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Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm 1 Chapter 12 Reporting and Analysing Investments 1. 2. 3. 4. 5. 6. After studying Chapter 12, you should be able to: Identify the reasons corporations invest in debt and equity securities. Explain the accounting for debt investments. Explain the accounting for equity investments. Describe the purpose and usefulness of consolidated financial statements. Distinguish between short-term and long-term investments. Indicate how debt and equity investments are valued and reported in the financial statements. 2 Illustration 12-1 Short-Term Investments and the Operating Cycle Illustration 12-2 Reasons Companies Invest Debt Investments Investments in money market instruments (short-term) and bonds (long-term) In accounting for debt investments, entries are required to record: Acquisition Interest revenue Sale Are recorded at cost including brokerage fees 5 Acquisition of Bonds Kuhl Corporation acquires 50 Doan, Inc. 12%, 10-year, $1,000 on Jan. 1 for $54,000. 1/1 Debt investments 54,000 Cash 54,000 (To record purchase of 50 Doan, Inc. bonds) 6 Bond Interest The bonds pay interest of $3,000 semiannually on July 1 and January 1. The entry to record the receipt of interest on July 1 is: 7/1 Cash 3,000 Interest Revenue 3,000 (To record receipt of interest on Doan Inc. bonds) 7 Accrued Bond Interest If the buyer’s (Kuhl) fiscal year ends on December 31, the following adjusting entry is needed to accrue interest of $3,000 earned since July 1: 12/31 Interest Receivable 3,000 Interest Revenue 3,000 (To accrue interest on Doan Inc. bonds) 8 Sale of Bonds Kuhl sells the bonds for $58,000 on January 1, 2002, after receiving the interest due. *The bonds were purchased for $54,000. Kuhl must record a gain of $4,000. The entry to record the sale of the bonds is as follows: 1/1 Cash 58,000 Debt Investments 54,000 Gain on sale of Debt Investments 4,000 (To record sale of Doan Inc. bonds) 9 Equity Investments Investments in the share capital (preferred or common) of corporations Accounting for investments in common shares is based on the extent of the investor's degree of influence over the operating and financial affairs of the issuing corporation (the investee) 10 Equity Investments Factors to consider in determining degree of influence are whether: Investor has representation on the investee's board of directors Investor participates in the investee's policy-making process Material transactions between the investor and the investee Common shares held by other shareholders are concentrated or dispersed 11 Illustration 12-3 Accounting Guidelines Equity Investments Cost Method (less than 20%) Record investment at cost Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any Recognize revenue when cash dividends are declared 13 Acquisition of Shares On July 1, 2001, Passera Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common shares at $40 per share plus brokerage fees of $500 7/1 Equity Investments 40,500 Cash 40,500 (To record purchase of 1,000 Beal common shares) 14 Dividends $2.00 per share dividend is received by Passera Corporation on December 31: 12/31 Cash (1,000 x $2) 2,000 Dividend Revenue 2,000 (To record receipt of cash dividend) 15 Sale of Shares Net proceeds from the sale (sales price less brokerage fees) - Cost of the shares =Gain (Loss) 16 Sale of Shares Passera Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation shares on February 10, 2002 1/1 Cash 39,500 Loss on Sale of Equity Investments 1,000 Equity Investments 40,500 (To record sale of Beal common shares) 17 Equity Method (more than 20%) Investment in common shares initially recorded at cost Investment account adjusted annually to show the investor’s equity in the investee Investor has significant influence over investee 18 Acquisition of Shares Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, 2001 1/1 Equity Investments 120,000 Cash 120,000 (To record purchase of Beck common shares) 19 Net Earnings (Loss) and Dividends For 2001, Beck reports net earnings of $100,000 and declares and pays a $40,000 cash dividend Milar is required to record It’s share of Beck's earnings, $30,000 (100,000 x 30%) The reduction in the investment account for the dividends received, $12,000 ($40,000 x 30%) 20 Revenue and Dividends 12/31 Equity Investments 30,000 Revenue from Investment in Beck Company 30,000 (To record 30% equity in Beck's 2001 net earnings) 12/31 Cash Equity Investments (To record dividends received) 12,000 12,000 During the year the investment account has increased by $18,000 ($30,000 - $12,000) 21 Controlling Interest Controlling interest Usually more than 50% of the common shares of another entity Investor – parent company Investee – subsidiary company Investor and investee are, in some sense, one company 22 Consolidated Financial Statements Inform creditors, investors, and others of magnitude and scope of operations of companies under common control Present assets and liabilities controlled by parent and aggregate profitability of subsidiary companies Prepared in addition to financial statements for individual parent and subsidiary companies 23 Short- and Long-Term Investments Investments include short-term paper (certificates of deposit, treasury bills, commercial paper), debt securities (government and corporate bonds) and equity securities (preferred and common shares) These can be classified as either short-term or long-term 24 Short- and Long-Term Investments Short-term investments are debt or equity securities, held by a company, that are Readily marketable Intended to be converted into cash in the near future Investments that do not meet both criteria (readily marketable; intent to convert) are classified as long-term investments 25 Valuation of Investments Value of debt and equity investments may fluctuate greatly during the time they are held Conservatism requires accountants to use the lower of cost and market (LCM) rule Application of the LCM rule varies depending upon whether the investment is short- or long-term 26 Valuation of Short-Term Investments LCM normally applied to total portfolio Allowance to Reduce Cost to Market Value used to record the difference between cost and market value Allowance account is a contra asset account deducted from the cost of the investments to arrive at the LCM valuation 27 Reporting of Short-Term Investments Current Assets Cash xxx Short-term investments, at cost $140,000 Less: Allowance to reduce cost to market value 2,000 Short-term investments, at market 138,000 28 Valuation of Long-Term Investments LCM applied to individual investments Carrying values not adjusted to reflect temporary fluctuations in market value When market falls below cost and the decline is not temporary, reduce investment to market value Investment is credited directly; no Allowance account is used 29 Evaluating Investment Portfolio Performance Time sale of investments before year-end Misclassification of investments as short- and long-term 30 Balance Sheet Presentation Short-term investments Report at LCM in current asset section of balance sheet Disclose market value Present after Cash or combined with Cash as a cash equivalent Long-term investments Separate section of the balance sheet immediately below Current Assets Report at cost or at equity (if significant influence) 31 Decision Checkpoints Is the company window-dressing its results by manipulating its investment portfolio? 32 Copyright Copyright © 2001 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 33