ACCT 101 - Professor Farina

APPENDIX C: INVESTMENTS

BASICS OF INVESTMENTS

Why do Corporations Invest in Other Entities’ Stocks or Bonds?

Most companies make investments for two reasons:

  1. Use excess cash to produce higher income.
  2. Obtain influence or control over another company.

Classifying Investments Not Made to Obtain Influence or Control

Investments in cash equivalents (money market funds or highly-liquid investments with original maturities of less than 3 months, such as bank certificates of deposit and U.S. Treasury bills) are always classified as current assets.

Companies may also invest in stocks or bonds of other entities. Broker fees are classified as a cost of the investment, not as an expense. Let’s assume for now that the investments in other companies’ stocks were not made for purposes of gaining influence or control. Generally accepted accounting principles require classification of these investments into one of three categories: Trading Securities, Held-to-Maturity Securities, or Available-for-Sale Securities. The table below summarizes the types of investments and financial reporting required.

Classification Includes Financial Reporting

Trading / Investments in stocks or bonds that are actively traded by the investor company. / The investments are adjusted to market value at the end of the accounting period. Any unrealized gain or loss is recorded and included as “Other Income (Expense)” in the Income Statement.
Held-to-Maturity / Investments in debt securities, such as bonds, that are expected to be held until they mature. / These investments are not adjusted to market value. They are reported at amortized cost.
Available-for-Sale Securities / Investments in stocks or bonds that are neither trading nor held-to-maturity. / The investments are adjusted to market value at the end of the accounting period. Any unrealized gain or loss is recorded and included as “Unrealized Gain” or “Unrealized Loss” in the stockholders’ equity section of the Balance Sheet.

Trading Securities are always classified as current assets. Held-to-Maturity investments are usually classified as long-term assets, since they comprised primarily of investments in bonds. Available-for-Sale Securities may be classified as either current or long-term assets, depending on management’s intent to dispose of the investments.

Sale of Investments

When an investment is sold, its carrying value is removed from the books and the cash receipt recorded. If the cash received is higher than the carrying value of the investment, a gain is recognized. If the cash received is less than the carrying value of the investment, a loss is recognized. These are called “realized” gains or losses. They are reported in the “Other Income (Expense)” section of the income statement.

Any brokerage or other fees incurred to sell investments are not recorded as expenses, as they have been deducted from the cash received from the broker.

Here are some video examples of accounting for these investments.

Trading securities:
http://www.viddler.com/embed/dfd89921/?f=1&autoplay=0&player=full&disablebranding=0" width="545" height="451" frameborder="0"</iframe>

Available-for-Sale securities:

http://www.viddler.com/embed/b660d69b/?f=1&autoplay=0&player=full&disablebranding=0" width="545" height="451" frameborder="0"</iframe>

Held-to-maturity securities:

http://www.viddler.com/embed/508b56d9/?f=1&autoplay=0&player=full&disablebranding=0" width="545" height="451" frameborder="0"</iframe>

Investments Made to Gain Influence or Control

Companies often make investments in other firms’ common stock to obtain either significant influence or control. When the investor owns between 20% - 50% of the investee company’s common stock, they are usually presumed to have a significant influence over the investee company’s operations. If the investor company owns more than 50% of the investee company’s common stock, they have control over the investee company.

Accounting for Investments with Significant Influence

Investments of between 20% - 50% in another company’s common stock are accounted for using the equity method. An illustration of the accounting required by the equity method follows.

On January 1, 2017, Washington Company purchased 4,000 of the 10,000 common shares of Lincoln Corporation for $100,000. Since that gives Washington a 40% ownership in Lincoln, Washington will use the equity method of accounting for its investment in Lincoln stock.

Lincoln Corporation’s income statement for the year ended December 31, 2017 reported net income of $25,000. On December 31, 2017, Lincoln Corporation declared and paid common dividends of $1 per share.

The journal entries to record each of these transactions by Washington Company are below.

Record purchase of 4,000 Lincoln Corporation stock:

Long-Term Investments-Lincoln 100,000

Cash 100,000

Record 40% equity in investee earnings:

Long-Term Investments-Lincoln 10,000

Earnings from Long-Term Investments 10,000

(40% stock ownership * $25,000 net income)

Record receipt of cash dividends paid by Lincoln:

Cash (4,000 shares * $1) 4,000

Long-Term Investments-Lincoln 4,000

The Long-Term Investments-Lincoln account would have a balance of $106,000 at December 31, 2017 ($100,000 + $10,000 - $4,000). This balance would be reported as a long-term asset in the balance sheet.

The Earnings from Long-Term Investments account balance of $10,000 would be reported as “Other Income” in Washington Company’s income statement.

Here is an example of accounting using the equity method.

http://www.viddler.com/embed/fd8b02c1/?f=1&autoplay=0&player=full&disablebranding=0" width="545" height="451" frameborder="0"</iframe>

Accounting for Investments with Controlling Influence

An investor who owns more than 50% of a company’s voting common stock has control over the investee company, as the investor can control election of the investee company’s board of directors.

In this case, the controlling investor (parent company) must use the equity method for its investment in the investee company (subsidiary company). The parent company must also consolidate the financial statements of the subsidiary company with its own financial statements. The study of consolidated financial statements is covered in the advanced accounting course.

Return on Total Assets ratio

The return on total assets ratio is one way to assess a company’s ability to generate net income from its assets. We will use the short formula for this ratio, which is:

Net Income ÷ Average total assets.

Here is a video demonstrating the calculation and analysis of the return on total assets.

http://www.viddler.com/embed/db77f9e3/?f=1&autoplay=0&player=full&disablebranding=0" width="545" height="451" frameborder="0"</iframe>

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