Objective 1: Identify and Explain the Management Issues Related to Investments

CHAPTER 12

Investments

reviewing the chapter

Objective 1: Identify and explain the management issues related to investments.

1. In making investments, management must address the issues of recognition, valuation, classification, disclosure, and ethics.

2. The purchases and sales of investments, as well as the realization of investment income and gains and losses, are recognized in the accounting records as they occur. The cash amounts of purchases and sales of investments appear in the investing activities section of the statement of cash flows.

3. Investments are recorded at cost, which would include any commissions or fees paid. However, their valuation on the balance sheet should reflect (depending upon the type of investment) changes in their fair value, amortization, or changes in the operations of the investee companies. In addition, long-term investments must be evaluated annually for any impairment that appears to be permanent (whereby a loss would be recognized).

4. Investments in debt and equity securities are classified as either short-term or long-term. Short-term investments (also called marketable securities) have a maturity of more than 90 days but are intended to be held only until cash is needed for current operations. Long-term investments are intended to be held for more than one year, and are reported in the investments section of the balance sheet. Short- and long-term investments are further classified as trading, available-for-sale, and held-to-maturity securities.

a. Trading securities are debt or equity securities expected to be held for only a short period of time, in hopes of generating short-term gains. They are classified on the balance sheet as current assets.

b. Available-for-sale securities are debt or equity securities that do not qualify as either trading securities or held-to-maturity securities. They are classified as current assets or long-term investments, depending on management’s intent.

c. Held-to-maturity securities are debt securities that management intends to hold until their maturity date. They are classified as current assets or long-term investments, depending upon the proximity of the maturity date.

5. The percentage ownership in another company can be described as noninfluential and controlling, influential but noncontrolling, and controlling.

a. A noninfluential and noncontrolling investment exists when a company owns less than 20 percent of another company’s voting stock.

b. An influential but noncontrolling investment exists when a company owns 20 to 50 percent of another company’s voting stock. With that degree of ownership, the investor company can normally exercise significant influence over (i.e., affect) the investee’s operating and financial policies.

c. A controlling investment exists when a company owns more than 50 percent of another company’s voting stock. With that level of ownership, the investor company can normally exercise control over (i.e., decide) the investee’s operating and financial policies.

6. Companies provide detailed information about their investments and the manner in which they account for them in the notes to their financial statements.

7. In the United States, insider trading, or making use of inside information for personal gain, is both unethical and illegal. Specifically, before a publicly held corporation releases significant information about an investment, its officers and employees are not allowed to buy or sell stock in that company. Offenders are vigorously prosecuted by the Securities and Exchange Commission.

Objective 2: Explain the financial reporting implications of short-term investments.

8. As stated above, trading securities consist of both debt and equity securities expected to be held for just a short period of time. These securities, which serve to generate profits on short-term price increases, are valued on the balance sheet at their fair value (normally, market value). Also, dollar increases or decreases in the total trading portfolio during the period are reflected on that period’s income statement.

a. Upon the purchase of trading securities, Short-Term Investments is debited and Cash is credited.

b. At the end of the accounting period, the cost and market (fair) value of the securities are compared, and an adjustment is made. When a decline in value has been suffered, Unrealized Loss on Investments (an income statement account) is debited and Allowance to Adjust Short-Term Investments to Market (a contra-asset account) is credited. When, on the other hand, an increase in value is experienced, Allowance to Adjust Short-Term Investments to Market is debited and Unrealized Gain on Investments (an income statement account) is credited. In either case, the investments are reported on the balance sheet at market value.

c. When an investment is sold, Cash is debited for the proceeds, Short-Term Investments is credited for the original cost, and Realized Gain (or Realized Loss) on Investments is credited (or debited) for the difference.

9. As stated above, available-for-sale securities are debt and equity securities that do not qualify as trading or held-to-maturity securities. These securities are accounted for in the same way as trading securities, except that (a) an unrealized gain or loss is reported as a special item in the stockholders’ equity section of the balance sheet, and (b) if a decline in the value of a security is considered permanent, it is charged as a loss in the income statement.

Objective 3: Explain the financial reporting implications of long-term investments in stock and the cost-adjusted-to-market and equity methods used to account for them.

10. The cost-adjusted-to-market method should be used in accounting for noninfluential and noncontrolling available-for-sale investments. The equity method, on the other hand, should be used in accounting for all other (that is, influential or controlling) investments. In addition, consolidated financial statements should usually be prepared when a controlling relationship exists.

a. Under the cost-adjusted-to-market method, the securities are initially recorded at cost. As dividends are received, Dividend Income is recorded. At the end of the accounting period, an adjustment is made for the difference between total cost and total market value. If total cost exceeds total market value, Unrealized Loss on Long-Term Investments is debited and Allowance to Adjust Long-Term Investments to Market is credited for the decline in value. The Unrealized Loss account appears as a special item within stockholders’ equity (assuming the loss is temporary), as well as a component of comprehensive income. The Allowance account appears as a contra account to the investment. An adjusting entry opposite to the one described above would be made when market value relative to cost has increased. When the investment is sold, any realized gain or loss would be reported in the income statement.

b. Under the equity method, the investor records investment income as a debit to the Investment account and a credit to an Investment Income account. The amount recorded is the investee’s periodic net income times the investor’s ownership percentage. When the investor receives a cash dividend, the Cash account is debited and the Investment account is credited. All long-term investments in stock are initially recorded at cost, regardless of the method used to account for subsequent transactions.

11. When a company has a controlling interest in another company, the investor is called the parent company and the investee is called the subsidiary. Companies in such a relationship must prepare consolidated financial statements (combined statements of the parent and its subsidiaries).

Objective 4: Explain the financial reporting implications of consolidated financial statements.

12. Consolidated financial statements are useful because they present a financial picture of the entire economic entity (parent and subsidiaries). Preparing consolidated statements under the purchase method involves combining similar accounts from the separate statements of the affiliated companies.

13. When consolidated financial statements are prepared, eliminations must be made on the consolidating work sheet for intercompany items. Among those items that must be eliminated are intercompany receivables, payables, sales, purchases, interest income, and interest expense, as well as the investment in the subsidiary company. In addition, under the purchase method, the entire stockholders’ equity section of the subsidiary is eliminated. These eliminations appear only on the work sheet and not in the accounting records or on the consolidated financial statements.

14. Under the purchase method of preparing a consolidated balance sheet, the parent records the investment at the purchase cost.

a. When the book value of the net assets purchased equals their purchase cost, the assets and liabilities acquired should appear at cost on the consolidated balance sheet. No goodwill should be recorded.

b. The stockholders’ equity section of the subsidiary at acquisition is not included on the consolidated balance sheet.

c. When less than 100 percent of the subsidiary has been purchased, the minority interest (outside ownership) must be disclosed on the consolidated balance sheet, either as a component of stockholders’ equity or by itself between long-term liabilities and stockholders’ equity.

15. If the purchase cost exceeds the book value of the net assets purchased, the extra amount should be allocated to the assets and liabilities acquired when consolidated financial statements are being prepared. The allocation should be based on fair market values at the date of acquisition. Any unassigned excess should be recorded as goodwill (or goodwill from consolidation) in the consolidated balance sheet, subject to an annual impairment test.

16. When the book value of the net assets purchased exceeds their purchase cost, the book value of the subsidiary’s long-term assets (other than marketable securities) should be reduced proportionately until the extra amount is eliminate.

17. When preparing a consolidated income statement, intercompany items must be eliminated. They include (a) intercompany purchases and sales, (b) intercompany income and expenses on loans, receivables, or bond indebtedness, and (c) other intercompany income and expenses.

18. Businesses that expand internationally are called multinational or transnational corporations. When such a business prepares consolidated financial statements, it must include the financial information of any foreign subsidiaries it controls. However, before consolidation can take place, the subsidiary’s financial statements—most likely presented in a foreign currency—must be restated into the parent’s reporting currency (usually the U.S. dollar for U.S. companies).

Objective 5: Explain the financial reporting implications of debt investments.

19. As mentioned above, held-to-maturity securities are debt securities that management intends to hold until their maturity date. Such securities are recorded at cost and valued on the balance sheet at amortized cost (that is, at cost adjusted for the effects of interest). When held-to-maturity securities are purchased, Short-Term Investments is debited and Cash credited. At year-end, accrued interest is recognized with a debit to Short-Term Investments and a credit to Interest Income. At maturity, Cash is debited for the maturity amount, and Short-Term Investments and Interest Income are credited.

20. Long-term investments in bonds are recorded at cost (including commissions). When the bonds are purchased between interest dates, the investor must also pay for the accrued interest (which will be returned to the investor on the next interest payment date).

21. Most long-term bond investments are classified as available-for-sale securities because investors usually sell before the securities mature. Such securities are value at fair (market) value. Long-term bond investments are classified as held-to-maturity securities when an early sale is not intended. Such securities are valued at cost, adjusted by discount or premium amortization.

Summary of Journal Entries Introduced in Chapter 16