(1,500 shares × $24 per share) + $40
Oct. 14 Cash………………………………………………………..
Dividend Revenue…………………………………
900
900*
*$0.60 per share × 1,500 shares
Nov. 11 Cash………………………………………………………..
Loss on Sale of Investments…………………………..
Investments—Monroe Company Stock……….
14,955*
3,065
18,020**
*(750 shares × $20) – $45
**$36,040 × 1/2
For Practice: PE 15-2A, PE 15-2B
15-25
15-23
11-23
3
Between 20% and 50% Ownership
If the investor purchases between 20%
and 50% of the outstanding stock of the
investee, the investor is considered to
have significant influence over the
investee and the investment is accounted
for using the equity method.
15-24
11-24
3
Purchase of Stock (Equity Method)
Simpson Inc. purchased a 40% interest in Flanders
Corporation’s common stock on January 2, 2010 for
$350,000.
15-25
11-25
3
Recording Investee Net Income
(Equity Method)
For the year ending on December 31, 2010, Flanders
Corporation reported net income of $105,000.
Income of Flanders Corporation, if significant, is reported
as Other Income on Simpson Inc.’s income statement.
15-26
11-26
3
Recording Investee Dividends
(Equity Method)
During the year, Flanders declared and paid cash dividends
of $45,000.
15-27
11-27
3
15-28
11-28
3
Sale of Stock (Equity Method)
On January 1, 2011, Simpson Inc. sold Flanders
Corporation’s stock for $400,000 a gain of $26,000
calculated as follows:
Proceeds from sale
Book value of stock investment
Gain on sale
15-29
11-29
$400,000
374,000
$ 26,000
3
Example Exercise 15-3
Equity Method
On January 2, Olson Company acquired 35% of the
outstanding stock of Bryant Company for $140,000.
For the year ending December 31, Bryant Company
earned income of $44,000 and paid dividends of
$20,000. Prepare the entries for Olson Company for
the purchase of the stock, share of Bryant income,
and dividends received from Bryant Company.
15-32
15-30
11-30
Example Exercise 15-3 (continued)
3
Follow My Example 15-3
Jan. 2 Investment in Bryant Company Stock.……………. 140,000
Cash………………………………………………….
140,000
Dec. 31 Investment in Bryant Company Stock……………….
Income of Bryant Company……………………...
15,400*
15,400
*Record 35% of Bryant income, 35% × $44,000
Dec. 31 Cash………………………………………………………..
Investment in Bryant Company Stock…………
7,000*
7,000
*35% × $20,000
For Practice: PE 15-3A, PE 15-3B
15-33
15-31
11-31
3
More Than 50% Ownership
If the investor purchases more than 50%
of the outstanding stock of the investee,
the investor is considered to have control
over the investee. The purchase is termed
a business consolidation.
15-32
11-32
3
More Than 50% Ownership
A corporation owning all or a majority of
the voting stock of another company is
called a parent company. The
corporation that is controlled is called
the subsidiary company.
15-33
11-33
4
Describe and illustrate
valuing and reporting
investments in the
financial statements.
15-36
11-34
15-34
4
Trading Securities
Trading securities are debt and
equity securities that are purchased
and sold to earn short-term profits
from changes in their market prices.
15-35
11-35
4
Maggie Company purchased a portfolio of trading
securities during 2009. On December 31, 2009, the
cost and fair values of the securities were as
follows:
15-36
11-36
4
The adjusting entry on December 31, 2009, to
record the fair value of the securities is as follows:
The Unrealized Gain on Trading Investments, if
significant, is reported on the income statement.
15-37
11-37
4
15-38
11-38
4
On September 10, 2010, Maggie Company
purchases 300 shares of Zane Inc. as a trading
security for $12 per share, including a brokerage
commission.
15-39
11-39
4
On December 31, 2010, the cost and fair
valuation of the portfolio of trading securities
are as follows:
15-40
11-40
4
Based on the above analysis, the adjusting entry
on December 31, 2010, is as follows:
15-41
11-41
4
The valuation allowance for trading investments
account after the December 31, 2010 adjusting
entry, has a credit balance of $3,100.
Valuation Allowance for Trading Investments
2009
Dec. 31 Adj.
Dec. 31 Bal.
1,300
1,300
2010
Jan.
1 Bal.
1,300
2010
Dec. 31 Adj.
Dec. 31 Bal.
15-42
11-42
4,400
3,100
4
15-43
11-43
4
Example Exercise 15-4
Valuing Trading Securities at Fair Value
On January 1, 2010, Valuation Allowance for
Investments had a debit balance of $23,500. On
December 31, 2010, the cost of the trading securities
portfolio was $79,200, and the fair value was
$95,000.
Prepare the December 31, 2010, adjusting journal
entry to record the unrealized gain or loss on trading
investments.
15-46
15-44
11-44
Example Exercise 15-4 (continued)
4
Follow My Example 15-4
2010
Dec. 31 Unrealized Loss on Trading Investments…………..
Valuation Allowance for Trading Investments
To record decrease in fair value of
trading investments.
Valuation allowance for trading investments, January 1, 2010
Trading investments at cost, December 31, 2010
Trading investments at fair value, December 31, 2010
Valuation allowance for trading investments, December 31, 2010
*Adjustment
7,700
7,700*
$23,500 Dr.
$79,200
95,000
15,800 Dr.
$ 7,700 Cr.
For Practice: PE 15-4A, PE 15-4B
15-47
15-45
11-45
4
Held-To-Maturity Securities
Held-to-maturity
securities are debt
investments, such as
notes or bonds, that a
company intends to
hold until their
maturity date.
15-46
11-46
4
Available-For-Sale Securities
Available-for-sale
securities are debt
and equity
securities that are
not classified as
trading or held-formaturity securities.
15-47
11-47
4
Maggie Company purchased securities during
2009 as available-for-sale securities instead of
trading securities. On December 31, 2009, the
cost and fair values of the securities are as
follows:
15-48
11-48
4
The adjusting entry on December 31, 2009, to
record the fair value of the securities is as follows:
15-49
11-49
4
A credit balance in Unrealized
Gain (Loss) on Available-for-Sale
Investments is added to
stockholders’ equity, while a debit
balance is subtracted from
stockholders’ equity.
15-50
11-50
4
15-51
11-51
4
On September 10, 2010, Maggie Company
purchases 300 shares of Zane Inc. as an
available-for-sale security for $12 per share,
including brokerage commission.
15-52
11-52
4
On December 31, 2010, the cost and fair
valuation of the portfolio of available-forsale securities are as follows:
15-53
11-53
4
Calculating the Adjustment Amount for
the Valuation Account
Valuation allowance for
available-for-sale
$1,300 Dr.
Available-for-sale
investments at cost
$27,600
Available-for-sale
investments at fair value
24,500
Valuation allowance for
available-for-sale investments,
December 31, 2010
3,100 Cr.
Adjustment
$4,400 Cr.
15-54
11-54
4
Based on the calculations on Slide 56, the
following December 31, 2010, adjusting entry
should be made:
15-55
11-55
4
15-56
11-56
4
Example Exercise 15-5
Valuing Available-for-Sale Securities at Fair Value
On January 1, 2010, Valuation Allowance for
Available-for-Sale Securities has a credit balance of
$9,000. On December 31, 2010, the cost of the
available-for-sale securities was $45,700 and the fair
value was $37,200.
Prepare the adjusting journal entry to record the
unrealized gain or loss for available-for-sale
investments on December 31, 2010.
15-59
15-57
11-57
Example Exercise 15-5 (continued)
4
Follow My Example 15-5
2010
Dec. 31 Valuation Allowance for Available-for-Sale
Investments
Unrealized Gain (Loss) on Available-forSale Investments
To record increase in fair value of
available-for-sale securities.
Valuation allowance for available-for-sale investments,
January 1, 2010
Available-for-sale investments at cost, December 31, 2010
Available-for-sale investments at fair value, December 31, 2010
Valuation allowance for available-for-sale investments,
December 31, 2010
*Adjustment
15-60
15-58
11-58
500*
500
$9,000
Cr.
8,500
$ 500
Cr.
Dr.
$45,700
37,200
For Practice: PE 15-5A, PE 15-5B
4
Exhibit 2
15-59
11-59
Summary of Valuing and Reporting Investments
4
15-60
11-60
4
15-61
11-61
5
Describe fair value
accounting and its
implications for the
future.
15-64
11-62
15-62
5
Fair Value Accounting
Fair value is the price that would be
received for selling an asset or paying
off a liability. Fair value assumes that
the asset is sold or the liability paid off
under normal rather than under distress
conditions.
15-63
11-63
5
Trends to Fair Value
Accounting
A current trend for the FASB and
other accounting regulators is to adopt
accounting principles using fair
values for valuing and reporting
assets and liabilities.
15-64
11-64
5
Trends to Fair Value
Accounting
Factors contributing to this trend
include the following:
1. Current generally accepted accounting
principles are a hybrid of varying
measurement methods that often conflict
with each other.
(continued)
15-65
11-65
5
2. A greater percentage of the total assets of
many companies consists of financial
assets such as receivables and securities.
3. The world economy has created pressure
on accounting regulators to adopt a
worldwide set of accounting principles
and standards.
15-66
11-66
5
Disadvantages of Fair
Value Accounting
Several potential disadvantages
include the following:
1. Fair value may not be readily obtainable
for some assets or liabilities resulting in
subjectivity.
(continued)
15-67
11-67
5
2. Fair values make it more difficult to
compare companies if companies use
different methods of determining
(measuring) fair values.
3. Using fair values will result in more
fluctuations in accounting reports
because fair values normally change
from year to year.
15-68
11-68
5
Effect of Fair Value Accounting on the
Financial Statements—Balance Sheet
1. When an asset or liability is reported at
its fair value, any difference between
the asset’s original cost or prior
period’s fair value must be recorded.
2. The unrealized gain or loss on changes
in fair value must be recorded. One
method reports these as part of
stockholders’ equity.
15-69
11-69
5
Effect of Fair Value Accounting on the
Financial Statements—Income Statement
Instead of recording the unrealized
gain or loss on changes in fair value
as part of stockholders’ equity, the
unrealized gains or losses may be
reported on the income statement.
15-70
11-70
5
Dividend Yield
The dividend yield indicates the rate of return to
stockholders in terms of cash dividends distributed.
Dividend Yield =
Dividends per Share of Common Stock
Market Price per Share of Common Stock
Mattel:
Dividend Yield =
15-71
11-71
$0.75
$19.09
= 3.93%
Appendix 1:
Accounting for Held-toMaturity Investments
15-72
11-72
15-75
Prices of Bonds
1. If the bond rate of interest is more
than the market rate of interest for
equivalent investments, bonds are
purchased at a premium.
2. If the bond rate of interest is less than
the market rate of interest for
equivalent investments, bonds are
purchased at a discount.
15-73
11-73
Amortization of a Premium on
a Bond Investment
15-74
11-74
Amortization of a Discount on
a Bond Investment
15-75
11-75
Purchase of bonds on April 1, 2010.
Receipt of semiannual interest on October 1.
15-76
11-76
(continued)
Adjusting entry for accrued interest on December 31.
Adjusting entry for amortization of discount on December
31 using the straight-line method.
15-77
11-77
(continued)
The bonds mature on April 1, 2020.
15-78
11-78
15-79
11-79
15-80
11-80