Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investments and Fair Value Accounting Chapter 15

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 1 1.Describe why companies invest in debt and equity securities.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 1 Investing Cash in Temporary Investments  Instead of letting excess cash remain idle in a checking account, most companies invest this cash in securities such as: 1. Debt securities, which are notes and bonds that pay interest and have a fixed maturity date. 2. Equity securities, which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 1 Investing Cash in Temporary Investments  The primary objective of investing in temporary investments is to:  earn interest income  receive dividends  realize gains from increases in the market price of the securities.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 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:  Reduction of costs  Replacement of management  Expansion  Integration

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 2 1.Describe why companies invest in debt and equity securities. 2.Describe and illustrate the accounting for debt investments.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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, 2012, plus accrued interest for 45 days. The bonds have an interest rate of 6%, payable on July 31 and January 31, $18,000 × 6% × (45/360) LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What is Accrued Interest???  Accruals were introduced in Accounting 1  Revenue that has been earned but not received or  Expenses that have been incurred but not paid We said that for accruals “the cash hasn’t happened yet” Accrued Interest: Interest that has already been earned (revenue) but not yet received, so for a bond it accumulates and adds to the value.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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, 2012, plus accrued interest for 45 days. The bonds have an interest rate of 6%, payable on July 31 and January 31, $18,000 × 6% × (45/360) LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × 1½). The $540 interest includes $135 of accrued interest that Homer Company purchased with the bonds on March 17. ($540 – $135) or [$18,000 × 6% × (135/360)] LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue LO 2 (continued)

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × 1½). The $540 interest includes $135 of accrued interest that Homer Company purchased with the bonds on March 17. ($540 – $135) or [$18,000 × 6% × (135/360)] LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue Homer Company’s accounting period ends on December 31. Thus, an adjusting entry must be made to accrue interest for five months. The following adjusting entry records the accrued interest: LO 2 $18,000 × 6% × 5/12

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue LO 2 For the year ended December 31, 2012, Homer Company would report Interest revenue of $855 ($405 + $450) as part of Other income on the income statement.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Revenue Homer Company receives interest of $540 on January 31, Notice that Interest Receivable is credited for $450 to reflect that this amount is a receivable from Interest Revenue of $90 is the interest earned from January 1 through January 31, LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sale of Bonds On January 31, 2013, Homer Company sells the Treasury bonds at 98. The sale results in a loss of $360. Proceeds from sale ($18,000 × 98%)$17,640 Less book value (cost) of the bonds18,000 Loss on sale of bonds$ (360) LO 2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 3 1.Describe why companies invest in debt and equity securities. 2.Describe and illustrate the accounting for debt investments. 3.Describe and illustrate the accounting for equity investments.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Accounting for Equity Investments

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Less Than 20% Ownership  Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method. Under the cost method, entries are recorded for the following transactions:  Purchase of stock  Receipt of dividends  Sale of stock

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Purchase of Stock 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Receipt of Dividends 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Sale of Stock On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission. The gain is reported as part of Other income on Bart Company’s income statement.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 15-2

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Between 20%─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. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Between 20%─50% Ownership  Under the equity method, the investment account is adjusted for the investor’s share of the net income and dividends of the investee. These adjustments are as follows:  Net income: Recorded as an increase in the investment account.  Dividends: Decrease the investment account. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Purchase of Stock Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2012 for $350,000. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Recording Investee Net Income For the year ended December 31, 2012, Flanders Corporation reported net income of $105,000. Income of Flanders Corporation may be reported separately or as part of Other Income on Simpson Inc.’s income statement. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Recording Investee Dividends During the year, Flanders declared and paid cash dividends of $45,000. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Recording Investee Dividends

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sale of Stock On January 1, 2013, Simpson Inc. sold Flanders Corporation’s stock for $400,000, a gain of $26,000, calculated as follows: LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 15-3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 combination. LO 3

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. More Than 50% Ownership  A corporation owning all or a majority of the voting stock of another corporation is called a parent company. The corporation that is controlled is called the subsidiary company.  At the end of the year, the financial statements of the parent and subsidiary are combined, and consolidated financial statements are issued. LO 3

Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investments and Fair Value Accounting The End