Investments in Debt and Equity Securities Investments in Debt and Equity Securities C H A P T E R 12

Learning Objective 1 Understand why companies invest in other companies.

A Cash Flow Pattern Companies often need cash flow from sources other than their own operations because the company’s own cash flow might vary greatly over the course of a year. Average Cash Needs 1/16/3012/31 Actual Cash on Hand Excess cash (used for short- term investments) Insufficient cash (relieved by short-term borrowing)

What Are Some Other Reasons Companies Invest Their Excess Cash? 4To earn a return. 7Banks give a fixed return. 7Investing in stocks or bonds of other companies may earn a higher rate of return (and demand a higher degree of risk). 4The ability to ensure a supply of raw materials. 4To influence a board of directors. 4To diversify their product offerings. 4Less expensive than R&D.

Learning Objective 2 Understand the different classifications for securities.

Define the Two Classifications for Securities. Debt Securities Financial instruments issued by a company that carry with them a promise of interest payments and the repayment of principal. Equity Securities (Stock) Shares of ownership in a corporation that can change significantly in value and that provide for a return to investors in the form of dividends.

Classifying Securities Investments DebtEquity

Classifying Securities—Matching Method used to account for an investment in the stock of another company when significant influence can be imposed (presumed when 20 to 50 percent of the outstanding voting stock is owned). Equity Method Securities Held-to-Maturity Securities Debt securities purchased by an investor with the intent of holding the securities until they mature. Equity Method Securities Held-to-Maturity Securities

Classifying Securities—Matching Debt and equity securities not classified as trading, held-to-maturity, or equity method securities. Debt and equity securities purchased with the intent of selling them should the need for cash arise or to realize short-term gains. Available-for-Sale Securities Trading Securities Available-for-Sale Securities

Classifying Securities Held-to- Maturit y Available- for-Sale Equity Method DebtEquity Trading Investments

Classifying Securities DebtEquity Held-to- Maturity Trading Available- for-Sale Equity Method Investments

Fair value Amortized cost Cost adjusted for changes in net assets of investee Income statement Stockholders’ equity Not recognized Classifying Securities— Fill in the Chart Held-to- Maturity Trading Available- for-Sale Equity Method Classification Disclosed at Reporting of Changes in FMV

Learning Objective 3 Account for the purchase, recognition of revenue, and sale of trading and available- for-sale securities.

Purchase of Securities Caribou Corp. purchased the following securities on January 1, Record the appropriate entry. 1DebtTrading$ 3,000 2EquityTrading15,500 3DebtAvailable-for-sale10,000 4EquityAvailable-for-sale7,300 TypeClassification Cost (including broker’s fees)

Purchase of Securities Investment in Trading Securities ,500 Investment in Available-for-Sale Securities..17,300 Cash ,800 Purchased debt and equity securities. 1DebtTrading$ 3,000 2EquityTrading15,500 3DebtAvailable-for-sale10,000 4EquityAvailable-for-sale7,300 TypeClassification Cost (including broker’s fees)

Accounting for Return Earned on an Investment Buffalo Corp. earned the following return on their owned securities. Record the journal entry. 1Debt$270 2Equity$895 3Debt920 4Equity560 SecurityInterest Dividends Cash ,645 Interest Revenue ,190 Dividend Revenue ,455 Received interest and dividend revenues.

Accounting for the Sale of Securities Buffalo Corp. sold Security 2 for $17,000. The historical cost was $15,500. Record the entry. 1DebtTrading$ 3,000 2EquityTrading15,500 3DebtAvailable-for-sale10,000 4EquityAvailable-for-sale7,300 TypeClassification Cost (including broker’s fees) Cash ,000 Investment in Trading Securities...15,500 Realized Gain on Sale of Securities 1,500 Sold Security 2 for $17,000.

What Are Realized Gains and Losses? Gains and losses resulting from the sale of securities in an arm’s- length transaction. At the end of the accounting period, any gain or loss on the sale of securities must be included on the income statement.

Learning Objective 4 Account for changes in the value of securities.

What Are Unrealized Gains and Losses? Gains and losses resulting from changes in the value of securities that are still being held.

Accounting for Changes in Value — Trading Securities The following market values were recorded for Buffalo Corp.’s portfolio on December 31, Record the changes in the values of the securities. 1Trading$ 3,000$ 2,800 3Available-for-sale 10,00010,500 4Available-for-sale 7,3009,250 Type Historical Cost Market Value 12/31/03 Unrealized Loss on Trading Securities Market Adjustment, Trading Securities 200 Recorded market adjustment for trading securities.

Accounting for Changes in Value — Available-for-Sale Market Adjustment, Available-for-Sale Securities. 2,450 Unrealized Increase in Value of Available-for-Sale Securities....2,450 Recorded market adjustment for available-for-sale securities. 1Trading$ 3,000$ 2,800 3Available-for-sale10,00010,500 4Available-for-sale7,3009,250 Type Historical Cost Market Value 12/31/03

Market Adjustment, Trading Securities Unrealized Gain on Trading Securities.300 Recorded market adjustment for trading security. The following market values were recorded for Buffalo Corp.'s portfolio on December 31, Record the subsequent change in the trading security. Subsequent Changes in Value 1Trading$ 3,000$ 3,100 3Available-for-sale10,00010,300 4Available-for-sale7,3009,500 Type Historical Cost Market Value 12/31/04

Expanded Material Learning Objective 5 Account for held-to- maturity securities.

The Moose Company purchased a 5- year, $500,000 bond and received interest payments of 10 percent, payable semiannually. Assume the effective rate is 12 percent. Record the investment. Example: Initial Purchase of Held- to-Maturity Securities 1.Semiannual interest payments$ 25,000 Present value of interest annuity$184,002 2.Principal of bonds$500,000 Present value of bonds 279,197 3.Present value of investment$463,199

Example: Initial Purchase of Held- to-Maturity Securities 1.Semiannual interest payments$ 25,000 Present value of interest annuity$184,002 2.Principal of bonds$500,000 Present value of bonds 279,197 3.Present value of investment$463,199 Investment in Held-to-Maturity Securities ,199 Cash ,199 Purchased a $500,000 bond as an investment.

Bonds Purchased Between Interest Dates Assume the bond purchased by the Moose Company paid interest on July 1 and January 1 of each year. If the Moose Company purchased the bond on April 31, 2003, how will the purchase be recorded? Investment in Held-to-Maturity Security ,199 Bond Interest Receivable ,667 Cash ,866 Purchased a $500,000 bond as an investment and paid four months’ accrued interest.

Accounting for Amortization of Premiums and Discounts. Define. Straight-Line Amortization A method of systematically writing off a bond discount or premium in equal amounts each period until maturity. Effective-Interest Amortization A method of systematically writing off a bond premium or discount that takes into consideration the time value of money and results in an equal rate of amortization for each period.

Cash Investment in Held-to-Maturity Securities Bond Interest Revenue Received bond interest and amortized discount. Straight-Line Amortization The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually. Using the straight-line method, record the first interest payment received.

Effective-Interest Amortization The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent. Using the effective-interest method, record the first interest payment received. Hint: Won’t you need an amortization table?

CashInterest Amortized Investment PaymentReceived EarnedAmount Balance (0.16 x 0.5 x Balance) $ 8,658 1 $600 $693 $ 93 8, , , , , , , , , ,000 Effective-Interest Amortization

Cash Investment in Held-to-Maturity Securities Bond Interest Revenue Received bond interest and amortized discount. Effective-Interest Amortization The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent. Using the effective-interest method, record the first interest payment received.

Sale or Maturity of Bonds The Rhinoceros Company holds the bond until maturity. Record the entry for the receipt of the bond principal. Cash ,000 Investment in Held-to-Maturity Securities ,000 Received the principal of bond at maturity.

Sale or Maturity of Bonds What journal entry is required if the Rhinoceros Company sells the bond for $9,900 before maturity when the balance in the bond account is $9,800? Cash ,900 Gain on Sale of Bond Investment in Held-to-Maturity Securities ,800 Sold bond for $9,900.

Expanded Material Learning Objective 6 Account for securities using the equity method.

Illustrating the Equity Method Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record Brown Tree’s transactions using both the available-for- sale method and the equity method. Equity Method Investment in Equity Method Securities200 Cash Available-for-Sale Method Investment in Available-for-Sale Securities Cash

Illustrating the Equity Method Equity Method Cash Investment in Equity Method Securities Available-for-Sale Method Cash Dividend Revenue Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record the $0.80 per share dividend.

Illustrating the Equity Method Equity Method Investment in Equity Method Securities. 2,000 Revenue from Investments ,000 Available-for-Sale Method No entry. Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Koala Corp. announces a $10,000 earnings for the year. Record the appropriate entries.