Financial Accounting and Accounting Standards

Financial Accounting and Accounting Standards

Prepared by Coby Harmon University of California, Santa Barbara Westmont College 16-1 16 Investments Learning Objectives After studying this chapter, you should be able to: [1] Discuss why corporations invest in debt and stock securities. [2] Explain the accounting for debt investments. [3] Explain the accounting for stock investments. [4] Describe the use of consolidated financial statements. [5] Indicate how debt and stock investments are reported in financial statements.

[6] Distinguish between short-term and long-term investments. 16-2 Preview of Chapter 16 Accounting Principles Eleventh Edition Weygandt Kimmel Kieso 16-3 Why Corporations Invest Corporations generally invest in debt or stock securities for one of three reasons. 1. Corporation may have excess cash. 2. To generate earnings from investment income. 3. For strategic reasons. Illustration 16-1

Temporary investments and the operating cycle 16-4 LO 1 Discuss why corporations invest in debt and stock securities. Why Corporations Invest Question Pension funds and banks regularly invest in debt and stock securities to: a. house excess cash until needed. b. generate earnings. c. meet strategic goals. d. avoid a takeover by disgruntled investors.

16-5 LO 1 Discuss why corporations invest in debt and stock securities. Accounting for Debt Investments Recording Acquisition of Bonds Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any. Recording Bond Interest Calculate 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. 16-6 LO 2 Explain the accounting for debt investments.

Accounting for Debt Investments Recording Sale of Bonds Credit 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. 16-7 LO 2 Explain the accounting for debt investments. Accounting for Debt Investments Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10year, $1,000 bonds on January 1, 2014, for $50,000, including brokerage fees of $1,000. The entry to record the investment is: Jan. 1 Debt Investments

Cash 16-8 50,000 50,000 LO 2 Explain the accounting for debt investments. Accounting for Debt Investments Illustration: Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2014, for $50,000, 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: July 1 2,000 *

Cash Interest Revenue 2,000 * ($50,000 x 8% x = $2,000) 16-9 LO 2 Explain the accounting for debt investments. Accounting for Debt Investments Illustration: If Kuhl Corporations fiscal year ends on December 31, prepare the entry to accrue interest since July 1. Dec. 31 Interest Receivable 2,000

Interest Revenue 2,000 Kuhl reports receipt of the interest on January 1 as follows. Jan. 1 Cash 2,000 Interest Receivable 16-10 2,000

LO 2 Explain the accounting for debt investments. Accounting for Debt Investments Illustration: Assume that Kuhl corporation receives net proceeds of $54,000 on the sale of the Doan Inc. bonds on January 1, 2015, after receiving the interest due. Prepare the entry to record the sale of the bonds. Jan. 1 Cash 54,000 Debt Investments Gain on Sale of Investments 16-11

50,000 4,000 LO 2 Explain the accounting for debt investments. Accounting for Debt Investments Question 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. 16-12 LO 2 Explain the accounting for debt investments.

Accounting for Debt Investments Question 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. 16-13 LO 2 Explain the accounting for debt investments. Accounting for Stock Investments Ownership Percentages 0 ------------------20% -------------- 50% -------------------- 100%

No significant influence usually exists Significant influence usually exists Investment valued using Cost Method Investment valued using Equity Method

Control usually exists Investment valued on parents books using Cost Method or Equity Method (investment eliminated in Consolidation) The accounting depends on the extent of the investors influence over the operating and financial affairs of the issuing corporation. 16-14 LO 3 Explain the accounting for stock investments. Accounting for Stock Investments Holding of Less than 20% Companies use the cost method. Under the cost method, companies record the investment at cost, and recognize

revenue only when cash dividends are received. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions). Helpful Helpful Hint Hint The The entries entries for for investments investments in in common common stock stock also also apply apply to

to investments investments in in preferred preferred stock. stock. 16-15 LO 3 Explain the accounting for stock investments. Holdings of Less than 20% Recording Acquisition of Stock Investments Illustration: On July 1, 2014, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock. Sanchez pays $40 per share. The entry for the purchase is: July 1

Stock Investments Cash 16-16 40,000 40,000 LO 3 Explain the accounting for stock investments. Holdings of Less than 20% Recording Dividends Illustration: During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is: Dec. 31

Cash 2,000 Dividend Revenue 16-17 2,000 LO 3 Explain the accounting for stock investments. Holdings of Less than 20% Recording Sale of Stock Illustration: Assume that Sanchez Corporation receives net proceeds of $39,000 on the sale of its Beal stock on February 10, 2015. Because the stock cost $40,000, Sanchez incurred a loss of $1,000. The entry to record the sale is:

Feb. 10 Cash 39,000 Loss on Sale of Stock Investments Stock Investments 16-18 1,000 40,000 LO 3 Explain the accounting for stock investments. Accounting for Stock Investments Holdings Between 20% and 50%

Equity Method: Record the investment at cost and subsequently adjust the amount each period for the investors proportionate share of the earnings (losses) and dividends received by the investor. If investors share of investees losses exceeds the carrying amount of the investment, the investor ordinarily should discontinue applying the equity method. 16-19 LO 3 Explain the accounting for stock investments.

Holdings Between 20% and 50% Question Under the equity method, the investor records dividends received by crediting: a. Dividend Revenue. b. Investment Income. c. Revenue from Investment. d. Stock Investments. 16-20 LO 3 Explain the accounting for stock investments. Holdings Between 20% and 50% Illustration: Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, 2014. For 2014, Beck reports net income of $100,000 and paid dividends of $40,000. Prepare the entries for these transactions.

Jan. 1 Stock Investments 120,000 Cash Dec. 31 120,000 Stock Investments ($100,000 x 30%) 30,000 Revenue from Stock Investments Dec. 31 Cash ($40,000 x 30%)

Stock Investments 16-21 30,000 12,000 12,000 LO 3 Explain the accounting for stock investments. Holdings Between 20% and 50% Illustration: Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, 2014. For 2014, Beck reports net income of $100,000 and paid dividends of $40,000. After Milar posts the transactions for the year, its investment and revenue accounts will show the following. Illustration 16-4

16-22 LO 3 Explain the accounting for stock investments. Accounting for Stock Investments Holdings of More than 50% Controlling Interest - When one corporation acquires a voting interest of more than 50 percent in another corporation 16-23 Investor is referred to as the parent.

Investee is referred to as the subsidiary. Investment in the subsidiary is reported on the parents books as a long-term investment. Parent generally prepares consolidated financial statements. LO 4 Describe the use of consolidated financial statements. 16-24 Valuing and Reporting Investments Categories of Securities

Companies classify debt and stock investments into three categories: Trading securities Available-for-sale securities Held-to-maturity securities These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%. 16-25

LO 5 Indicate how debt and stock investments are reported in financial statements. Categories of Securities Trading Securities 16-26 Companies hold trading securities with the intention of selling them in a short period. Trading means frequent buying and selling.

Companies report trading securities at fair value, and report changes from cost as part of net income. LO 5 Indicate how debt and stock investments are reported in financial statements. Valuing and Reporting Investments Question 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. stock securities. d. trading securities 16-27 LO 5 Indicate how debt and stock investments are reported in financial statements.

Trading Securities Illustration: Investment of Pace classified as trading securities on December 31, 2014. Illustration 16-7 The adjusting entry for Pace Corporation is: Dec. 31 Fair Value AdjustmentTrading 7,000 Unrealized GainIncome 7,000 16-28 LO 5 Indicate how debt and stock investments are reported in financial statements.

16-29 Categories of Securities Available-for-Sale Securities 16-30 Companies hold securities with the intent of selling these investments sometime in the future. These securities can be classified as current assets or as long-term assets, depending on the intent of management.

Companies report securities at fair value, and report changes from cost as a component of the stockholders equity section. LO 5 Indicate how debt and stock investments are reported in financial statements. Available-For-Sale Securities Problem: How would the entries change if the securities were classified as available-for-sale? The entries would be the same except that the 16-31

Unrealized Gain or LossEquity account is used instead of Unrealized Gain or LossIncome. The unrealized loss would be deducted from the stockholders equity section rather than charged to the income statement. LO 5 Indicate how debt and stock investments are reported in financial statements. Available-For-Sale Securities Illustration: Assume that Elbert Corporation has two securities that it classifies as available-for-sale. Illustration 16-8 provides information on their valuation. Illustration 16-8 The adjusting entry for Elbert Corporation is:

Dec. 31 Unrealized Gain or LossEquity 9,537 Fair Value AdjustmentAvailable-for-Sale 16-32 9,537 LO 5 Indicate how debt and stock investments are reported in financial statements. Available-For-Sale Securities Question An unrealized loss on available-for-sale securities is: a. reported under Other Expenses and Losses in the income statement.

b. closed-out at the end of the accounting period. c. reported as a separate component of stockholders' equity. d. deducted from the cost of the investment. 16-33 LO 5 Indicate how debt and stock investments are reported in financial statements. Balance Sheet Presentation Short-Term Investments Also called marketable securities, are 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. Investments that do not meet both criteria are classified as

long-term investments. 16-34 Helpful Helpful Hint Hint Trading Trading securities securities are are always always classified classified as as short-term. short-term. Available-for-sale Available-for-sale securities

securities can can be be either either short-term short-term or or long-term. long-term. LO 6 Distinguish between short-term and long-term investments. Valuing and Reporting Investments Presentation of Realized and Unrealized Gain or Loss Illustration 16-10 Nonoperating items related to investments

16-35 LO 6 Distinguish between short-term and long-term investments. Valuing and Reporting Investments Realized and Unrealized Gain or Loss Unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders equity. Illustration 16-11 16-36 LO 6 Distinguish between short-term and long-term investments. Balance Sheet Presentation 16-37

Illustration 16-12 LO 6 Distinguish between short-term and long-term investments. A Look at IFRS Key Points 16-38 The basic accounting entries to record the acquisition of debt securities, the receipt of interest, and the sale of debt securities are the same under IFRS and GAAP.

The basic accounting entries to record the acquisition of stock investments, the receipt of dividends, and the sale of stock securities are the same under IFRS and GAAP. Both IFRS and GAAP use the same criteria to determine whether the equity method of accounting should be usedthat is, significant influence with a general guide of over 20 percent ownership, IFRS uses the term associate investment rather than equity investment to describe its investment under the equity method. LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS Key Points 16-39

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 associates policies to conform to the investors books. GAAP does not have that requirement. 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 percent of another company. LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS

Key Points 16-40 In general, IFRS requires that companies determine how to measure their financial assets based on two criteria: The companys business model for managing their financial assets; and The contractual cash flow characteristics of the financial asset. If a company has (1) a business model whose objective is to hold assets

in order to collect contractual cash flows and (2) the contractual terms of the financial asset gives specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding, then the company should use cost (often referred to as amortized cost). LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS Key Points 16-41 Equity investments are generally recorded and reported at fair value under IFRS. In general, equity investments are valued at fair value, with all gains and losses reported in income.

GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments). IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications. GAAP classifications are based on managements intent with respect to the investment. IFRS classifications are based on the business model used to manage the investments and the type of security. LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS Key Points 16-42

The accounting for trading investments is the same between GAAP and IFRS. Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses related to available-for-sale securities (GAAP) and non-trading equity investments (IFRS) are reported in other comprehensive income. 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 balance sheet. IFRS does not use Other Revenues and Gains or Other Expenses and Losses in its income statement presentation. It will generally classify these items as unusual items or financial items. LO 7

A Look at IFRS Looking to the Future 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. 16-43 LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS IFRS Self-Test Questions The following asset is not considered a financial asset under IFRS:

a) trading securities. b) held-for-collection securities. c) equity securities. d) inventories. 16-44 LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS IFRS Self-Test Questions Under IFRS, the equity method of accounting for long-term investments in common stock should be used when the investor has significant influence over an investee and owns: a) between 20% and 50% of the investees common stock. b) 30% or more of the investees common stock. c) more than 50% of the investees common stock. d) less than 20% of the investees common stock.

16-45 LO 7 Compare the accounting for investments under GAAP and IFRS. A Look at IFRS IFRS Self-Test Questions Under IFRS, unrealized gains on non-trading stock investments should: a) be reported as other revenues and gains in the income statement as part of net income. b) be reported as other gains on the income statement as part of net income. c) not be reported on the income statement or balance sheet. d) be reported as other comprehensive income. 16-46

LO 7 Compare the accounting for investments under GAAP and IFRS. Copyright Copyright 2013 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 16-47

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