1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL

2 Chapter 12 Reporting and Analysing Investments After studying Chapter 12, you should be able to: 1.Identify the reasons corporations invest in debt and equity securities. 2.Explain the accounting for debt investments. 3.Explain the accounting for equity investments. 4.Describe the purpose and usefulness of consolidated financial statements. 5.Distinguish between short-term and long-term investments. 6.Indicate how debt and equity investments are valued and reported in the financial statements.

Short-Term Investments and the Operating Cycle Illustration 12-1

Reasons Companies Invest Illustration 12-2

5 +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 Debt Investments

6 Kuhl Corporation acquires 50 Doan, Inc. 12%, 10-year, $1,000 on Jan. 1 for $54,000. 1/1 Debt investments54,000 Cash54,000 (To record purchase of 50 Doan, Inc. bonds) Acquisition of Bonds

7 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 Cash3,000 Interest Revenue 3,000 (To record receipt of interest on Doan Inc. bonds)

8 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 Receivable3,000 Interest Revenue3,000 (To accrue interest on Doan Inc. bonds) Accrued Bond Interest

9 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 Cash58,000 Debt Investments 54,000 Gain on sale of Debt Investments 4,000 (To record sale of Doan Inc. bonds) Sale of Bonds

10 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)

11 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

Accounting Guidelines - Equity Investments Illustration 12-3

13 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

14 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 Investments40,500 Cash40,500 (To record purchase of 1,000 Beal common shares)

15 Dividends $2.00 per share dividend is received by Passera Corporation on December 31: 12/31Cash (1,000 x $2)2,000 Dividend Revenue 2,000 (To record receipt of cash dividend )

16 Sale of Shares +Net proceeds from the sale (sales price less brokerage fees) - Cost of the shares =Gain (Loss)

17 Sale of Shares Passera Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation shares on February 10, /1Cash 39,500 Loss on Sale of Equity Investments 1,000 Equity Investments40,500 (To record sale of Beal common shares)

18 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

19 Acquisition of Shares Milar Corporation acquires 30% of the common shares of Beck Company for $120,000 on January 1, /1 Equity Investments120,000 Cash120,000 (To record purchase of Beck common shares)

20 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%)

21 Revenue and Dividends 12/31 Equity Investments30,000 Revenue from Investment in Beck Company30,000 (To record 30% equity in Beck's 2001 net earnings) 12/31 Cash12,000 Equity Investments 12,000 (To record dividends received) During the year the investment account has increased by $18,000 ($30,000 - $12,000)

22 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

23 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

24 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

25 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

26 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

27 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

28 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 market138,000 Reporting of Short-Term Investments

29 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

30 Evaluating Investment Portfolio Performance +Time sale of investments before year-end +Misclassification of investments as short- and long-term

31 +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) Balance Sheet Presentation

32 Decision Checkpoints +Is the company window-dressing its results by manipulating its investment portfolio?

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