© 2015 Pearson Education, Limited. Investments Chapter 15 © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objectives Identify why companies invest in debt and equity securities, and classify investments Account for investments in debt securities Account for investments in equity securities © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objectives Describe and illustrate how debt and equity securities are reported Use the rate of return on total assets to evaluate business performance © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objective 1 Identify why companies invest in debt and equity securities, and classify investments © 2015 Pearson Education, Limited.

Reasons to Invest in Other Companies Opportunities to invest excess cash. Opportunities to achieve strategic objectives by establishing relationships through investment of capital. Strategic Investments can be used to: Acquire control of another company. Establish a relationship that allows the investor to have significant influence over the investee company. Companies often take the opportunity to invest in other companies. Sometimes the investment is as simple as taking advantage of an opportunity to invest for a short period of time and then sell the investment when profits can be realized. Other times, the investment is for strategic purposes; to form a relationship with another company, to expand horizontally or vertically, or to gain control of the other company. © 2015 Pearson Education, Limited.

Classification of Investments Debt and equity securities can be subdivided into 5 types: Trading Investments Held-to-Maturity Investments Available-for-Sale Investments Significant Interest Investments Controlling Interest Investments Short-term Investments Marketable securities Current Assets Intended to be sold for profit in 1 year Long-term Investments Can be investments in stocks or bonds Investments are classified as either short-term or long-term based on the underlying reason for the investment. There are five basic ways to classify an investment: Trading Investments Held-to-Maturity Investments Available-for-Sale Investments Significant Interest Investments Controlling Interest Investments © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Trading Securities—are usually short-term investments in either equity or debt securities of other companies. They represent less than a 20% ownership of the company being invested in (for equity securities) and are usually acquired for speculative purposes. Held-to-Maturity Investments—are debt securities that are purchased to generate income. They are classified as short-term or long-term based on the maturity date. Available-for-Sale Securities—are debt or equity securities that represent less than 20% of the outstanding equity of the investee company. They are usually considered long-term, but can be short-term. The investor usually does not have an immediate intention to sell the securities. The intent is usually to establish a financial relationship with a company that has a strategic relationship to the investor. Significant Interest Investments—are investments in equity securities. They represent ownership that is sufficient to establish significant influence over the investee company. The number of equity shares owned usually represents between 20 and 50% of the outstanding voting stock of the investee company. Controlling Interest Investments—are investments in equity securities. They represent ownership that is sufficient to establish control over the investee company, which implies ownership of more than 50% of the outstanding voting stock of the investee company. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! © 2015 Pearson Education, Limited.

Account for investments in debt securities Learning Objective 2 Account for investments in debt securities © 2015 Pearson Education, Limited.

Purchasing Debt Securities On July 1, 2014, Smart Touch Learning invests $100,000 in excess cash to buy bonds from Neon Company that have $100,000 face value and pay 9% interest over their 5-year life. Smart Touch plans to hold bonds until maturity. When a company purchases debt securities of another company, the investment is recorded at cost at the time of the investment. While interest revenue will accrue on the investment, there is not interest recorded on the date of the investment. On July 1, 2014, Smart Touch Learning invests $100,000 to buy bonds of Neon Company. The bonds carry a $100,000 face value and pay 9% interest over their 5-year life. Record the investment in bonds on July 1, 2014. Record the investment in bonds on July 1, 2014. © 2015 Pearson Education, Limited.

Purchasing Debt Securities On July 1, 2014, Smart Touch Learning invests $100,000 in excess cash to buy bonds from Neon Company that have $100,000 face value and pay 9% interest over their 5-year life. Smart Touch plans to hold bonds until maturity. The entry requires a debit to Long-term Investments--Held-to-Maturity Securities for $100,000 and a credit to Cash for $100,000. © 2015 Pearson Education, Limited.

Record the interest revenue on December 31, 2014. On December 31, 2014, Smart Touch Learning will receive their first interest payment from Neon Company for the bonds purchased on July 1, 2014. On December 31, 2014, six months have passed since making the investment in the bonds. Smart Touch Learning will receive their first interest payment on December 31, 2014. Record the interest received on December 31, 2014. Record the interest revenue on December 31, 2014. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Interest Revenue On December 31, 2014, Smart Touch Learning will receive their first interest payment from Neon Company for the bonds purchased on July 1, 2014. Smart Touch Learning is owed $4,500 interest. The calculation is: $100,000 face value x 9% interest rate x 6/12 of a year = $4,500 The entry requires a debit to Cash for $4,500 and a credit to Interest Revenue for $4,500. © 2015 Pearson Education, Limited.

Record the maturity of the bonds. Disposal at Maturity On June 30, 2019, the Neon Company bonds will mature and Smart Touch Learning will receive a final payment. Jump forward to the maturity date of June 30, 2019. The Neon Company bonds mature and Smart Touch Learning will receive back their original investment. (Assume that the final interest payment has already been received and recorded.) Record the maturity of the bond investment at June 30, 2019. Record the maturity of the bonds. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Disposal at Maturity On June 30, 2019, the Neon Company bonds will mature and Smart Touch Learning will receive a final payment. The entry will require a debit to Cash for $100,000 and a credit to Long-term Held-to-Maturity Securities for $100,000. © 2015 Pearson Education, Limited.

Account for investments in equity securities Learning Objective 3 Account for investments in equity securities © 2015 Pearson Education, Limited.

Equity Investments < 20% Accounted for as either Trading Securities Available-for-Sale Securities Must recognize dividend revenue Will be adjusted for changes in market value (see Learning Objective 4) Record at cost when acquired. Recognize dividend revenues. Record a gain or loss on disposal when the investment is sold. Equity investments that are less than 20% of the outstanding equity of the investee are accounted for as either Trading Securities or Available-for-Sale Securities. For both types of investments, the original investment will be recorded at cost at the time of the investment. Any dividends received from those investments will be recorded as Dividend Revenue. The difference in accounting for the two types of securities is related to how changes in market value for the securities is recorded. © 2015 Pearson Education, Limited.

Equity Investments < 20% On March 1, 2014, Smart Touch Learning acquires 1,000 shares of stock in Yellow Corporation for $26.16 per share. This will be treated as an available-for-sale investment. On March 1, 2014, Smart Touch Learning acquires 1,000 shares of stock in Yellow Corporation for $26.16 per share. This is an Available-for-Sale Security. Record the acquisition of stock on March 1, 2014. Record the stock acquisition on March 1, 2014. © 2015 Pearson Education, Limited.

Equity Investments < 20% On March 1, 2014, Smart Touch Learning acquires 1,000 shares of stock in Yellow Corporation for $26.16 per share. This will be treated as an available-for-sale investment. The entry will require a debit to Long-term Investments (Available-for-Sale Securities) for $26,160 (1,000 shares x $26.16 per share) and a credit to Cash for $26,160. © 2015 Pearson Education, Limited.

Equity Investments < 20% On May 17, 2014, Yellow Corporation declares a cash dividend of $0.16 per share to stockholders of record on March 17, 2014. The dividend will be paid on June 9, 2014. On May 17, 2014, Yellow Corporation declares a dividend of $.16 per share to stockholders of record on March 17, 2014. Record the receipt of the dividend on June 9, 2014. Record the dividend when it is received on June 9, 2014. © 2015 Pearson Education, Limited.

Equity Investments < 20% On May 17, 2014, Yellow Corporation declares a cash dividend of $0.16 per share to stockholders of record on March 17, 2014. The dividend will be paid on June 9, 2014. The entry requires a debit to Cash for $160 and a credit to Dividend Revenue for $160. © 2015 Pearson Education, Limited.

Equity Investments < 20% On July 15, 2014, Smart Touch Learning sells 800 shares of its Yellow Corporation stock for $25,000. On July 15, 2014, Smart Touch Learning sells 800 shares of its Yellow Corporation stock for $25,000. Record the sale of Yellow Corporation stock on July 15, 2014. Record the sale of Yellow Corporation stock on July 15, 2014. © 2015 Pearson Education, Limited.

Equity Investments < 20% On July 15, 2014, Smart Touch Learning sells 800 shares of its Yellow Corporation stock for $25,000. The cost of the shares sold is: 800 shares x $26.16 per share = $20,928. The entry requires a debit to Cash for $25,000. However, the Investment account must be credited only for the cost of the 800 shares that were sold. Because the original cost was $26.16 per share, we can calculate the cost of the 800 shares sold as: 800 shares x $26.16 per share = $20,928. A credit will be made to Long-term Investments (Available-for-Sale Securities) for $20,928. At this point the journal entry does not yet balance. The difference will be recorded as either a gain or a loss, depending on what is needed to balance the journal entry. The journal entry does not yet balance. The difference will be either a gain since proceeds > cost. © 2015 Pearson Education, Limited.

Equity Investments < 20% On July 15, 2014, Smart Touch Learning sells 800 shares of its Yellow Corporation stock for $25,000. The gain on disposal is: $25,000 proceeds - $20,928 cost = $4,072 gain In this case, the amount received for the shares of $25,000 exceeds the cost of the shares sold of $20,928 by $4,072. This will be recorded as a credit to Gain on Disposal of Long-term Investment for $4,072. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% Significant influence is assumed. Accounted for using the Equity method of accounting for investments. EQUITY METHOD Record investment at cost when acquired. Dividends reduce the investment balance. Investor’s share of investee’s income increases the investment balance. When the level of the investment is between 20 and 50%, then a different accounting approach is required. At this level of ownership, it is assumed that the investing company has the ability to exercise significant influence over the investee company. The accounting requires the investment to be recorded at cost. Dividends received related to this investment will be recorded as a return OF investment instead of a return ON investment and accordingly will be accounted for as a reduction to the investment. In addition, the investor will increase the investment account for the investor’s share of the investee’s net income for the period. This approach is referred to as the Equity Method of Accounting for Investments. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On January 6, 2014, Smart Touch Learning paid $400,000 to acquire 40% of the common stock of Kline, Inc. On January 6, 2014, Smart Touch Learning paid $400,000 to acquire 40% of the common stock of Kline, Inc. Record the acquisition of the Kline, Inc. stock on January 6, 2014. Record the acquisition of the Kline, Inc. stock on January 6, 2014. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On January 6, 2014, Smart Touch Learning paid $400,000 to acquire 40% of the common stock of Kline, Inc. The entry will require a debit to Long-term Investment (Equity Securities) for $400,000 and a credit to Cash for $400,000. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On June 30, 2014, Smart Touch Learning receives a dividend of $20,000 from Kline, Inc. (Remember: in the equity method, dividends reduce the investment account). On June 30, 2014, Smart Touch Learning receives a dividend of $20,000 from Kline, Inc. Record the receipt of dividends from Kline, Inc. on June 30, 2014. Record the receipt of dividends from Kline, Inc. on June 30, 2014. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On June 30, 2014, Smart Touch Learning receives a dividend of $20,000 from Kline, Inc. (Remember: in the equity method, dividends reduce the investment account). The entry requires a debit to Cash for $20,000 and a credit to Long-term Investment (Equity Securities) for $20,000. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% At December 31, Kline, Inc. reports net income of $125,000 for 2014. Smart Touch Learning must account for 40% of Kline’s net income. (In the equity method, investee net income increases the investment account). At December 31, 2014, Kline, Inc. reports net income of $125,000 for 2014. Remember that Smart Touch Learning owns 40% of the stock of Kline, Inc. Record Smart Touch Learning’s share of Kline, Inc.’s net income for 2014. Record the Smart Touch Learning’s share of Kline, Inc.’s net income at December 31, 2014. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% At December 31, Kline, Inc. reports net income of $125,000 for 2014. Smart Touch Learning must account for 40% of Kline’s net income. (In the equity method, investee net income increases the investment account). Smart Touch Learning is entitled to take accounting credit for 40% of Kline, Inc.’s net income for 2014. The amount is computed as: $125,000 Net Income x 40% ownership = $50,000 The entry will require a debit to Long-term Investments (Equity Securities) for $50,000 and a credit to Revenue from Investments of $50,000. It is important to note that Smart Touch Learning does not actually RECEIVE $50,000 from Kline, Inc. Rather, Smart Touch Learning is merely recording (as part of the change in the Investment’s book value) its right to CLAIM 40% of Kline, Inc.’s net income. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On January 1, 2015, Smart Touch Learning sells 10% of the Kline, Inc. stock for $40,000. The Long-term Investment account for Kline, Inc. has a balance of $430,000. On January 1, 2015, Smart Touch Learning sells 10% of the Kline, Inc. stock for $40,000. At this point, the Long-term Investment account for Kline, Inc. is at $430,000. $43,000 (10%) of that book value is being sold for $40,000, a loss of $3,000. Record the disposal of 10% of the Kline, Inc. investment on January 1, 2015. Record the disposal of 10% of Smart Touch Learning’s investment in Kline, Inc. on January 1, 2015. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On January 1, 2015, Smart Touch Learning sells 10% of the Kline, Inc. stock for $40,000. The Long-term Investment account for Kline, Inc. has a balance of $430,000. The entry will require a debit to cash for $40,000 and a credit to Long-term Investment (Equity Securities) for $43,000. The entry at this point is not yet balanced. © 2015 Pearson Education, Limited.

Equity Investments > 20%, but < 50% On January 1, 2015, Smart Touch Learning sells 10% of the Kline, Inc. stock for $40,000. The Long-term Investment account for Kline, Inc. has a balance of $430,000. To balance the entry a debit to Loss on Disposal is recorded for $3,000. © 2015 Pearson Education, Limited.

Equity Investments > 50% Control is established. Parent company must report the subsidiary company as if they were one company. Combined statements are called “Consolidated Statements” Effectively, the financial information for the two companies is combined, and adjusted for intra-company effects. When investments exceed 50% ownership, the investor holds effective control over the investee. At the point, the investor is referred to as the Parent Company, and the investee is now referred to as the Subsidiary Company. At this point, the financial statements of the Parent and Subsidiary companies can no longer be treated as two independent companies. Instead, accounting rules require that the financial statements of the two companies be reported as if they are one company. Such “combined” statements are recorded as Consolidated Financial Statements. The process for consolidating the financial statements for Parent and Subsidiary companies is quite complex, and involves making a series of adjustments to eliminate and adjust balances that would otherwise appear to be confusing if they appeared on the consolidated financial statements. © 2015 Pearson Education, Limited.

Describe and illustrate how debt and equity securities are reported Learning Objective 4 Describe and illustrate how debt and equity securities are reported © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Trading Investments Recorded initially at cost. Adjusted for changes in fair value. The adjustment is called “Unrealized Holding Gain/Loss” Shown on the Income Statement Fair Value is the price that would be used if the company were to sell the investments on the market. Trading Securities are initially recorded at cost at the time of the investment. However, as time passes, the market value of the securities underlying the investment will change. Typically, accounting rules do not allow companies to adjust the carrying amounts of assets for changes in the market value. For example, when land is acquired, it is recorded at cost. It is subsequently carried on the books at cost indefinitely, until such time as the land is disposed of. There is no adjustment for changes in the market value of the land during the time that the company owns it. However, in the case of both Trading Securities and Available-for-Sale Securities, the change in market value is recorded. The change in market value is recorded as a either an Unrealized Holding Gain, or an Unrealized Holding Loss, depending on whether the equity securities increased or decreased in value during the period. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Trading Investments On December 31, 2014, Smart Touch Learning reported trading investments of $26,160. The market value of the investments is $24,000. The adjustment is recorded as: On December 31, 2014, Smart Touch Learning reported Trading Investments of $26,160. The market value of those securities on December 31, 2014 is only $24,000. Because there has been a change in market value, the change must be recorded. The entry will require a debit to Unrealized Holding Loss—Trading Securities for $2,160 and a credit to Fair Value Adjustment—Trading Securities for $2,160. For Trading Securities, the Unrealized Holding Loss will appear on the Income Statement and will reduce Net Income for Smart Touch Learning for 2014. The Fair Value Adjustment will be reported in the asset section of Smart Touch Learning’s balance sheet. It will reported with Trading Investments and treated as a contra-asset. © 2015 Pearson Education, Limited.

Available-for-Sale Investments Recorded initially at cost Adjusted for changes in fair value The adjustment is called “Unrealized Holding Gain/Loss” Shown in Stockholders’ Equity The adjustment is recorded and shown in the stockholders’ equity section of the balance sheet as part of Accumulated Other Compre-hensive Income. Available-for-Sale Securities are also recorded at cost and subsequently adjusted for changes in market value. However, in the case of Available-for-Sale Securities, the Unrealized Holding Gain or Loss will be reported in equity as part of Accumulated Other Comprehensive Income. It will not show up as part of Smart Touch Learning’s net income for 2014. © 2015 Pearson Education, Limited.

Available-for-Sale Investments On December 31, 2014, Smart Touch Learning reported AFS investments of $60,000. The market value of the investments is $64,000. The adjustment is recorded as: At December 31, 2014, Smart Touch Learning reported Available-for-Sale (AFS) securities of $60,000. The market value of those securities is $64,000, a market gain of $4,000. The entry will record a debit to Fair Value Adjustment (AFS Securities) for $4,000 and a credit to Unrealized Holding Gain (AFS) of $4,000. The debit to Fair Value Adjustment will be treated as an Adjunct Account and will appear in the asset section of the balance sheet with the related Investment account. © 2015 Pearson Education, Limited.

Summary of Accounting for Debt & Equity Securities Exhibit 15-3 in the text explains how market changes are treated for the various types of investments. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objective 5 Use the rate of return on total assets to evaluate business performance © 2015 Pearson Education, Limited.

Rate of Return on Total Assets © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Practice Questions © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. End of Chapter 15 © 2015 Pearson Education, Limited.