University of California, Santa Barbara

University of California, Santa Barbara
Prepared by Coby Harmon University of California, Santa Barbara Westmont College Copyright ©2015 Pearson Education Inc. All rights reserved.

Copyright ©2015 Pearson Education Inc. All rights reserved.
Investments Stocks Bonds Investor (entity that owns stock or bonds of a corporation) Investee (entity that issues stock) Debtor (entity that issues bonds) Copyright ©2015 Pearson Education Inc. All rights reserved.

Stock and Bond Prices During the previous 52 weeks, Intel common stock had a High price of $29.27 per share and a low of $19.23 per share Annual cash dividend was $0.90 per share 17.34 million shares traded the previous day Stock closed at $21.26, up $0.11 from preceding day Copyright ©2015 Pearson Education Inc. All rights reserved.

Reporting Investments on the Balance Sheet Short-term or long-term Short-term investments are current assets Trading Held-to-maturity Available-for-sale To be listed as short-term must be liquid (readily convertible to cash), and intend to convert investment to cash within one year or to use it to pay a current liability Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Relationship between issuing corporation and investor If investing company intends to hold a debt security until maturity, it accounts for the security at amortized cost LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Reported at amortized cost Interest received semi-annually Usually issued in $1,000 denominations Price is quoted as percent of par Fluctuate with market interest rates If market rate > face rate, sell at discount If market rate < face rate, sell at premium LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Initially recorded at cost Interest revenue recorded at semiannual interest payment date Premium or discount is amortized Carrying value is adjusted towards face value Face value received at maturity LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Illustration: Intel Capital Purchases $10,000 of 6% CBS bonds at a price of on April 1, 2014 Intends to hold bonds until their maturity date, April 1, 2018 Interest dates are semiannual, on April 1 and October 1 Bonds mature on April 1, 2018, they will be outstanding for four years (48 months) LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Intel Capital records the purchase of $10,000 of 6% CBS bonds at a price of 95.2 on April 1, 2014. Bond issue price = $10,000 x = $9,520 Account Debit Credit Apr 1 Held-to-Maturity Investment 9,520 Cash 9,520 To purchase bond investment LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Intel Capital purchased $10,000 of 6% CBS bonds at a price of on April 1, Intel records the receipt of interest and amortization of the discount on October 1, 2014, as follows: Account Debit Credit Oct 1 Cash ($10,000 x .06 x 6/12) 300 Interest Revenue 300 To receive semiannual interest Oct 1 Held-to-Maturity Investment 60 * Interest Revenue 60 Amortize discount on bond investment * [($10,000 - $9,520) ÷ 48] x 6 = 60 LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Intel Capital purchased $10,000 of 6% CBS bonds at a price of on April 1, At December 31, 2014, Intel Capital’s year-end adjustments are: Account Debit Credit Dec 31 Interest Receivable 150 Interest Revenue 150 $10,000 x 0.06 x 3/12 Dec 31 Held-to-Maturity Investment 30 Interest Revenue 30 [($10,000 - $9,520) ÷ 48] x 3 LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN HELD-TO-MATURITY DEBT SECURITIES Financial statements of Intel Capital at December 31, 2014 By April 1, 2018 (maturity date) carrying value will equal face value LO 1 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES Available-for-Sale Securities Less than 20% ownership Long-term Recorded at cost Adjusted to fair value at each reporting period Exhibit 8-3 | Accounting Methods for Long-Term Stock Investments by Percentage of Ownership LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES Illustration: Intel purchases 1,000 shares of Hewlett-Packard common stock at the market price of $44 per share. Intel intends to hold this investment for longer than a year and therefore treats it as a long-term available-for-sale security (AFSS). Intel’s entry to record the investment is Account Debit Credit Oct 23 Investment in AFSS (1,000 x $44) 44,000 Cash 44,000 Purchase investment LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES Illustration: Assume that Intel receives a $0.20 cash dividend per share on the Hewlett-Packard stock. Intel’s entry to record receipt of the dividend is Account Debit Credit Nov 14 Cash (1,000 x $20) 200 Dividend Revenue 200 Received Cash Dividend LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

The Fair Value Adjustment (AFSS) GAAP requires available-for-sale securities be reported at fair value as of the balance sheet date Three approaches to determine fair value Level 1: Quoted prices in active markets for identical assets Level 2: Estimates based on prices for similar assets Level 3: Estimates based on company’s own estimates LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

The Fair Value Adjustment (AFSS)
Carrying Amount of Investment Original cost of investment If fair value > cost Debit balance in Allowance to Adjust Investments to Market OR If fair value < cost Credit balance in Allowance to Adjust Investments to Market LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

The Fair Value Adjustment (AFSS) Illustration: Continuing with the previous example, assume that the quoted market price of the stock is $46.50, making fair value of the 1,000 shares of Hewlett-Packard common stock $46,500 on December 31, In this case, Intel makes the following entry to adjust the investment to fair value: Account Debit Credit Dec 31 Allowance to Adjust Investment in AFSS to Market 2,500 Unrealized Gain on Investment in AFSS 2,500 ($46,500 - $44,000) LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

The Fair Value Adjustment (AFSS)
Unrealized Gains and Losses Fair value declines Unrealized loss on investments DEBIT Reported as element of other comprehensive income Fair value increases Unrealized gain on investments CREDIT LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

The Fair Value Adjustment (AFSS) Unrealized Gain (or Loss) on Investment in AFSS account Change in owners’ equity Reported as element of accumulated other comprehensive income Bypasses net income Reported in separate Statement of comprehensive income or Section of income statement below net income in a combined statement of income and comprehensive income LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Statement of Comprehensive Income
The Fair Value Adjustment (AFSS) Statement of Comprehensive Income LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Selling an Available-for-Sale Investment Suppose Intel sells its entire investment in Hewlett-Packard stock for $43,000 during Intel would record the sale as follows: Account Debit Credit May 19 Unrealized Gain on Investment in AFSS 2,500 Allowance to Adjust Investment in AFSS to Market 2,500 Eliminate unrealized gain on AFSS sold May 19 Cash 43,000 Loss on Sale of Investment in AFSS 1,000 Investment in AFSS 44,000 Sold investment LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Suppose Intel Corporation holds the following available-for-sale securities as long-term investments at December 31, 2015: Show how Intel will report long-term investments on its December 31, 2015, balance sheet. Answer: Assets Investment in AFSS $83,000 LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Illustration Journalize the following long-term available-for-sale security transactions of Barbara Brothers Department Stores: Purchased 410 shares of California Fine Foods common stock at $35 per share, with the intent of holding the stock for the indefinite future. Received a cash dividend of $1.90 per share on the California Fine Foods investment. At year-end, adjusted the investment account to fair value of $41 per share. Sold the California Fine Foods stock for the price of $25 per share. LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Illustration: Journal entries for long-term available-for-sale security transactions of Barbara Brothers Department Stores: Account Debit Credit a. Investment in AFSS (410 x $35) 14,350 Cash 14,350 b. Cash (410 x $1.90) 779 Dividend Revenue 779 c. Allowance to Adjust Investment in AFSS to Market 2,460 Unrealized Gain on Investment in AFSS 2,460 (410 shares x ($41 - $35) = $2,460) LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

Illustration: Journal entries for long-term available-for-sale security transactions of Barbara Brothers Department Stores: Account Debit Credit d. Unrealized Gain on Investment in AFSS 2,460 Allowance to Adjust Investment in AFSS to Market 2,460 Eliminate unrealized gain on AFSS sold d. Cash (410 x $25) 10,250 Loss on Sale of Investment in AFSS 4,100 Investment in AFSS 14,350 Sold investment LO 2 Copyright ©2015 Pearson Education Inc. All rights reserved.

ANALYZE AND REPORT INVESTMENTS IN AFFILIATED COMPANIES USING THE EQUITY METHOD Buying a Large Stake in Another Company Method used when investor owns between 20 – 50% of investee’s voting stock Investor has significant influence over investee operations Investment initially recorded at cost Investor records its share of investee net income and dividends LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-Method Investments Illustration: January 1, 2014, Intel pays $490 million for 49% of the ownership of IM Flash Technologies, LLC. Intel’s entry to record the purchase of this investment follows (in millions): Account Debit Credit Jan 1 Equity-method Investment 490 Cash 490 LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-Method Investments
Illustration: IM Flash Technologies reports net income of $300 million for 2014, Intel records 49% of this amount as follows (in millions): Account Debit Credit Dec 31 Equity-method Investment 147 Equity-method Investment Revenue 147 Net income $300 million x 49% = $147 million LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-Method Investments
Illustration: IM Flash declares and pays a cash dividend of $200 million, Intel receives 49% of this dividend and records this entry (in millions): Account Debit Credit Dec 31 Cash 98 Equity-method Investment 98 Dividends $200 million x 49% = $98 million LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-Method Investments Illustration: Intel’s Equity-method Investment account at December 31, 2014, shows Intel’s equity in the net assets of IM Flash Technologies (in millions): LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-Method Investments Illustration: Intel’s sale of 20% of the IM Flash Technologies common stock for $100 million on January 1, 2015 would be recorded as follows (in millions): Account Debit Credit Jan 1 Cash 100.0 Loss on Sale Equity-method Investment 7.8 Equity-method Investment 107.8 Purchase of 49% $ 490 % of investee income + 147 Dividends received x 20% = $107.8 LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Illustration Larsen Corporation owns equity-method investments in several companies. Suppose Larsen paid $1,800,000 to acquire a 40% investment in Lim Software Company. Lim Software reported net income of $650,000 for the first year and declared and paid cash dividends of $450,000. Requirements Record the following in Larsen’s journal: (a) purchase of the investment, (b) Larsen’s proportion of Lim Software’s net income, and (c) receipt of the cash dividends. What is the ending balance in Larsen’s investment account? LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Illustration: Journal entries for equity-method investment transactions of Larsen Corporation: Account Debit Credit a. Equity-method Investment 1,800,000 Cash 1,800,000 b. Equity-method Investment 260,000 Equity-method Investment Revenue 260,000 ($650,000 x 40%) c. Cash ($450,000 x 40%) 180,000 Equity-method Investment 180,000 LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

Equity-method Investment
Illustration: What is the ending balance in Larsen’s investment account? Equity-method Investment Purchase $1,800,000 Earnings 260,000 180,000 Dividends End balance $1,880,000 LO 3 Copyright ©2015 Pearson Education Inc. All rights reserved.

CONTROLLING INTERESTS IN OTHER CORPORATIONS USING CONSOLIDATED FINANCIAL STATEMENTS Why Buy Controlling Interest in Another Company? Investor controls investee Owns more than 50% of investee’s voting stock Investor can elect majority of board members Investor is called the parent company Investee is called the subsidiary LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Why Buy Controlling Interest in Another Company? McAfee, Inc. is a Subsidiary of Intel Corporation. Stockholders of Intel control McAfee, Inc., as shown in Exhibit 8-4 Exhibit 8-4 LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Consolidation Accounting Method of combining financial statements of all companies controlled by same stockholders Result is a single set of statements as if parent and its subsidiaries are one company Gives better perspective on total operations than individual statements Worksheet is used to combine parent and sub accounts Intercompany accounts are eliminated LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Consolidation Accounting Exhibit 8-6 | Parent Company with Consolidated Subsidiaries and an Equity-Method Investment Consolidated entities are enclosed by the dashed line LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Examine Exhibit 8-7. Why does the consolidated stockholders’ equity ($176,000 + $155,000) exclude the equity of Subsidiary Corporation? Answer: The stockholders’ equity of the consolidated entity is that of the parent only. To include the stockholders’ equity of the subsidiary as well as the investment in the subsidiary on the parent’s books would be double counting. LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Noncontrolling Interest
Goodwill and Noncontrolling Interest Goodwill Noncontrolling Interest Arises when parent pays more to acquire a subsidiary than the fair value of its net assets Recorded as an intangible asset Arises when parent company owns less than 100% of subsidiary stock Recorded as a separate account in the stockholders’ equity section LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Income of a Consolidated Entity Illustration: Suppose Parent Company owns all the stock of Subsidiary S-1 and 60% of the stock of Subsidiary S-2. During the year just ended, Parent earned net income of $330,000, S-1 earned $150,000, and S-2 had a net loss of $100,000. Parent Company would report net income computed as follows: Advance slide in presentation mode to reveal answers LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Accounting Methods for Long-Term Investments
Type of Long-Term Investment Accounting Method Intel owns a portfolio of bond and other debt securities as well as equity securities (less than 20%) that it intends to hold long-term Available-for-sale Intel owns between 20 – 50% of investee/affiliate stock Equity Intel owns more than 50% of investee stock Consolidation Intel owns bonds that it intends to hold to maturity Amortized cost LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Many U.S. companies conduct a large part of their business abroad. Intel, General Electric, and PepsiCo, among others, are more active in other countries than they are in the United States. In fact, Intel earns 84% of its revenue outside the United States. Exhibit 8-8 shows the approximate percentages of international revenues for these companies. LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Foreign Currencies and Exchange Rates International business often results in companies receiving or paying in a foreign currency Measure of one nation’s currency against another: Foreign-currency exchange rate Conversion of an item in one currency to another: Translation LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Ratio of Imports to Exports Rate of Return in Capital Markets
Factors Affecting Exchange Rates Ratio of Imports to Exports Rate of Return in Capital Markets If exports exceed imports, increase in demand drives up price of currency If imports exceed exports, supply increases and currency price falls If high, increases international investments and demand for currency LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Foreign Currency Translation Adjustments Foreign subsidiaries financial statements are translated into US dollars Assets and liabilities at current exchange rates Stockholders’ equity at historical exchange rates Difference cause out-of-balance condition Translation adjustment needed to balance LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Foreign Currency Translation Adjustments Illustration: Intel has an Italian subsidiary whose financial statements are expressed in euros (the European currency). Intel must consolidate the Italian subsidiary’s financials into its own statements. When Intel acquired the Italian company in 2009, a euro was worth $1.35 (assumed). When the Italian firm earned its retained income during 2009–2014, the average exchange rate was $1.30 (assumed). On the balance sheet date in 2014, a euro is worth only $1.20 (assumed). Exhibit 8-10 shows how to translate the Italian company’s balance sheet into dollars. LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

Foreign Currency Translation Adjustments Illustration: Exhibit 8-10 shows how to translate the Italian company’s balance sheet into dollars Exhibit 8-10 Foreign-currency translation adjustment is the balancing amount that brings total liabilities and equity into agreement with total assets LO 4 Copyright ©2015 Pearson Education Inc. All rights reserved.

REPORT INVESTING ACTIVITIES ON THE STATEMENT OF CASH FLOWS Exhibit 8-11 | Intel Corporation’s Investing Activities on the Statement of Cash Flows LO 5 Copyright ©2015 Pearson Education Inc. All rights reserved.

IMPACT OF THE TIME VALUE OF MONEY ON CERTAIN TYPES OF INVESTMENTS Time Value of Money Money earns interest over time Interest is the cost of using money To borrowers, interest is the fee To lenders, interest is the revenue earned LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

TIME VALUE OF MONEY Future Value Value at a specified date in the future Suppose you invest $4,545 in corporate bonds that pay 10% interest each year. After one year, the value of your investment has grown to $5,000 Exhibit 8-12 | Future Value of an Investment LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

TIME VALUE OF MONEY Future Value To calculate, need three inputs: Amount of initial payment (or receipt) Length of time between investment and future receipt (or payment) Interest rate Compound interest is interest you receive on the interest you have already earned LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

TIME VALUE OF MONEY Future Value The following table shows interest revenue earned on the original $4,545 investment each year for five years at 10%: LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value Value on a given date of a future payment or series of future payments, discounted to reflect the time value of money Often called discounting To simplify calculations Present value tables Excel software Single amount or annuity LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value Illustration: In our investment example, the future receipt is $5,000. The investment period is one year. Assume that you demand an annual interest rate of 10% on your investment. With all three factors specified, you can compute the present value of $5,000 at 10% for one year: LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value Illustration: If the $5,000 is to be received two years from now, you will pay only $4,132 for the investment, as shown in Exhibit 8-13. Exhibit 8-13 | Present Value: An Example Difference of $868 between amount invested ($4,132) and amount to be received ($5,000) is the return on investment LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value Tables Illustration: Compute the present value of $5,000 at 10% for one year: Present Value? Future Value $5,000 1 2 3 4 5 6 What table do we use? LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value of an Ordinary Annuity Ordinary annuity investments provide multiple receipts of an equal amount at fixed year-end intervals over the investment’s duration Illustration: Compute the present value an investment that promises annual cash receipts of $10,000 to be received at the end of each year for three years. Assume a 12% return on investment. Future Values Present Value? $10,000 $10,000 $10,000 1 2 3 4 5 6 LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value of an Investment in Bonds Illustration: Compute the present value of 9% five-year bonds of Southwest Airlines from the standpoint of an investor Face value of bonds is $100,000 Face interest rate is 9% annually Bonds pay 4 1/2% interest semiannually Market interest rate is assumed to be 10% annually 5% rate used to compute present value Market price of these bonds is $96,149 LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

Present Value of an Investment in Bonds Illustration: Compute the present value of 9% five-year bonds of Southwest Airlines from the standpoint of an investor LO 6 Copyright ©2015 Pearson Education Inc. All rights reserved.

This work is protected by United States copyright law and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright ©2015 Pearson Education Inc. All rights reserved.

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