1. Topic 6
INVESTMENTS
Chapter 12: Investments
Download Excel file Brief Exercises” in topic 6 area of Handouts

2. Common and preferred stock
Nature of Investments
Bonds and notes
(Debt securities)
Common and preferred stock
(Equity securities)
To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities, also called financial instruments, are purchased as investments by individual investors, mutual funds, and also by other corporations. Our focus in this chapter is on the corporations that invest in securities issued by other corporations as well as those issued by governmental units (bonds, Treasury bills, and Treasury bonds).
Investments can be accounted for in a variety of ways, depending on the nature of the investment relationship.

3. Reporting Categories for Investments
To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities are purchased as investments by individual investors, mutual funds, and also by other corporations. In later chapters we discuss equity and debt securities from the perspective of the issuing company. Our focus in this chapter is on the corporations that invest in debt and equity securities issued by other corporations as well as debt securities issued by governmental units (bonds, Treasury bills, and Treasury bonds).
Most companies invest in financial instruments issued by other companies. For some investors, these investments represent ongoing affiliations with the companies whose securities are acquired.

4. Investor Lacks Significant Influence
When the investor lacks significant influence over the investee, the investment is classified in one of three categories: held-to-maturity securities (HTM), trading securities (TS), and available-for-sale securities (AFS). Each type of investment has its own reporting method. However, regardless of the investment type, investors can elect the “fair value option” that we discuss later in the chapter and classify HTM and AFS securities as TS. The key difference among the reporting approaches is how we account for unrealized holding gains and losses.

5. Securities to Be Held to Maturity
Securities are investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the “positive intent and ability” to hold the securities to maturity and can therefore be classified as held-to-maturity (HTM).
They are reported on the balance sheet at “amortized cost.”
Amortized cost (Face amount less unamortized discount, or plus unamortized premium).
Securities are investments in bonds or other debt security that have a specified maturity date. The bonds or other debt are initially recorded at cost. The investor may have the “positive intent and ability” to hold the securities to maturity and can therefore be classified as held-to-maturity (HTM).
They are reported on the balance sheet at “amortized cost.” Amortized cost is equal to the face amount of the debt less any unamortized discount, or plus any unamortized premium. If management decides to sell the securities prior to maturity, they will be reclassified to trading securities. We will discuss trading securities later in the presentation.
Balance
Sheet

6. Securities to Be Held to Maturity
On January 1, 2013, Matrix Inc. purchased as an investment $1,000,000, of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%. Let’s look at the calculation of the present value of the bond issue.
Present
Amount
PV Factor
Value
Interest
$ ,000 × =
$573,496
Principal
1,000,000
311,805
Present value of bonds
$885,301
PV of ordinary annuity of $1, n = 20, i = 6%
On January 1, 2013, Matrix Inc. purchased as an investment $1,000,000 of 10%, 10-year bonds, interest paid semi-annually. The market rate for similar bonds is 12%. Let’s look at the calculation of the present value of the bond issue. The interest annuity is $50,000 ($1,000,000 times 10% equals $100,000, divide $100,000 by 2 for $50,000 cash interest). Look at the present value of an ordinary annuity of $1 table. Find the 20 periods row and move across to the 6% column to find the factor of Go to the present value of $1 table and follow the same procedures to arrive at the present value factor of The present value of the bonds at 12% return is $885,301.
PV of $1, n = 20, i = 6%

7. Securities to Be Held to Maturity
Partial Bond Amortization Table
January 1, 2013
Investment in bonds 1,000,000
Discount on bond investment ,699
Cash ,301
Here is a partial amortization table for the bonds purchased on January 1, 2013, with the intent of holding them to maturity. The bonds were priced as $885,301, to yield Matrix a 12% return with interest compounded semi-annually on June 30 and December 31. Let’s look at the journal entry to record the initial purchase of the bonds and the subsequent receipt of the first interest amount.
On January 1, Matrix will debit investment in bonds for the face amount of $1 million, credit discount on bond investment for $114,699, and credit cash for $885,301. On June 30, the first payment is due to Matrix. The journal entry is to debit cash for $50,000, debit discount on bonds payable for $3,118, and credit interest revenue for $53,118. The interest revenue is determined by taking 6% of the carrying value of the bonds, which is $885,301. The $50,000 cash received is determined by multiplying the face amount of the bonds, $1 million, by 5%, the stated rate. The difference between the calculated interest revenue and the cash interest received represents the amortization of the bond discount.
June 30, 2013
Cash (stated rate × face amount) ,000
Discount on bond investment ,118
Investment revenue ,118

8. Securities to Be Held to Maturity
This investment would appear on the June 30, 2013, balance sheet as follows:
$114,699 - $3,118 = $111,581 unamortized discount
As of June 30, discount on the bond investment account has been reduced to $111,581. The amortized amount of the investment is $888,419. If a balance sheet were prepared as of June 30, the investment in bonds would be shown at $888,419. We do not recognize unrealized holding gains and losses for HTM investments.
Unrealized holding gains and losses are not recognized for HTM investments.

9. Securities to Be Held to Maturity
On December 31, 2013, after interest is received by Matrix, all the bonds are sold for $900,000 cash.
December 31, 2013
Cash 50,000
Discount on bond investment 3,305
Investment revenue 53,305
On December 31, 2013, Matrix receives $50,000 cash interest. The journal entry to record the receipt is to debit cash for $50,000, debit discount on bonds payable of $3,305, and credit investment revenue for the total of $53,305.
Immediately after the receipt of interest, Matrix sells its investment in bonds for $900,000 cash. The entry to record the sale is to debit cash for the proceeds of $900,000, eliminate the unamortized discount with a debit to discount on bonds payable for $108,276, credit the investment in bonds for $1,000,000, and credit the realized gain on sale of investment for $8,276 (the difference between the cash received of $900,000 and the carrying value of the investment of $891,724).
December 31, 2013
Cash ,000
Discount on bond investment 108,276
Investment in bonds 1,000,000
Gain on sale of investment ,276

10. Brief Exercise 12-1
Lance Brothers Enterprises acquired $720,000 of 3% bonds, dated July 1, on July 1, 2013, as a long-term investment. Management has the positive intent and ability to hold the bonds until maturity. The market interest rate (yield) was 4% for bonds of similar risk and maturity. Lance Brothers paid $600,000 for the investment in bonds and will receive interest semiannually on June 30 and December 31. Prepare the journal entries (a) to record Lance Brothers’ investment in the bonds on July 1, 2013, and (b) to record interest on December 31, 2013, using the effective (market) rate method.

11. Trading Securities Income Statement Unrealized Gain Unrealized Loss
Investments in debt or equity securities acquired principally for the purpose of selling them in the near term. Adjustments to fair value are recorded
in a valuation account called fair value adjustment, or as a direct adjustment to the investment account.
as a net unrealized holding gain/loss on the income statement.
Trading securities are investments in debt or equity securities acquired principally for the purpose of selling them in the near term. The holding period for trading securities generally is measured in hours and days rather than months or years. These investments typically are reported among the investor’s current assets. Trading securities initially are recorded at cost including any brokerage fees. When a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value, or “marked to market.” These adjustments are typically made to a fair value adjustment account, but could also be made directly to the investment account.
Unrealized Gain
Unrealized Loss
Income Statement

12. Trading Securities
Matrix Inc. purchased securities classified as Trading Securities (TS) on December 22, The fair value amounts for these securities on December 31, 2013, are shown below. Prepare the journal entries for Matrix Inc. to show the purchase of the securities, and adjust the securities to fair value at 12/31/13.
On December 22, 2013, Matrix purchases 1,000 shares of Mining Inc. and 1,500 shares of Toys and Things to be held as trading securities. The cost of these securities are shown on the table at the bottom of your screen. On December 31, 2013, the fair value of the Mining Inc. shares is $41,000, and the fair value of Toys and Things shares is $20,000. Let’s see how we record the purchase of the shares and the unrealized holding loss on the securities.

13. Trading Securities
December 22, 2013
Investment in Mining Inc. stock ,000
Investment in Toys and Things stock 22,500
Cash ,500
On December 22, 2013, Matrix purchases shares of stock and classified these shares as trading securities. The journal entry to record the investments is to debit investment in Mining Inc. stock for $42,000 and debit investment in Toys and Things stock for $22,500, with a credit to cash for the total amount of $64,500.
At December 31, 2013, the journal entry required is to debit net unrealized holding gains and losses ― on the Income Statement (IS) for $3,500, and credit the fair value adjustment account for the same amount. The net unrealized holding loss will be reported in the current period income statement. The fair value adjustment account is an allowance account netted against the investment account on the balance sheet, so that the investment is carried at fair value. Also, any interest revenue is handled the same as with HTM investments, and any dividend revenue is handled similarly, with a debit to cash and a credit to investment revenue.
Reported on the balance sheet as a adjunct account to the investment.
December 31, 2013
Net unrealized holding gains and losses – I/S 3,500
Fair value adjustment ,500
The Net Unrealized Holding Loss is reported on the Income Statement.

14. Trading Securities
On January 3, 2014, Matrix sold all trading securities for $65,000 cash. Let’s record the entry for the sale and the adjustment to the fair value adjustment account.
January 3, 2014
Cash ,000
Investment in Mining, Inc. stock – T/S 42,000
Investment in Toys and Things stock – T/S 22,500
Gain on sale of investment
December 31, 2014
Fair value adjustment ,500
Net unrealized holding gains or losses – I/S 3,500
On January 3, 2014, Matrix sold all its trading securities for $65,000 cash. The entry to record the sale is to debit cash for $65,000, credit each trading security for its cost, and credit gain on sale of investments for $500.
In the period of sale, the fair value adjustment associated with the sold investment is eliminated, typically as part of the normal valuation process at the end of the period. This also has the effect of backing out of income any unrealized gains and losses that were recognized in prior periods, which avoids the double accounting that would result from including gains and losses both when unrealized (because fair value changes) and when realized (because the investment is sold). So, in our example, we eliminate the fair value adjustment with a debit of $3,500, and credit net unrealized gain or loss for the same amount.
Note that before-tax income is decreased by $3,500 in 2013 and increased by $4,000 (the $500 realized gain and the reversal of $3,500 of unrealized losses recorded previously) in So, over the life of the investment, the total effect on net income is ($3,500) + $4,000, or $500, equal to the realized gain on sale. The unrealized gains and losses show the effects of fair value changes in net income, but in the end the financial statements end up accumulating to equal the realized gain or loss associated with the investment.

15. Financial Statement Presentation
Trading securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income.
Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.
Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations.
Trading securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income
Balance Sheet: Securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity.
Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the investors that hold trading securities consider them as part of their normal operations. However, as discussed in more detail later, it may be appropriate to classify cash flows from buying and selling some trading securities as investing activities if they are not held for sale in the near term (which is particularly likely when an investment is classified as a trading security as a result of electing the fair value option).

16. Financial Statement Presentation
Presented below are the partial financial statements showing the accounting for TS owned by Matrix:
Presented below are the partial financial statements of the trading securities owned by Matrix for the years ended December 31, 2013 and Notice the reporting of realized and unrealized gains and losses on investments that are reported on the income statement. The interest and dividends were received from the investments. The purchase and sale of the securities are classified as operating activities in the statement of cash flows because they will be traded in the near term.

17. Securities Available-for-Sale
Investments in debt or equity securities that are not for active trading and not to be held to maturity are classified as available-for-sale (AFS).
Adjustments to fair value are recorded
in a valuation account called fair value adjustment, or as a direct adjustment to the investment account.
as a net unrealized holding gain/loss in other comprehensive income (OCI), which accumulates in accumulated other comprehensive income (ACOI).
When an investment is not classified as an HTM or trading security, it is classified as an allowance as available-for-sale (AFS). Available-for-sale securities are recorded on the balance sheet at fair value subsequent to acquisition. Adjustments to fair value are recorded in account called fair value adjustment, or as a direct adjustment to the investment account. The net unrealized holding gains or losses is shown in the account other comprehensive income (OCI), which accumulates in accumulated other comprehensive income (ACOI).
The big concern is that including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than it really is. For example, many companies purchase AFS investments for the purpose of having the changes in fair value of those investments offset changes in the fair value of liabilities. This hedging insulates the company from risk and ensures that earnings are stable. However, if fair value changes for investments were to be recognized in income (as is the case with trading securities), but the offsetting fair value changes for liabilities were not recognized in income as well, we could end up with income appearing very volatile when in fact the underlying assets and liabilities are hedged effectively.
Unrealized Gain
Unrealized Loss
Other Comprehensive Income (OCI)

18. Other Comprehensive Income (OCI)
When we add other comprehensive income to net income we refer to the result as “comprehensive income.”
Other comprehensive income consists of the four elements shown and is reported net of aggregate income tax expense or benefit.

19. Accumulated Other Comprehensive Income
Unrealized holding gains and losses on available-for-sale securities are accumulated in the shareholders’ equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income (AOCI).
Shareholders’ Equity
Common stock
Paid-in capital in excess of par Accumulated other comprehensive income Retained earnings
Total shareholders’ equity
Net unrealized holding gains and losses.
Unrealized holding gains and losses on available-for-sale securities are reported in the shareholders’ equity section of the balance sheet. Specifically, the account is included in accumulated other comprehensive income. The reason for this placement is that many in the business world believe that including unrealized holding gains and losses on available-for-sale securities would cause greater volatility in net income than was appropriate (or at least desired!).

20. Securities Available for Sale Example
Assume the same information for our T/S example for Matrix Inc., except that the investments are classified as available-for-sale securities rather than trading securities.
Assume the same information for our previous T/S example for Matrix Inc., except that the investments are classified as available-for-sale securities rather than trading securities. Recall that on December 31, 2013, we calculated a net unrealized holding loss of $3,500. Let’s see how we account for this net unrealized holding gain or loss on available-for-sale securities.
The adjusting entry on December 31, 2013, is to debit the net unrealized holding gains and losses for other comprehensive income for $3,500, and credit the fair value adjustment account for the same amount.
December 31, 2013
Net unrealized holding gains and losses – OCI 3,500
Fair value adjustment ,500

21. Financial Statement Presentation
AFS securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold.
Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.
Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.
AFS securities are presented on the financial statement as follows:
Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold.
Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.
Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

22. Brief Exercise 12-2
S&L Financial buys and sells securities expecting to earn profits on short-term differences in price. On December 27, 2013, S&L purchased Coca-Cola common shares for $875,000 and sold the shares on January 3, 2014, for $880,000. At December 31, the shares had a fair value of $873,000.
What journal entries would S&L make in 2013 and as a result of this investment?

23. Brief Exercise 12-3
S&L Financial buys and sells securities with the intent of holding for an extended period of time. Since this is their intent all securities are reported as available for sale.
On December 27, 2013, S&L purchased Coca-Cola common shares for $875,000 and sold the shares on January 3, 2014, for $880,000. At December 31, the shares had a fair value of $873,000.
What journal entries would S&L make in 2013 and as a result of this investment?

24. Brief Exercise 12-2 & 12-3
For trading securities, unrealized holding gains and losses:
are or are not
included in earnings.
For securities available-for-sale, unrealized holding gains and losses:

25. BE 12-4
For several years Fister Links Products has held shares of Microsoft common stock, considered by the company to be securities available-for-sale. The shares were acquired at a cost of $500,000. Their fair value last year was $610,000 and is $670,000 this year. At what amount will the investment be reported in this year’s balance sheet? What adjusting entry is required to accomplish this objective?

26. Transfers Between Reporting Categories
Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Securities are transferred at fair market value on the date of transfer.
At each reporting date, the appropriateness of the classification is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. Reclassifications are quite unusual, so when they occur, disclosure notes should describe the circumstances that resulted in the transfers.
When a security is reclassified between two reporting categories, the security is transferred at its fair value on the date of transfer. This table illustrates reclassification of securities from one category to another. We will concentrate of the proper handling of any unrealized gain or loss from the transfer at fair market value.

27. Financial Statement Presentation and Disclosure
Aggregate Fair Value
Gross realized & unrealized holding gains & losses
Maturities of debt securities
Amortized cost basis by major security type
Listed on this slide are six disclosures required for investments in securities classified as held-to-maturity, available-for-sale, or trading. Additional disclosures are also required.
Change in net unrealized holding gains and losses
Inputs to fair value estimates

28. Impairment of Investments
Occasionally, an investment’s value will decline for reasons that are other-than- temporary (OTT).
For HTM and AFS investments, a company recognizes an impairment loss in earnings. Determining an “other than temporary” decline for debt securities can be quite complex. For both equity and debt investments, after an impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.
Sometimes an investment will incur an other-than-temporary or permanent decrease in value. We refer to this as an impairment in value.
For HTM and AFS investments, a company recognizes an OTT impairment loss in earnings. Determining an other-than-temporary decline for debt securities can be quite complex. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.

29. Brief Exercise 12-13
LED Corporation owns 100,000 shares of Branch Pharmaceuticals common stock and classifies its investment as securities available-for-sale. The market price of Branch’s stock fell over 30%, by $4.50 per share when the FDA banned one of the company’s principal drugs. What journal entry should LED record to account for the decline in market value? How should the decline be reported?

30. Investor Has Significant Influence
Now we are going to change the accounting for investments dramatically. We are going to assume a company has acquired enough equity securities in another company to exert significant influence over the operating policies of that company. The presumption is that if the investor owns between 20 and 50 percent of the voting stock of the investee company, the investor is able to exert significant influence over the policies of the investee. Under these circumstances, the equity method of accounting for the investment is required.

31. Investor Has Significant Influence
Extent of Investor Influence
Reporting Method
Lack of significant influence (usually < 20% equity ownership)
Varies depending on classification previously discussed
Significant influence (usually 20% - 50% equity ownership)
Equity method
Has control (usually > 50% equity ownership)
Consolidation
We use the equity method for investments in equity securities that are large enough to allow us to exert significant influence, typically assumed as occurring when we own between 20% and 50% of the voting common stock. If we own more than 50% of the voting common stock, we use consolidation. Consolidated financial statements combine the separate financial statements of the parent and the subsidiary each period into a single aggregate set of financial statements as if there were only one company. The investor is referred to as the parent; the investee is termed the subsidiary. In a consolidation, if the acquisition price is more than the sum of the separate fair values of the acquired net assets (assets less liabilities), that difference is recorded as an intangible asset — goodwill.

32. Criteria for Determining Whether There is Influence FASC Sec 323
Representation on the investee’s Board of Directors
Participation in the investee’s policy-making process
Material intercompany transactions.
Interchange of managerial personnel.
Technological dependency.
Extent of ownership in relationship to other ownership percentages. 6

33. What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if
the investee challenges the investor’s ability to exercise significant influence through litigation or other methods.
the investor surrenders significant shareholder rights in a signed agreement.
the investor is unable to acquire sufficient information about the investee to apply the equity method.
the investor tries and fails to obtain representation on the board of directors of the investee.
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if:
The investee challenges the investor’s ability to exercise significant influence through litigation or other methods.
The investor surrenders significant shareholder rights in a signed agreement.
The investor is unable to acquire sufficient information about the investee to apply the equity method.
The investor tries and fails to obtain representation on the board of directors of the investee.

34. The investment account is increased by:
Equity Method
The investment account is increased by:
Original investment cost.
Proportionate share of investee's earnings.
The investment account is decreased by:
Dividends received.
Under the equity method the investment account is increased by the original investment cost, plus the company’s proportionate share of the investees reported earnings. The investment account is decreased, when dividends are received. 56 56 52 56

35. Equity Method
The investment account is reported on the balance sheet as a single amount.
The investor’s share of the investee’s earnings from date of acquisition is reported as a single item on the investor’s income statement.
When we use the equity method, the investment account has reported on the balance sheet has a single amount. The investor’s proportionate share of the investees earnings is reported as a single amount, in the investor’s income statement. 57 57 53 57

36. Equity Method
On January 1, 2013, Wilmer Inc. acquired 45% of the equity securities of Apex Inc. for $1,350,000. On the acquisition date, Apex’s net assets had a fair value of $3,000,000. During 2013, Apex paid cash dividends of $150,000 and reported net income of $1,750,000.
What amount will Wilmer Inc. report on the balance sheet as Investment in Apex Inc. on December 31, 2013?
Let’s look at a rather straightforward example of the equity method. In this case, the investor acquires 45% of the voting common stock of the investee. The investor pays $1,350,000, for its proportionate share of net assets with a fair value of $3 million. During 2013, the investee reports earnings of $1,750,000 and pays cash dividends of $150,000. Let’s look at the accounting for this investment under the equity method.

37. Equity Method January 1, 2013 Investment in Apex Inc. stock 1,350,000
Cash ,350,000
2013
Investment in Apex Inc. stock ,500
Investment revenue ,500
On January 1, 2013, we paid $1,350,000 cash for 45 percent of the stock of Apex Inc. The fair value of the net assets of Apex was $3,000,000, and we acquired 45 percent of these net assets. The journal entry at date of acquisition will be to debit investment in Apex Inc. for $1,350,000, and credit cash for the same amount.
During 2013, Apex reported net earning of $1,750,000. Our share of the reported earning is $787,500 ($1,750,000 × 45 percent). The journal entry to recognize our share of the earnings of the investee is to debit the investment in Apex Inc. stock for $787,500, and credit investment revenue for the same amount.
During 2013, Apex declared and paid dividends of $150,000. Our share of the dividends is $67,500 ($150,000 × 45 percent). The journal entry to record the dividend received is to debit cash for $67,500, and to credit investment in Apex Inc. stock for the same amount. Note that dividends are not considered revenue under the equity method. Instead, that payment of cash to the investor is considered a partial liquidation of the investment.
2013
Cash ,500
Investment in Apex Inc. stock ,500

38. Equity Method Investment in Apex Inc.
Investment ,350, , % Dividends
45% Earnings ,500
Reported amount 2,070,000
The investment in Apex Inc. account will be shown in the balance sheet of the investor at $2,070,000. Notice that the dividends received reduces the investment account, and recognition of the proportionate share of earnings increases the investment account.
If the investee company had reported a loss, the investment account would have been reduced by the investor’s proportionate share of that loss.
If the investee had a loss, the investment account would have been reduced with a credit.

39. Equity Method
On January 1, 2013, Wilmer Inc. purchased 25% of the common stock of Apex Inc. for $180,000. At the date of acquisition, the book value of the net assets of Apex was $400,000, and the fair value of these assets is $600,000. During 2013, Apex paid cash dividends of $40,000, and reported earnings of $100,000.
Now let’s complicate our discussion of the equity method. Please read this information carefully, noting that the price Wilmer paid for 25% of Apex stock ($180,000) is greater than 25% of the fair value of Apex’s net assets ($150,000). That difference of price paid over fair value of net assets is viewed as a goodwill component of the purchase price. Notice also that the fair value of Apex’s net assets is greater than 25% of the book value of those net assets on Apex’s balance sheet (25% times $400,000 equals $100,000).

40. Equity Method
The excess of the fair value of net assets over book value of those net assets is 75% attributable to depreciable assets with a remaining life of 20 years and is 25% attributable to land. Wilmer uses the straight-line depreciation.
Of the $50,000 excess of the fair value over book value of those net assets on Apex’s balance sheet, 75% is attributable to depreciable assets with a remaining useful life of 20 years. Wilmer, the investor, uses the straight-line method to depreciate similarly owned assets. Wilmer must depreciate its share of the fair value of the depreciable assets at the time it made it investment. This will cause Wilmer’s share of that additional depreciation expense would be $1,875 per year. To capture this income effect, Wilmer will record that depreciation expense as a deduction of investment revenue and a deduction of the investment. Note that, because neither goodwill nor land is depreciated, Wilmer makes no adjustment for those items.

41. Equity Method January 1, 2013 Investment in Apex stock 180,000
Cash ,000
2013
Cash ,000
Investment in Apex stock ,000
Investment in Apex stock ,000
Investment revenue ,000
December 31, 2013
Investment revenue ,875
Investment in Apex stock ,875
Wilmer will record the following journal entries on its books during We are familiar with the first three entries: purchase of the investment, recognition of dividends received, and recording of our proportionate share of earnings reported by Apex. The only new entry is the last one. This is the entry to recognize the additional depreciation that Wilmer must record. The journal entry is to debit investment revenue and credit investment in Apex stock for $1,875. The additional depreciation reduces the investment revenue Wilmer recognized.

42. Brief Ex 12-8
Turner Company owns 10% of the outstanding stock of ICA Company. During the current year, ICA paid turner a $500,000 cash dividend.
What journal entry is made for the dividend Turner receives in the current year?
Our sixth learning objective in Chapter 12 is to explain the adjustments made in the equity method when the fair value of the net assets underlying an investment exceed their book value at acquisition.

43. Brief Ex 12-8 Explanation
Turner should account for the dividends as trading or available for sale investments, unless they have the ability to exercise significant influence, then Turner would account for the investment using the equity method as investment revenue.
Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company.

44. Brief Exercise 12-7
Turner Company owns 40% of the outstanding stock of ICA Company. During the current year, ICA paid a $2 million cash dividend to Turner.
What journal entry is made for the dividend Turner receives in the current year?

45. Brief Exercise 12-7 Explanation
Turner is presumed to have the ability to exercise significant influence over ICA based on the 40% ownership.
Turner should account for ICA’s dividends as a reduction in its Investment in ICA account. Since investment revenue is recognized as ICA earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investment in ICA’s net assets, reflecting the fact that the Turner’s ownership interest in those net assets declined proportionately.

46. Brief Ex 12-9
The fair value of Wallis, Inc.’s depreciable assets exceeds their book value by $50 million. The assets have an average remaining useful life of 15 years and are being depreciated by the straight-line method. Park Industries buys 30% of Wallis’s common shares.
When Park adjusts its investment revenue and the investment by the equity method, what adjusting journal entry will be made?

47. Brief Ex 12-9 Explanation
The equity method reports acquired net assets at their fair values. Both the accounts Equity Income and Investment in Wallis would be reduced by the “extra depreciation” the higher fair value.
This would equal 30% x $50 million ÷ 15 years = ?
each year for fifteen years.

48. End of Required Course Material
The following will be covered in Advanced Accounting
Will not be tested on final.

49. Fair Value Option The investment is carried at fair value.
GAAP allows companies to use a “fair value option” for HTM, AFS, and equity method investments.
The investment is carried at fair value.
Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the investments as trading.
For equity method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.
The fair value option is determined for each individual investment, and is irrevocable.
GAAP allows companies to use a “fair value option” for HTM, AFS, and equity method investments as long as
The investment is carried at fair value and
Unrealized gains and losses are included in income.
For HTM and AFS investments, this amounts to classifying the investments as trading.
For equity method investments, the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.
The fair value option is determined for each individual investment, and is irrevocable.

50. Financial Instruments and Investment Derivatives
Cash.
Evidence of an ownership interest in an entity.
Contracts meeting certain conditions.
Investment Derivatives:
Value is derived from other securities.
Derivatives are often used to “hedge” (offset) risks created by other investments or transactions
Financial instruments include cash, evidence of ownership interest in an entity, and contracts meeting certain conditions. To be treated as a financial instrument will require a contract that (a) imposes on one entity an obligation to deliber cash (say accounts payable) or another financial instrument and (b) conveys to the second entity a right to receive cash (say accounts receivable) or another financial instrument, or A contract that (a) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms (say the issuer of a stock option) and (b) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms (say the holder of a stock option).
These financial instruments often are called derivatives because they “derive” their values or contractually required cash flows from some other security or index. For instance, an option to buy an asset in the future at a preset price has a value that is dependent on, or derived from, the value of the underlying asset. Their rapid acceptance as indispensable components of the corporate capital structure has left the accounting profession scrambling to keep pace. Derivatives are often used to “hedge” (offset) risks created by other financial investments or transactions.