1. Chapter 10 Investments

2. Chapter 10 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
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3. Chapter 10 Learning Objectives
Describe and illustrate how debt and equity securities are reported
Use the rate of return on total assets to evaluate business performance
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Learning Objective 1
Identify why companies invest in debt and equity securities and classify investments
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5. WHY DO COMPANIES INVEST?
Businesses invest in a variety of companies’ stocks and bonds.
An investor is the owner of a bond or share of stock.
The investee issues the bond or stock to the investor.
A security is a share or interest representing financial value. There are two types of securities:
Debt securities are investments in notes or bonds payable issued by another company.
Equity securities are investments in stock ownership in another company.
Just as individuals invest in a variety of companies’ stocks and bonds, the same is true for businesses. Investments in stock or bonds can range from a few securities to the acquisition of an entire company. An investor is the owner of a bond or stock of a corporation. An investee is the corporation that issued the bond or stock to the investor. A security is a share or interest representing financial value. A debt security represents a credit relationship with another company or governmental entity that typically pays interest for a fixed period. An equity security represents stock ownership in another company that sometimes pays dividends.
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Reasons to Invest
There are two commons reasons a company would invest in debt or equity securities:
To invest excess cash in order to generate investment income
To invest in a debt or equity security of another company as a business strategy, such as enhancing a business relationship
Why would a company invest in debt securities? A company may have short-term, excess cash that it doesn’t need for normal operations. This excess cash could be the result of temporary or seasonal business fluctuations, or it could be cash available for a longer term. The company wants to make the best use of its excess cash, so it invests in debt or equity securities to generate investment income. This investment income may come from interest earned from debt investments, dividends earned from stock investments, and/or increases in the market value of the security.
Another reason a company may invest in debt or equity securities of other companies is to pursue a certain business strategy. For example, a company may invest in a key vendor’s debt or equity securities to further enhance a business relationship with that vendor. Doing so might strengthen the relationship between the investing company and the vendor.
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7. Classification and Reporting of Investments
Investments are classified as:
Short-term investments if the investor intends to sell them in one year or less
Long-term investments if the investor intends to hold them for longer than one year
An investment is classified based on the length of time the investor intends to hold the investment. Short-term investments are investments in debt and equity securities that are highly liquid and that the investor intends to sell in one year or less. Long-term investments are investments in bonds (debt securities) or stocks (equity securities) in which the company intends to hold the investment for longer than one year.
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Debt Securities
Debt securities can be further classified into three specific types, based on how long the investor intends to hold the investment:
A trading debt investment is a debt security that the investor plans to sell in the very near future.
A held-to-maturity (HTM) debt investment is a debt security the investor intends to hold and has the ability to hold until it matures.
An available-for-sale (AFS) debt investment is a debt security that isn’t a trading debt investment or a held-to-maturity debt investment.
Debt securities can be further classified into three specific types, based on how long the investor intends to hold the investment:
A trading debt investment is a debt security that the investor plans to sell in the very near future.
A held-to-maturity (HTM) debt investment is a debt security the investor intends to hold and has the ability to hold until it matures.
An available-for-sale (AFS) debt investment is a debt security that isn’t a trading debt investment or a held-to-maturity debt investment.
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Equity Securities
Equity securities can also be classified into three specific types, based on the investor’s level of influence over the investee company:
No significant influence equity investment―The investor lacks the ability to participate in the decisions of the investee company.
Significant influence equity investment―The investor has the ability to exert influence over operating and financial decisions of the investee company.
Controlling interest equity investment―The investor owns more than 50% of the investee’s voting stock.
Equity securities can also be classified into three specific types, based on the investor’s level of influence over the investee company:
No significant influence―The investor lacks the ability to participate in the decisions of the investee company.
Significant influence equity investment―The investor has the ability to exert influence over operating and financial decisions of the investee company.
Controlling interest equity investment―The investor owns more than 50% of the investee’s voting stock.
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10. Classification and Reporting of Investments
Exhibit 10-1 summarizes the five types of investments.
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Learning Objective 2
Account for investments in debt securities
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12. HOW ARE INVESTMENTS IN DEBT SECURITIES ACCOUNTED FOR?
Companies record an investment in debt securities by first recording the purchase of the investment.
Companies record interest revenue.
At the date of maturity, companies record the disposition of the investment.
Debt securities are accounted for through journal entries, including the purchase, interest revenue earned, and disposition of the securities.
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13. Purchase of Debt Securities
Smart Touch Learning has excess cash to invest and pays $100,000 to buy $100,000 face value, 9%, five-year Neon Company bonds on July 1, Smart Touch Learning plans to hold the 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 accrues on the investment, there is no interest recorded on the date of the investment.
Assume that Smart Touch Learning has excess cash to invest and pays $100,000 to buy $100,000 face value, 9%, five-year Neon Company bonds on July 1, The bonds are issued on June 30 and December 31. Smart Touch Learning intends to hold the bonds to maturity and, therefore, records them as held-to-maturity investments.
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Interest Revenue
On December 31, 2018, Smart Touch Learning receives the first interest payment on the bond investment.
On December 31, 2018, six months have passed since making the investment in the bonds, and Smart Touch Learning receives the first interest payment. Record the interest received on December 31, 2018.
Smart Touch Learning is owed $4,500 interest. The calculation is:
$100,000 face value × 9% interest rate × 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.
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15. Disposition at Maturity
When Smart Touch Learning disposes of the bonds at maturity on June 30, 2023, it will receive the face value of the bonds. Assuming that the last interest payment has been recorded, the entry is:
When Smart Touch Learning disposes of the bonds at maturity (June 30, 2023), it will receive the face value of the bonds and record the journal entry. (Assume that the final interest payment has already been received and recorded.)
The entry will require a debit to Cash for $100,000 and a credit to Held-to-Maturity Debt Investments for $100,000.
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Learning Objective 3
Account for investments in equity securities
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17. HOW ARE INVESTMENTS IN EQUITY SECURITIES ACCOUNTED FOR?
The accounting for equity securities is based on the percentage of ownership:
The cost method is used for ownership less than 20%.
The equity method is used for ownership between 20% and 50%.
Consolidations are used for ownership greater than 50%.
The accounting for equity securities must be separated into three categories, based on the percentage of ownership of the investor. Equity securities in which the investor owns less than 20% ownership in the voting stock of the investee can be either trading investments or available-for-sale investments. When a company invests in equity securities with 20% to 50% ownership of the investee’s voting stock, the investor can significantly influence the investee’s decisions. An investor that owns more than 50% of the investees stock owns a controlling interest.
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18. Purchase of Equity Securities
On March 1, 2018, Smart Touch Learning acquires 1,000 shares of stock in Yellow Corporation for $26.16 per share. Smart Touch Learning owns less than 20% of Yellow’s voting stock.
Smart Touch Learning has excess cash to invest and buys 1,000 shares of stock in Yellow Corporation for $26.16 per share on March 1, Smart Touch Learning owns less than 20% of Yellow’s voting stock and intends to hold the stock for two years.
The entry requires a debit to Equity Investments for $26,160 (1,000 shares × $26.16 per share) and a credit to Cash for $26,160.
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Dividend Revenue
Yellow Corporation declares and pays a cash dividend of $0.16 per share on June 9, Smart Touch Learning receives the cash dividend on June 9.
Yellow Corporation declares and pays a cash dividend of $0.16 per share on June 9, Smart Touch Learning receives the cash dividend on June 9.
The entry requires a debit to Cash for $160 and a credit to Dividend Revenue for $160 ($0.16 per share × 1,000 shares).
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Disposition
On July 15, 2018, Smart Touch Learning sells 800 shares of Yellow Stock for $25,000.
Assume that on July 15, 2018, Smart Touch Learning sells 800 shares of Yellow stock for $25,000. Smart Touch Learning compares the cash received with the cost of the stock disposed of and determines the amount of gain or loss.
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Disposition
On July 15, 2018, Smart Touch Learning sells 800 shares of Yellow Stock for $25,000.
Assume that on July 15, 2018, Smart Touch Learning sells 800 shares of Yellow Stock for $25,000. Smart Touch Learning compares the cash received with the cost of the stock disposed of and determines the amount of gain or loss.
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 × $26.16 per share = $20,928
A credit is made to Equity Investments for $20,928.
To get the journal entry to balance, a gain must be recorded of $4,072 to Gain on Disposal. Remember that Gain on Disposal is a temporary equity account and is reported in the Other Revenues and (Expenses) section of the income statement. If the company had sold the stock at a loss, the account Loss on Disposal would be recorded as a debit.
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22. Equity Securities with Significant Influence (Equity Method)
Significant influence is assumed when a company has 20% to 50% ownership.
Accounted for using the equity method.
Initial investment
Record investment at cost when acquired
Receipt of dividends
Adjust the investment account balance for dividends received
Share of profits
Adjust the investment account for the investor’s share of investee’s net income or net loss
When a company invests in equity securities with 20% to 50% ownership in the investee’s voting stock, the investor can significantly influence the investee’s decisions. This influence may be helpful if the investee’s and investor’s businesses are somehow related. These types of investments must be accounted for using the equity method.
Investments accounted for by the equity method are recorded at cost at the time of purchase. When dividends are received, they are treated as if they were a return of capital rather than as earnings. Under the equity method, the investor also must record annually its share of the investee’s net income.
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Purchase
Smart Touch Learning pays $400,000 to purchase 40% of the common stock of Kline, Inc.
Investments accounted for by the equity method are recorded at cost at the time of purchase. Suppose Smart Touch Learning pays $400,000 to purchase 40% of the common stock of Kline, Inc. Smart Touch Learning then refers to Kline as an affiliated company. Smart Touch Learning’s entry to record the purchase of this investment on January 6, 2018, is shown here. Notice that the investor includes the name of the investee on the account to signify that Smart Touch Learning has significant influence over Kline, Inc.
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24. Dividends Received and Share of Net Income
Kline declares and pays a cash dividend of $50,000 on June 30, 2018.
When Smart Touch Learning receives cash dividends from Kline, it records its proportionate part of the cash dividends. Suppose that Kline declares and pays a cash dividend of $50,000 on June 30, Because Smart Touch Learning owns 40% of the stock, it receives 40%, or $20,000, of the dividend.
The Equity Investments account is credited for the receipt of a dividend because it decreases the investor’s investment. In other words, the dividends are treated as if they were a return of capital rather than as earnings.
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25. Dividends Received and Share of Net Income
Kline reports net income of $125,000 for 2018.
Under the equity method, the investor also must record annually its share of the investee’s net income. The investor debits the Equity Investments account and credits Revenue from Investments when the investee reports income. As Smart Touch Learning’s equity in Kline increases, so does the Equity Investments account on the investor’s books.
Suppose Kline reported net income of $125,000 for the 2018 year. Smart Touch Learning would record 40% of this amount as an increase in the investment account.
Smart Touch Learning reports the equity investments on the balance sheet and the revenue from investments on the income statement.
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Disposition
Smart Touch Learning sells 10% of the Kline common stock for $40,000 on January 1, 2019.
When Smart Touch Learning decides to sell its investment in Kline, Inc. it needs to determine whether there is a gain or loss. Suppose Smart Touch Learning sells 10% of the Kline common stock for $40,000 on January 1, Smart Touch Learning then calculates the gain or loss.
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Disposition
Smart Touch Learning records the sale of Kline common stock as follows:
The entry debits Cash for $40,000, debits Loss on Disposal for $3,000, and credits Equity-Investments-Kline, Inc. for $43,000.
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28. Equity Securities with Control (Consolidations)
A controlling interest exists when the investor owns more than 50% of the investee’s voting stock.
The parent company is the corporation that controls the other company.
The subsidiary company is the company controlled by another corporation.
The parent prepares consolidated statements using consolidation accounting.
Many large corporations own controlling interests in other companies. An investor that owns more than 50% of the investee’s voting stock owns a controlling interest. This type of investment enables the investor to elect a majority of the board of directors and thereby control the investee. A parent company is a company that owns a controlling interest in another company. A subsidiary company is a company that is controlled by another corporation.
Consolidation accounting is the way to combine the financial statements of two or more companies that have the same owners. Consolidated financial statements are financial statements that combine the balance sheets, income statements, and statements of cash flow of the parent company with those of its controlling interest affiliates.
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Learning Objective 4
Describe and illustrate how debt and equity securities are reported
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30. HOW ARE DEBT AND EQUITY SECURITIES REPORTED?
Corporations’ debt and equity securities are reported on the balance sheet in either the current or the long-term asset section.
How they are reported depends upon the type of investment.
Trading debt investments
Available-for-sales (AFS) debt investments
Held-to-maturity investments
Corporations’ debt and equity securities are reported on the balance sheet in either the current or long-term asset section. How they are reported, though, depends on the type of investment and ownership percentage.
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31. Trading Debt Investments
Trading debt investments are initially recorded at cost.
They are adjusted for changes in fair value.
Fair value is the price that would be used if the investments were sold on the market.
An adjustment is recorded as an unrealized holding gain or loss and is reported in the Other Income and (Expenses) section of the income statement.
At disposal, the fair value adjustment is ignored in determining the calculation of the gain or loss.
Trading investments, those that the investor plans to sell in the very near future, are initially recorded at cost. At the end of each period, though, trading securities must be adjusted and reported at fair value. Fair value is the price that would be used if the investments were sold on the market. The company makes a year-end adjustment of the trading investment to bring the account to market value. This adjustment is recorded as an unrealized holding gain or loss and is reported in the Other Revenues and (Expenses) section of the income statement.
It’s important to note the distinction between unrealized and realized gains or losses. Unrealized gains or losses occur when a company adjusts an asset to fair value but has not yet disposed of the asset. Realized gains or losses occur when a company disposes of an asset and represent the difference between the cash received at the time of disposal and the basis of the asset.
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32. Trading Debt Investments
On December 31, 2018, Smart Touch Learning reports trading debt investments of $26,160. The market value of the trading debt investments is $24,000. The company has an unrealized loss of $2,160 on the investments ($24,000 – $26,160).
Suppose that on December 31, 2018, Smart Touch Learning reports trading investments of $26,160. After careful evaluation, Smart Touch Learning concludes that the market value of the trading investments has decreased to $24,000. Because there has been a change in market value, the change must be recorded.
The entry requires a debit to Unrealized Holding Loss—Trading for $2,160 and a credit to Fair Value Adjustment—Trading for $2,160.
In this case, the Fair Value Adjustment account is considered a contra account and is subtracted from the Short-term Investments account to determine carrying value when it has a credit balance. If the account has a debit balance, it is considered an adjunct account and is added to the Short-term Investments account to determine carrying value.
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33. Trading Debt Investments
After the adjustment, the investment T-accounts appear as follows:
After the adjustment, the investment T-accounts have a balance of $26,160.
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34. Trading Debt Investments
Smart Touch Learning reports as follows:
The combined T-accounts show the $24,000 balance for trading debt investments. Smart Touch Learning reports its trading debt investments on the balance sheet at $24,000 at December 31, 2018, and the $2,160 unrealized holding loss on the trading debt investments on the 2018 income statement.
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35. Available-for-Sale Debt Investments
AFS debt investments are recorded at current market value.
They are adjusted for changes in fair value.
The adjustment is called unrealized holding gain/loss.
AFS debt investments are included in Other Comprehensive Income on the Statement of Comprehensive Income and in the stockholders’ equity section of the balance sheet.
Disposition of available-for-sale debt investments is handled in the same manner as trading debt investments.
Available-for-sale securities are reported as current assets on the balance sheet if the business expects to sell them within one year. All other AFS investments that are planned to be held longer than a year are reported as long-term assets on the balance sheet. The fair value method is used to account for AFS investments because they are normally sold in the near future at their current market value. AFS investments are reported on the balance sheet at current market value. This requires a year-end adjustment of the AFS investments to current market value, much as is done with trading investments.
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36. Available-for-Sale Debt Investments
On December 31, 2018, Smart Touch Learning reports AFS investments of $60,000. The market value of the investments is $64,000.
Assume that on December 31, 2018, Smart Touch Learning reports long-term available-for-sale investments of $60,000. After careful review, the company determines that the market value of the AFS investments has increased to $64,000. Smart Touch Learning has an unrealized holding gain of $4,000 on the investment ($64,000 market value ‒ $60,000 purchase price).
Smart Touch Learning records a debit to Fair Value Adjustment—Available-for-Sale for $4,000 and a credit to Unrealized Holding Gain—Available-for-Sale for $4,000. The debit to Fair Value Adjustment is treated as an adjunct account and appears in the asset section of the balance sheet with the related investment account.
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37. Available-for-Sale Debt Investments
After Smart Touch learning posts the December 31, 2018, adjustment, the investment T-accounts appear as follows:
After Smart Touch learning posts the December 31, 2018, adjustment, the Available-for-Sale Debt Investments account has a debit balance of $60,000 and the Fair Value Adjustment-AFS account had a debit balance of $4,000. This the net book value for AFS debt investments is $64,000.
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38. Available-for-Sale Debt Investments
Smart Touch Learning reports as follows:
The combined T-accounts show the $64,000 balance for the AFS debt investments. Smart Touch Learning reports the investment on the balance sheet at $64,000 at December 31, The $4,000 Unrealized Holding Gain—AFS is reported in the stockholders’ equity section of the balance sheet as Accumulated Other Comprehensive Income.
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39. Available-for-Sale Debt Investments
Comprehensive income is a company’s change in total stockholders’ equity from all sources other than owners’ investments and dividends.
Comprehensive income includes net income plus some specific gains and losses, as follows:
Unrealized holding gains or losses on available-for-sale debt investments
Foreign currency translation adjustments
Gains or losses from post-retirement benefit plans
Deferred gains or losses from derivatives
It’s important to remember that unrealized holding gains or losses on available-for-sale investments are not included in net income. Instead, they are included as other comprehensive income, which adjusts net income to determine comprehensive income. Comprehensive income is a company’s change in total stockholders’ equity from all sources other than owners’ investments and dividends. Comprehensive income includes net income plus some specific gains and losses, including:
Unrealized holding gains or losses on available-for-sale debt investments
Foreign currency translation adjustments
Gains or losses from post-retirement benefit plans
Deferred gains or losses from derivatives
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40. Available-for-Sale Debt Investments
Comprehensive income can be reported one of two ways: as a second income statement or combined with a traditional income statement into a combined statement of comprehensive income. Exhibit 10-2 provides an example of how comprehensive income can be reported.
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41. Held-to-Maturity Debt Investments
Held-to-maturity (HTM) investments are reported at amortized cost.
An HTM investment may be reported as a current asset or a long-term asset on the balance sheet, depending on the maturity date.
Interest revenue is reported on the income statement in the Other Revenues and (Expenses) section.
Held-to-maturity (HTM) investments are normally reported at amortized cost, which is explained in advanced accounting courses. Depending on the maturity date, the HTM investment is reported as a current asset or long-term asset on the balance sheet. When the maturity date is within one year of the balance sheet date, the HTM investment is reported as a current asset; otherwise, the asset is reported as long term. Interest revenue earned on HTM investments is reported on the income statement in the Other Revenues and (Expenses) section.
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42. Equity Investments with No Significant Influence
Equity investments with no significant influence must be adjusted at the end of the year and reported at fair value.
The company makes a year-end adjustment of the equity investment to bring the account to market value.
The adjustment is recorded as an unrealized holding gain or loss and is reported in the Other Income and (Expenses) section of the income statement.
Equity investments with no significant influence must be adjusted at the end of the year and reported at fair value.
The company makes a year-end adjustment of the equity investment to bring the account to market value.
The adjustment is recorded as an unrealized holding gain or loss and is reported in the Other Income and (Expenses) section of the income statement.
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Exhibit 10-3 summarizes the accounting methods for debt and equity securities and also the financial statement effects.
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Learning Objective 5
Use the rate of return on total assets to evaluate business performance
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HOW DO WE USE THE RATE OF RETURN ON TOTAL ASSETS TO EVALUATE BUSINESS PERFORMANCE?
The rate of return on total assets measures a company’s success in using assets to earn a profit.
Companies finance assets two ways:
Debt―A company borrows from creditors to purchase assets.
Equity―A company receives cash or other assets from stockholders.
The rate of return on total assets is a ratio that measures the success a company has in using its assets to earn income: (Net income + Interest expense) / Average total assets.
There are two ways that a company can finance its assets:
Debt―A company can borrow money from creditors to purchase assets. Creditors earn interest on the money that is loaned.
Equity―A company may receive cash or other assets from stockholders. Stockholders invest in the company and hope to receive a return on their investment.
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HOW DO WE USE THE RATE OF RETURN ON TOTAL ASSETS TO EVALUATE BUSINESS PERFORMANCE?
The rate of return on total assets for Kohl’s:
Using Kohl’s Corporation’s Fiscal 2015 Annual Report, we can determine its rate of return on total assets. (Visit to view a link to Kohl’s Corporation’s annual report.) Net income and interest expense are taken from the company’s income statement, and total assets is taken from the balance sheet.
Kohl’s Corporation has a rate of return on total assets of 7%, which means that for each $1.00 invested in the company’s average assets, the company earned $0.07 in profits before considering interest expense. What is a good rate of return on total assets? There is no single answer because rates of return vary widely by industry. Suppose that for the department stores industry, a 12% rate of return on total assets is considered good. In that case, Kohl’s Corporation’s 7% return on assets would be considered very low compared to the industry average.
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