1. 1 CHAPTER 23 INVESTMENTS IN STOCKS AND BONDS OF OTHER COMPANIES

2. 2 Chapter Overview  How does a company classify its investments on its financial statements?  How does a company record and report its investments that are available for sale?  How does a company record and report its investments in companies over which it has significant influence?

3. 3 Chapter Overview  When and why does a company prepare consolidated financial statements?  How does a company record and report its investments in bonds that it expects to hold until maturity?

4. 4 Classification of Investments  Common stock is the ownership unit of a corporation; common stockholders are the owners.  Owners have the right to vote on company policies and the right to share in the corporation’s net income by receiving dividends.  Bonds are a type of note in which a company agrees to pay the holders the face value on maturity and interest periodically at a specified rate.  Bondholders are creditors and cannot vote; they only share in the company’s income by receiving a fixed amount of interest each period.

5. 5 Classification of Investments  A company (called an investor) may choose to invest in the common stock of another company (called an investee).  How the investor accounts for its investment under GAAP depends on its “influence” over the investee.  Influence is defined by the percentage ownership the investor company has in the investee; percentage ownership being the number of votes the investor has.

6. 6 Classification of Investments  If an investor company has no significant influence (less than 20% ownership), the investor has “available-for-sale stock “ and must use the market value method of reporting.  If an investor company has significant influence (20% to 50% ownership), the investor has an equity investment and uses the equity method of reporting.  If an investor company owns more than 50%, the investor has control and uses the consolidated method of reporting.

7. 7 Classification of Investments  A company may choose to invest in another company’s bonds. How the investor accounts for this investment under GAAP depends on how long it expects to hold the bond.  If the company expects to sell the bond before maturity date, it calls them “available for sale bonds” and reports this investment using the market value method.  If the company expects to hold the bonds to maturity, it calls them “held-to-maturity bonds” and reports this investment using the amortized cost method.

8. 8 Accounting for Investments

9. 9 Market Prices of Stocks and Bonds  A company (just like an individual) usually makes an investment in stocks or bonds of publicly traded companies through a stockbroker.  Stocks and bonds of large corporations are traded on organized securities exchanges such as the New York Stock Exchange, the Tokyo Stock Exchange, or the Oslo Stock Exchange.  The stocks of other companies are traded in the over-the-counter markets, such as NASDAQ, in which brokers deal directly with each other rather than through stock exchange.

10. 10  The market prices of stocks are quoted daily and are reported on many Internet sites and in many newspapers. For example, the stock of IBM was recently listed as follows – what does all of this mean? Market Prices of Stocks The stock sold at a high of $126.39 and a low of $66.10 per share in the last 52 weeks. The stock ticker symbol The stock price decreased 39.2% in the last year. The closing price is 18 times EPS for last 4Qs 5,204,400 shares traded Dividend as % of market price Closing price per share Change in price from previous day The annual dividend per share

11. 11  The market prices of bonds are quoted daily and are reported on many Internet sites and in many newspapers. For example, IBM bonds were recently listed as follows – what does all of this mean? This is the contract rate of interest paid (7%) – bonds due 2025 10 bonds were traded Based on current market price, yield is 6.8%. Change in price from previous day The bond is trading at 102.63% of face, or $1,026.30 Market Prices of Bonds

12. 12  A company uses the market value method for investments in the available-for-sale securities category.  Stock is this category means the investor does not have significant influence (less than 20% ownership). For bonds, it means the investor does not expect to hold them to maturity.  Available-for-sale securities are sometimes called marketable securities. Market Value Method

13. 13  Under the market value method, a company must report investments at their fair market value on the balance sheet at the end of the year. This is based primarily on management’s intention – the intention not to hold the securities.  Lets look at a comprehensive example of how to record the investment, report investment income, report the value on the balance sheet, and calculate gain or loss on sale when this method is used. Market Value Method

14. 14  Suppose Unlimited Decadence purchases 200 shares of Fox Company common stock for $4,000 and 8 bonds of Crow Company for $8,000. These investments qualify as available-for-sale securities.  The bonds have a contract interest rate of 10% and pay interest semiannually on June 30 and December 31. How are the investments initially recorded. Market Value Method -$12,000 (Cash) Assets = Liabilities + Stockholders’ Equity +$12,000 (Investments in Available-for- Sale Securities)

15. 15 +$400 (Cash) +$200 (Cash) Assets = Liabilities + Stockholders’ Equity  During 2004, Unlimited Decadence receives $200 in dividends from the Fox Company common stock.  Also during 2004, Unlimited Decadence receives interest payments on the Crow Bonds. On each payment date, $400 would be received ($8,000 X 10%/2). Only one interest payment is illustrated below. Market Value Method +$400 (Interest Revenue) Crow interest payment +$200 (Dividend Revenue) Fox cash dividend

16. 16  Under the market value method, Unlimited Decadence must adjust the value of its available- for-sale securities to fair market value at year-end even though they are still on hand.  Based on a review of market value, the available- for-sale investments are worth $12,500, up $500 from when they were purchased on January 1. How is this recorded? Market Value Method Assets = Liabilities + Stockholders’ Equity +$500 (Available-for- sale Securities) +$500 (Unrealized Increase in Market Value of Investments) The value of the securities on the balance sheet is now $12,500, the current market value The unrealized gain is not reported as income on the income statement but is part of comprehensive income in stockholders’ equity

17. 17 Schedule to Compute Market Value of Investments in Available-for-Sale Securities

18. 18  When Unlimited Decadence sells an investment, it must record the cash received, reduce the investment account, and record a gain or loss that is reported on the income statement.  When the gain or loss is reported on the income statement, any related unrealized gain or loss already recognized under the market value method must be reversed.  This means if Unlimited Decadence sells the 200 shares of Fox Company stock, the $600 increase in market value already recognized must be reversed when the gain is recognized on the income statement. Market Value Method

19. 19  If 200 shares of Fox Company are sold for $4,800, what is the gain and how is it recorded?  The gain is calculated as follows: Market Value Method -$600 (Unrealized Increase in Market Value of Investments) -$4,600 (Available- for-sale Securities) +$800 (Gain on Sale of Investment Assets Stockholders’ Equity +$4,800 (Cash) When the gain is reported on the income statement, the related unrealized gain account must be eliminated

20. 20 Equity Method  A company whose investment in the common stock of another company enables it to have significant influence (but not control) over the operations of the other company uses the equity method to account for the investment.  Under GAAP, significant control exists when the investee owns between 20% and 50% of the investee’s common stock.  Under the equity method, the investee accounts for its investment using the following formula: Investment = Cost+ Income earned- Dividends Received

21. 21 Equity Method Investment = Cost+ Income earned- Dividends Received  The investor company records as income its share of the investee company’s net income, which increases the investment account.  The investor company records as dividend income its share of dividends paid by the investee company, which decrease the investment account. Income Earned = Investee’s Net Income X Investor’s Ownership % Dividends Received = Investee’s Dividends Paid X Investor’s Ownership %

22. 22  On January 1, 2004, suppose Unlimited Decadence purchased 30% of Sanchez Sugar Company’s common stock for $60,000.  This is an equity investment because ownership is at least 20% but not more than 50%. How is this recorded? Accounting for Equity Method Transactions -$60,000 (Cash) Assets = Liabilities + Stockholders’ Equity +$60,000 (Investment in Sanchez Sugar Company)

23. 23  An the end of 2004, Sanchez reports net income of $40,000 and pays dividends of $10,000.  Using the equity investment formula, how is the income earned and dividends received calculated? Accounting for Equity Method Transactions Investment = Cost+ Income earned- Dividends Received Income Earned = $40,000 net income X 30% = $12,000 Dividends Received = $10,000 dividend paid X 30% = $3,000

24. 24  The share of net income earned by Unlimited Decadence is $12,000. This increases the investment account and is also reported as income on the income statement in 2004. Accounting for Equity Method Transactions Assets = Liabilities + Stockholders’ Equity +$12,000 (Investment in Sanchez Sugar Company) +$12,000 (Income from Investment in Sanchez Sugar Company) Income Earned = $40,000 net income X 30% = $12,000

25. 25  The share of dividends received by Unlimited Decadence is $3,000. This increases cash and decreases the investment account in 2004. Accounting for Equity Method Transactions -$3,000 Investment in Sanchez Sugar Company) Assets = Liabilities + Stockholders’ Equity +$3,000 (Cash) Dividends Received = $10,000 dividend paid X 30% = $3,000

26. 26 Equity Method  At the end of 2004, Unlimited Decadence's 30% interest in Sanchez Sugar Company is reported on the balance sheet at $69,000, summarized as follows:

27. 27 Consolidated Financial Statements  When an investor company owns more that 50% of the common stock of another company, the investor has control over the investee.  In this situation, the investor is called the parent company and the investee is called the subsidiary company.  The parent and subsidiary companies are legally separate entities and keep separate accounting records. Users are interested in financial statements that report their combined activities.

28. 28 Consolidated Financial Statements  Consolidated financial statements are a single set of financial statements that combine the parent company with all other companies over which it has control.  The underlying GAAP reasoning is that the parent and its controlled subsidiaries represent a single economic entity for financial reporting purposes.  This is another good illustration of where economic substance takes precedent over legal form in GAAP.

29. 29 Segment Reporting  Even though a company files consolidated financial statements, information about reporting operating segments must also be provided under GAAP.  A company may have many operating segments, but GAAP only requires additional information about those segments that qualify as reportable segments by meeting certain reporting tests, such as profit or revenue.  Reportable segments must provide their profit or loss, assets, and general information such as products and geographic areas.

30. 30 Consolidated Financial Statements and Segment Reports Exhibit 23-4

31. 31 Investments in Held-to-Maturity Bonds  An investor company may invest in bonds that it expects to hold until maturity.  These investment do not qualify as available-for- sale investments under the market value method.  When a company purchases bonds as an investment and has both the intent and the ability to hold bonds until maturity, the investments are reported at their cost.  If the purchase involved a discount or premium, then the investment is reported at its amortized cost.

32. 32 Zero-Coupon Bonds  Recall from Chapter 22 that zero-coupon bonds pay no interest each period.  These investments are always purchased at a discount, and the different between the purchase price and the maturity value is interest which is accrued over time by the buyer and the seller.  As the interest is recognized, this is called amortizing the discount.

33. 33  For example, assume Beany Biscuit Company purchased for $385,500 (at a 10% yield) all of Unlimited Decadence’s 10-year $1,000,000 face value zero-coupon bonds on January 1, 2004.  Purchase price = $1,000,000 X 0.3855 (Table 20-1 - present value of a single sum for 10 periods at 10%) = $385,500 Recording the Purchase of Zero-Coupon Bonds -$385,500 (Cash) +$385,500 (Investment in Held-to- Maturity Bonds) Assets = Liabilities + Stockholders’ Equity

34. 34  The interest income for the first year is then computed as follows: X Book Value of Bonds Payable at Beg. of Period = Interest Revenue X $385,500 = $38,550 10% Yield (the market rate) Recording the Interest Revenue on Zero-Coupon Bonds

35. 35  To report the interest revenue on the zero coupon bonds, Beany Biscuit Company would increase its investment in its held-to- maturity bonds and increase interest revenue for $38,550. Recording the Interest Revenue on Zero-Coupon Bonds Assets = Liabilities + Stockholders’ Equity +$38,550 Investment in (Held-to- maturity Bonds) +$38,550 (Interest Revenue)

36. 36  By looking at a bond amortization schedule, it is easier to see how the pieces fit together: Recording the Interest Revenue on Zero-Coupon Bonds Interest revenue for 2005 is then calculated as $424,050 X 10% = $42,405; each time interest revenue is reported, the bond’s book value increases for the discount amortized.